Many ETFs over-concentrated

"There is a widespread assumption that indexed funds look after these things for investors and ensure that they are immune from company-specific risk. Not so. Investors in these funds often unwittingly break some of the most basic rules of prudent portfolio management."  John Plender in the FT writes.  

The answer would be education.  (Is that not the answer for almost everything?) If people really knew what they are buying, then they could be happy either a concentrated fund like these or settle for an ETF that tracks the World index or a broader US index. It is not such a big problem except that the writer indicates that consumers presumably do not understand what they are buying.

"Take the Nasdaq 100 index on which the popular PowerShares Nasdaq 100 ETF is based. It has almost $50bn of assets, making it one of the 10 largest ETFs in the US. ..just the top five holdings in the Nasdaq 100 — Apple, Google, Microsoft, Amazon and Facebook — comprise 41 per cent of the value of the entire index. If an active manager took on such a concentration of risk it would be regarded as daring, bordering on reckless. ... in some jurisdictions it would violate regulations.  Concentration risk that is forbidden to an active manager is considered reasonable and permissible if it happens to be an index.

A case in point is Europe, where certain UCITS funds cannot have more than 40% exposure from position sizes of 5% or greater. To do so is indeed considered reckless. Yet, the Nasdaq 100 is available via the iShares Nasdaq 100 UCITS ETF and has more than $1.1bn in assets under management in the UK alone. In other words, concentration risk that is forbidden to an active manager is considered reasonable and permissible if it happens to be an index. This is dangerous nonsense.

Similar considerations apply to smart-beta strategies, whereby the fund manager recalibrates broad indices to reflect factors such as growth, value, low volatility, dividends or momentum. Backtesting of these strategies throws up favourable results partly because they tend to have a bias towards value and small-capitalisation stocks, which academic research suggests outperform over the long run...."

Cross fertilise. Read about the autistic mind here and ideas on the arts here. On investing try a thought on stock valuations. 

Drones Inspecting Environment

The use of drones in China to follow up on environmental inspections seems like it should be science fiction, but is an evolving reality (SCMP post article). Amazon are developing drones, Walmart too for inventory management (though they seem a long term loser to Amazon); Easyjet have thought about them for inspections and maintenance of planes.

"Dongguan, one of the world’s biggest manufacturing hubs, is home to more than 300,000 factories making everything from shoes to smartphones, and all crammed into a region about the size of Hong Kong. About 200 environmental inspectors oversee the plants’ emissions.

The use of pollution-detecting drones has helped the city identify and punish tens of thousands of polluting factories, and cut the number of smoggy days to just 12 last year from 104 in 2015, when the devices were introduced as part of an environmental clean-up campaign, according to the local environmental protection bureau.

In the past, residents would regularly don face masks on the streets to protect themselves from the smog. But the practice has since waned as the city’s air quality is now ranked among the best in China. The average PM2.5 level – the small polluting particles deemed most harmful to health – is 35 micrograms per cubic metre, close to that of downtown Paris."

"With the help of drones, any resident can now pick up their phone and stop pollution within hours." From the SCMP post article. There are wider implications, but it is a sign of how technology might be used in ways unexpected to combat our problems.

It is impacting agriculture too:

"Another major application for drones is in agriculture. Liu Jun, a farmer from the village of Dongan, Yanshou county, in northern China’s Heilongjiang province, said that this summer it was almost impossible to cross a field without hearing the buzzing of drones.

“That wasn’t the case last year. Then, boom, there were drones everywhere. And they’re doing all the dirty and harmful work such as spraying crops with pesticides and disease prevention drugs,” Liu said.


“Overnight, their performance [in the agriculture sector] has changed farmers’ suspicions of new technology. Now almost every farming family in our village has either bought or hired a drone.”

Heilongjiang, which spans more than 13 million hectares of flat, fertile farmland, churns out more agricultural products than any other province in China. According to government statistics, its annual food output is enough to feed everyone in China for nearly two months.

As in many other parts of China, however, Heilongjiang’s agriculture sector is facing a growing labour shortage as young people head to the city in search of better pay and less physically demanding work.

“Drones are saving us,” said Liu, who helped set up Dongan’s “drone squadron”. More than 20 young people in the village are training to become professional drone pilots this year. Last year, the number was just one, he said...."

From what I can tell - supposedly many other industries are being persuaded by the cost and safety benefits of drone-based data as well. In transportation, American railroad BNSF is partnering with the Federal Aviation Administration to test drones for remote track and bridge inspection and air quality monitoring. Network Rail in the United Kingdom is using drones as part of its ORBIS project to digitize the country’s rail network in 3D, to enable better planning of track maintenance and renewal.

Miner, Rio Tinto is using drones to survey equipment and mining pits in Australia. Industrial machinery company Caterpillar is exploring the use of drones for fleet vehicle management in the field, while drones are important in Komatsu’s “Smart Construction” service, which can fully automate bulldozers and excavators.

Cross fertilise. Read about the autistic mind here and ideas on the arts here. On investing try a thought on stock valuations. 
 

Stock (over)? Valuations

 "Last week, the median price/revenue ratio of S&P 500 component stocks reached the highest level in history, advancing far beyond the levels reached at both the 2000 and 2007 market peaks." Writes John Hussman (See chart above and on his site).

Hussman, along with Albert Edwards (currently at SocGen (with Andrew Lapthorne, his recent chart here), I worked with him at Dresdner Kleinwort) and to some extent James Montier (who also worked alongside Albert at DK previously, but has a behavioural economist streak to his work; now at GMO) and Jeremy Grantham (at GMO) have tended to put quite some weight on these type of metrics and valuation discipline, at least for long cycle returns (around 7 years). It's interesting that most of this group are chiming quite loudly, with the possible exception of Grantham who is ringing in a slightly different key (suggesting much slower reversions to the mean than before). The world of macro has so many cross currents (I shall try and put forward the optimists view in later posts). One reason I prefer micro - bottom up company fundamentals.

There is another interesting chime with Nassim Taleb's thinking from his pop risk books. This idea that we do not handle "fat tails" or "Black Swan" events very well.  That models do not account for these events well (real world is not "normal" or "gaussian").  This dovetails well with Hyman Minsky's observation/theory on why we have and will always have boom/bust cycles.    

What to do about this ? That's an even longer more complex answer.  I would suggest it pays to be prepared (Warren Buffet always seems to be), but if you can't perhaps don't make life plans based on what we've seen in the last 5 years, but leave enough flex for a plan B.

I leave you with another Hussman chart on his view that markets are over valued (for long term performance) on many (reliable) metrics.

Cross fertilise. Read about the autistic mind here and ideas on the arts here.

Ethics of Stuffing

The Business Ethics of stuffing. Discussed by Nassim Taleb. And me.

Nassim Taleb writes about this old ethical question here (worth reading the whole piece here as part of his next book in progress).  I wrote about Taleb’s commencement address here.

…The question “is it ethical to sell something to someone knowing the price will eventually drop” is an ancient one –but its solution is no less straightforward. The debate goes back to a disagreement between two stoic philosophers, Diogenes of Babylon and his student Antipater of Tarsus, who took the higher moral grounds on asymmetric information and seems to match current ethics endorsed by this author. Not a piece from both authors is extant, but we know quite a bit from secondary sources, or, in the case of Cicero, tertiary. The question was presented as follows, retailed by Cicero inDe Officiis. Assume a man brought a large shipment of corn from Alexandria to Rhodes, at a time when corn was expensive in Rhodes because of shortage and famine. Suppose that he also knew that many boats had set sail from Alexandria on their way to Rhodes with similar merchandise. Does he have to inform the Rhodians? How can one act honorably or dishonorably in these circumstances?[ii]

We traders had a straightforward answer. We called this “stuffing” –selling quantities to people without informing them that there are large inventories waiting to be sold. An upright trader will not do that to other professional traders; it was a no-no. The penalty was ostracism. But it was sort of permissible to do it to the anonymous market and the faceless nontraders, or those we called the Swiss, or some sucker far away. There were people with whom we have a relational rapport, others with whom we had a transactional one. The two were separated by an ethical wall, much like the case with domestic animals that could not be harmed, but rules on cruelty were lifted when it came to cockroaches.”

I have an answer through the lens of sustainability (in its broadest sense).

Assuming you are going to be in business for the long-horizon then you should disclose everything.

If you do not disclose this, then your customers will not come back and buy from you.  In modern day jargon you would have incurred “reputational damage” but more simply customer will not trust you. They will believe (and with proof) you will likely price gouge them again, if given the chance, and in any case, why not take business to someone who will be honest.

Full disclosure is the most sustainable answer for the business, assuming it wants to stay in business. A single day trade, where the trader will never trade again then perhaps the impact on the trader will be felt as they will never trade again in any case, although there reputation could well be damaged in other areas of their life.

On a 5 year view, or any long horizon view, the trader will make more sustainable profits from the full disclosure and trust from his customers.

The ethical view, aligns with the most sustainably profitable view.

This seems to be Taleb’s view, and Antipater’s view although through slightly different lens. Taleb writes:

“Diogenes held that the seller ought to disclose as much as civil law would allow. Antipater believed that everything ought to be disclosed –beyond the law –so that there was nothing that the seller knew that the buyer didn’t know.

Clearly Antipater’s position is more robust –robust being invariant to time, place, situation, and color of the eyes of the participants. Take for now that

The ethical is always more robust than the legal. Over time, it is the legal that should converge to the ethical, never the reverse.

hence:

Laws come and go; the ethics stays.”

You see a variant of this in that (decent) shops do not change the price of a snow shovel just because there is a snow storm. IF they increased snow shovel prices, just because there’s a desperate short term need for them, then customers will be disinclined to shop at that business again, if they can help it, because the customer will feel price gouged.

It’s also why one of the most disliked features of Uber is the price surge, even if there is an demand/supply balance and a tacit understanding for its purpose.  The customer feels gouged and feels it is unethical.

This is a difficulty even with the straightforward interpretation of Milton Friedman’s thought that the socially responsibility of business is to increase profits.  Indeed, beyond the scope here (hopefully addressed at a later point), but required reading for anyone interested in sustainability and indeed business management.

A more careful reading of Friedman would suggest his view is that managers have a responsibility to act in the long-run interests of shareholders, which many “responsible” decisions might well align with.

By extension, if it is in the interests of shareholder to have a planet to live on in 50 years time, is there not a responsibility to act on climate change under this view?

In any event the idea that law/business converges on the ethics is an interesting concept (rather than the other way round) and one leadership should think about.

Cross fertilise. Read about the autistic mind here and ideas on the arts here.

A correct economist?

Stability begets instability and thus good and stable times sow the seeds of the next bust.

"We fat all creatures else to fat us, and we fat ourselves for maggots. " Hamlet, Shakespeare.

Are we headed for another Minsky moment? Minsky describes how a boom or periods of stability by their nature and human nature cause increased risk taking (for yield and return) which becomes excessive risk taking which leads to bust.

I think this intersects interestingly well with Nassim Taleb's thoughts on antifragility and black swan events.   If we are always due for instability then being antifragile is a useful state of being (second best perhaps would be resilience).

My example to explain Minsky would be in housing.

You buy a house with a mortgage loan.  The loan costs £100 a month in interest.  After costs your rental income is £150 a month.   Your finances are more than covered (Minsky describes this as hedged finance).   You can afford the interest and repay your capital.

The house market is stable, rising even and you see other landlords make larger levered returns.  The long years of stability give you psychological comfort to borrow more.

The loan on your new house now costs £150 in interest a month.  The rental income is still £150.   You now rely on growth in the house price asset to give you a return as your yield is zero.  You can cover your interest costs, but you can not pay down any capital from your rental income.  (This isdescribed by Minsky as a speculative borrower).    However if house prices rise, the amount of leverage you have will give you large returns.   It naturally comes about as people are drawn to higher returns and more leverage as the markets have been stable for so long.  The capital loan you owe is only paid back if you sell the asset.

House prices continue to rise, you have seen great returns. The world remains stable.  This encourages you to even greater risks, maybe your friends join in too as they've seen so many millionaires being created.

Now the loan on your new house is £200 in interest a month.  The rental income is still £150(somehow the bank has been convinced to give you this loan either because you lied, the surveyor lied, or the bank believes in strong capital appreciation).  Now you are £50 a month in deficit, and you need strong house price appreciation just to break even. (Minksy calls this Ponzi financing)  If this does not happen and you can not meet loan repayments, the bubble bursts and instability occurs.    Stretched investor are forced to sell, lowering prices and producing a downwards spiral - a Minksy moment.

Indeed, when growth seems stable, why not borrow more? When bad debt is low, why not lend more ?

This is Minsky's Financial Instability Hypothesis.  It seems to me to take human nature at its core and thus also seems to me inevitable.  History would suggest this is also true.  I would also posit perhaps no matter how hard policy leans against this ultimately the pattern will repeat.

The parallel I draw in nature is with forest fires. This study suggests suppressing the 98% of small fires eventually leads to the 2% of major fires that not only can not be suppressed but because of the successful suppression of earlier small fires leads to an even larger major fire.  

Perhaps the answer is then to be ready for the instability as it comes, and even better have the instability make you stronger (cf Taleb's antifragile notions) but at the least be resilient to it.

I can also see a parallel with climate and energy.  My reading of Vaclev Smil's position and the current state of affairs suggests that a 3 - 4c warming by 2050 is the most likely scenario (with perhaps the best counter, if we systematically eat less beef; transatlantic flights, car travel and fewer children would also help, but I think less likely to be able to happen), while advocating for change one needs to plan in a resilient/anti-fragile manner for it.   I'm very sorry for Bangladesh and Florida.  There's a map showing indicated world flooding here.  

One reason I like Minsky’s thinking is that it threads human behaviour on to a “macro” effect. I’m typically a micro person, empirically based where I can. Humans often don’t follow the (economic) models! One problem for Minksy’s theory in academic economic world, is there is not mathematical model to test and indeed to some extent it is untestable (as many economic theories are); the empiricist in me doesn’t like untestable theories although we might get better at the testing; and certainly the theory makes you sit back and think.

If you are interested in finding out more; there’s a 2013 conference based on his work you tube below and here and some more presentation links based on his work at that conference.

There’s a more reader friendly piece from Paul McCulley (now retired from PIMCO) who spoke a lot about this in the 2007 to 2009 period.

Much of Hyman Minksy’s work is archived at the Levy Economics Institute.  I think this 1992 Hyman Minksy paper is reasonably accessibly for the lay reader (like me!)

a more detailed look at his life's work in the context of economic thinking is on this blog though in my thinking it is the FIH which really stands out. 

And below I leave his hypothesis in his own words:

“Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to “roll over” their liabilities (e.g., issue new debt to meet commitments on maturing debt).… For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principal or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes.… It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and -containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values. "(Minsky 1992, pp. 6 to 8, referred above).

Stock Valuations

 “Stocks valuations remain remarkably high, but as valuations alone tell us little or nothing in terms of market timing, it seems valuation concerns are increasingly ignored. That said, if individual stock valuations are largely unhelpful for timing markets, their correlation with future (one year forward or more) returns is relatively good. Today's levels infer paltry low single digit future returns if we use history as our guide. Just to get back to average US enterprise values would need a 30% fall from here. Surely that should still be a concern?” writes Andrew Lapthrone of SG (who works near Albert Edwards so don't be surprised when their views chime). 

See John Hussman, James Montier (note the debate amongst GMO staff from my reading on it) and Albert Edwards on more on this theme.  

This is for information and debate, not necessarily my view (plus what do I know about macro? Give me healthcare or sustainablity queries at will ! ) 

Cross fertilise. Read about the autistic mind here and ideas on the arts here.

Oglivy. Principles of Management.

In 1968, David Ogilvy set this down:

"...Nor do I seek to freeze the style of Ogilvy & Mather after I retire.

[To me this resonates with the idea that a set of rules or regulations can tend to only freeze best ideas at that time.  Innovation will always conflict with regulation, as rules ossify.  See my commentary on John Kay.]

I hope that future generations will improve upon the Principles I enunciate in this paper...

1. To serve our clients more effectively than any other agency.
2. To earn an increased profit every year
3. To maintain high ethical standards
4. To run the agency with a sense of competitive urgency
5. To keep our services up-to-date
6. To Make Ogilvy & Mather the most exciting agency to work in
7. To earn the respect of the community

On Profit:   in business to earn a profit through superior service... we must pursue profit - not billing. The chief opportunities for increasing profit lie in:

... separating passengers without delay... discontinuing boondoggles and obsolete services:

To keep your ship moving through the water at maximum efficiency, you have to keep scraping the barnacles off its bottom. It is rare for a department head to recommend the abolition of a job, or even the elimination of a man; the pressure from below is always for adding. If the initiative for barnacle-scraping does not come from Management, barnacles will never be scraped

[is this Ogilvy recommending zero based budgeting before ZBB became a management movement?  "I've never heard a budget that can't be justified"  one CEO told me.]

Avoiding duplication of function - two men doing a job which one can do... reducing wheel-spinning in the creative area  [easier said than done though]

On Morale:   Ad agencies are fertile ground for office politics. You should hard to minimise them, because they take up energy which can better be devoted to our clients; some agencies have been destroyed by internal politics.

• Always be fair an honest in your own dealings; unfairness and dishonesty at the top can demoralise an agency.
• Never hire relatives or friends.
• Sack incurable politicians.
• Crusade against paper warfare. Encourage your people to air their disagreements face-to-face [I think we've lost this battle on Twitter etc.]
• Discourage secrecy.
• Discourage poaching
• compose sibling rivalries.

I want all our people to believe that they are working in the best agency in the world. A sense of pride works wonders.

The best way to "install a generator" in a man is to give him the greatest responsibility.  Treat your subordinates as grown-ups - and they will grow up. Help them when they are in difficulty. Be affectionate and human, not cold and impersonal.

It is vitally important to encourage free communication upward. Encourage your people to be candid with you. Ask their advice - and listen to it.

Hard work never killed a man. Men die of boredom, psychological conflict and disease. They do not die of hard work.

While you are responsible to your clients for sales results, you are also responsible to consumers for kind of advertising you bring into their homes. Your aim should be to create advertising that is in good taste. I abhor advertising that is blatant, dull, or dishonest. Agencies which transgress this principle are not widely respected.

Some different quotes from this work found on Papova's Brainpickings.  More from me in an earlier post on advertising.

Global Equity Active Manager Performance. Academic Study.

I take a look at this paper also published in the CFA journal by David Gallagher (professor of finance at the UNSW Business School), Graham Harman (Russell Investments, Sydney), Camille Schmidt and Geoffrey Warren.

"We use portfolio holdings data to examine the performance of 143 global equity funds over the period 2002 to 2012. We find that the average global equity manager outperforms their benchmark by 1.2% to 1.4% per annum before fees. Attribution analysis reveals that the prime source of excess return relates to selecting stocks that beat their local markets. Modest contributions arise from country selection, most notably in emerging markets; while currency effects are mixed. Our findings support giving consideration to active management in global equity markets, at least for institutional investors who pay fees below 1% per annum."

There is evidence that some funds are "closet trackers" and not truly "active".  In 2016, Esma, the European markets watchdog, said that up to a sixth of actively managed equity funds sold on the continent were potential closet trackers. If this is the case then possibly the average results for truly active managers should be better than what is reported too. It would be interesting to know the active share of the funds although I note this work has not been done in this case.

However it does seem that "retail investor" fees can be above 1% and that would negate the outperformance gained seen here. But institutions should be able to do better. The authors quote 70bps (0.7%) as a typical institutional fee. My reading of the literature would suggest moderately large institutional buyers can be paying a much lower rate than that.

"According to Mercer Investment’s Fee Survey 2006 (i.e. around the middle of our sample period), the average fee for global equity core segregated funds was 0.74% per annum for a US$25 million mandate and 0.50% per annum for a US$200 million mandate."

There has only been fee pressure since 2006.

"This article contributes to the understanding of active management in various ways. First, the finding that active managers generate significant outperformance in global equities calls into question whether the uninspiring performance of active management in US markets applies in other contexts. Second, we uncover evidence that the outperformance of global managers primarily relates to stock selection skill. Third, the fact that managers can source significant excess returns from emerging markets raises the possibility that the degree of market efficiency or segmentation might influence the capacity of active managers to outperform."

So Global managers do seem a different breed than US only managers according to this research.

"Regressions of fund excess returns on international factors suggest that benchmark-relative outperformance remains robust to common factor exposures, although loading towards small stocks appears to make a positive contribution"

This is also an interesting finding as it suggests that Global Managers could blend well with quantitative funds that make returns by accessing common factor exposures (for instance "smart beta" funds or those seeking exposure to a "value" or "volatility" or other common factor). Although I note the analysis in this respect was with a smaller sample and more (what I would call) exploratory.

To conclude:

"This study provides support for considering an active approach in global equity markets, subject to the fee paid by the investor and perhaps the ability to identify and access skilled managers. Given the evidence that the prime sources of excess returns relate to stock selection and emerging markets, there appears to be a case for considering managers that adopt a bottom-up approach and have emerging market capabilities. In contrast, the case for investing with top-down managers who focus on country selection as a driver of returns remains to be established. While it is still possible that a top-down approach could be successful, our analysis suggests that these skills are not broadly held across global equity managers."

The authors leave it as an open questions as to whether top-down eg global macro funds, can add any returns.

Another caveat is that I assume the database is the Russell Investment database and how selective that database might be could also be a cause of bias, which is not explored in the study.