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Recognizing skill in different markets. A Weblog by Ronald J. Surz.Investment skill can only be proven relative to a naive implementation of the investment approach, which requires a unique barometer for each manager and market. November 14, 2009 Whose style is it anywayThere are plenty of style indexes from which to choose, and for the most part this choice is made on the basis of brand name, with Russell in the lead. But would we make the same choices if we actually understood how these sausages are made? These popular indexes use the ratio of price to book (P/B) to divide the universe of stocks into value and growth. High P/B is growth and low P/B is value. The idea is that a stock trading at a price near its cost basis is inexpensive, a good value. But as Laurence Siegel states in a CFA Research Foundation monograph [see Siegel, 2003] “Book value is mostly a historical accident. It is the accounting profession’s estimate of the company’s value; it reflects what the company paid for assets…includes the goodwill of companies acquired.” But not all indexes are constructed using P/B. Some use price/earnings ratio (P/E) combined with other factors like dividend yield. P/E is a growth measure. Investors will pay more for current earnings if they expect those earnings to grow. Dividend yield is a value measure, since dividends are generally paid by companies with established product lines who would rather pay out earnings to shareholders than invest in new projects. It matters a lot which factors are used to define stock style classifications. Different approaches not only assign stocks to different styles, but they result in financial characteristics and performance behaviors that are materially different. It's important to know how these sausages are being made. For a thorough examination of the significant differences that currently exist in this economic crisis, visit http://www.ppca-inc.com/pdf/Style-Definitions-in-2009-20090930.pdf Posted by Ronald J. Surz at 01:19 AM | Comments (0) August 21, 2009 Measuring the Risk of Target Date Fund Glide PathsTraditional risk measures are wealth agnostic. An individual losing $1000 on his $10,000 portfolio is treated the same as a $million loss on a $10 million portfolio. Most say that these losses are equally as painful, and that it may well be that the $10,000 investor suffers the greater pain. This may be true for different investors, but what if we’re talking about the same investor, namely an investor in a target date fund? It has recently been shown [see Basu 2009] that a glide path that increases equity exposure through time dominates the traditional glide path, which has decreasing equity exposures. This “Contrarian” path delivers greater ending wealth 90% of the time, with about the same risk, leading to a characterization called “Almost Statistical Dominance” (ASD). ASD means the Contrarian path is better most of the time in both risk and reward. So what is wrong with this picture? Few if any would recommend 100% equity exposure at retirement, yet traditional risk and reward measures indicate that a glide path with increasing equities, rather than decreasing, results in greater wealth with about the same risk – it’s a significant winner. In other words, our intuition tells us that retirees can’t “afford” that much risk taking, but traditional risk measures argue otherwise. Consequently, we need an alternative risk measure that captures the importance of protecting account balances near retirement, if for no other reason than retirees have limited opportunities to make up losses by working longer. That is, we need a risk measure that is weighted by either account value and/or time remaining to retirement. For example, a dollar-weighted risk measure reveals that the Contrarian glide path is in fact 75% riskier than the traditional glide path. In a recent article [see Surz 2009] I measure risk as dollar-weighted downside deviation, where the dollar weights are account balances through time. Some have argued that I’ve concocted a risk measure to make a point; these detractors need to deal with the ASD problem, or they should invest their retired clients entirely in equities.
Surz, Ronald J., “Should Investors Hold More Equities Near Retirement, or Less?.” Advisor Perspectives, August 2009 Posted by Ronald J. Surz at 07:36 PM | Comments (0) July 15, 2009 An important distinction in target date fundsThe June 18, 2009 joint SEC and DOL hearings uncovered an interesting fact: most target date funds miss their target dates on purpose because they are actually targeted to death rather than retirement. Accordingly, these "through" funds should be renamed "target death" or "lifecycle" funds and the date should be changed to "when the last person dies." In contrast to "through" funds there are in fact "to" funds that end at the target date, & deliver safe assets, namely TIPS and T-bills, but these are not being sold by the fund companies because their revenue stream is limited to the working lives of investors rather than the entire life. The justification for "through" funds is the need to manage mortality risk, but this does not stand up to scrutiny because there are superior ways to manage mortality risk. We have here another unfortunate example of an industry motivated by profit rather than the best interests of investors. As Pete Seeger sang "When will we ever learn? When will we ever learn?" Posted by Ronald J. Surz at 02:51 PM | Comments (0) June 22, 2009 DOL & SEC June 18 Hearings on Target Date FundsLast week the DOL & SEC conducted their first joint hearing ever. The topic was target date funds, and focused on the apparent failure of these Qualified Default Investment Alternatives (QDIAs) in 2008. Despite all the finger pointing, disagreement, and controversy that characterized these hearings, there was one fact with which everyone agreed: plan sponsors have the fiduciary responsibility to select and monitor target date funds. The buck stops with plan sponsors so they need to decide what is right for their employees. However, investment managers have been making this decision so far, even though mutual funds are not fiduciaries. Mutual fund companies offer target date funds that they have decided are appropriate. Where is the sponsor’s voice? It was not heard at these proceedings, perhaps because these fiduciaries have not yet decided what they need and want. The decision is actually quite simple: safety or growth. Safe target date funds are "To" target date, ending the glide path at retirement in safe assets, like T-bills and TIPS. Less safe, growth-focused TDFs are "Through" target date, with an actual target 20-30 years beyond target date; these funds are more appropriately labeled "target DEATH funds." In my opinion, fiduciary duty argues for safety. Plan sponsors need to adopt a standard that explicitly conveys their desire for safety or growth. This communication from the plan sponsor community is critical. Plan sponsors need to drive this bus, and investment consultants should be advising their clients accordingly. Posted by Ronald J. Surz at 03:22 PM | Comments (0) December 19, 2008 Sharing the Shame of the Madoff ShamLast year I wrote an article exposing fake due diligence by hedge fund intermediaries, namely consultants and fund-of-funds. The Madoff Mayhem gives me an "I told you so" I’d rather not have. Please visit http://www.ppca-inc.com/pdf/Shame-on-the-Sham.pdf . We need to learn from this mistake or we are doomed to repeat it. A version of this paper entitled "Visit Monte Carlo to Remove the Peer Group Gamble from Hedge Fund Due Diligence" has been awarded the prestigious 2007 Kessler Award by the Investment Management Consultants Association (IMCA). It's worth re-reading even if you've seen it before. Posted by Ronald J. Surz at 01:56 PM | Comments (0) November 05, 2008 Decimation of the Finance Sector
The exhibit above shows the style make-up and aggregate characteristics of the October, 2007 large cap Finance sector as it existed a year ago, and compares these to today’s profiles for the same stocks. As you can see, 80% of the dollars in the 2007 Finance sector were classified as large value, whereas today only a third are large value, with much of the former value dollars moving to growth. Growth, at 38%, is now a larger component of the 2007 large Finance sector than value. Also, the total market value of this sector has declined by almost $1 Trillion, from $2.6 Trillion to $1.7 Trillion. Average capitalization has declined from $56.4 Billion to $38.8 Billion, while P/Es have increased from 12.3 to 20.2. Earnings have fallen faster than prices, with some firms posting negative earnings for the trailing 12 months. In a nutshell, the decimation of the Finance sector has caused it to take on a smaller company, more growth orientation. You’d think the decrease in prices would have made these companies even deeper value, but earnings deterioration has more than offset the price erosion effect. In style space, these companies are priced to grow their way out of the current dilemma. This has significant implications for style specific portfolio managers and their evaluators. Most view Finance as a value play, but this is simply not the rule anymore, and may not be for some time. The game has changed, and the sooner we realize it the better. Index providers with annual June resets will ignore these changes for another 8 months, so the reader is forewarned. Large Finance Companies Then and Now Source: PPCA Inc. Posted by Ronald J. Surz at 12:55 AM | Comments (0) August 20, 2008 Consultants have it bass ackwardsThe professional search for investment talent is currently being conducted in the same way that the drunk looks for his keys under the light of a lamppost. When asked where the keys were lost, the drunk replies “up the street, but the light is much better here.” When it comes to investment fund selection and allocation, financial consultants are currently doing what is easy rather than what makes sense. What makes sense is customizing the benchmark rather than limiting performance comparisons to off-the-shelf indexes, like Russell and S&P. Also, consultants should allocate to talent rather than to style boxes. Posted by Ronald J. Surz at 10:44 PM | Comments (0) July 06, 2008 Target Date Funds Are Too RiskyTarget date lifecycle funds are becoming the darlings of defined contribution plans because they are simple and because they are Qualified Default Investment Alternatives (QDIAs) under the Pension Protection Act. But it is extremely difficult to evaluate these funds because their "glide paths" are all over the map. A glide path is the planned transition through time from aggressive at 1st to defensive at the target date. The range of "defensiveness" at target date is most problematic. Equity allocations at target date across target date funds currently range from a low near zero to a high above 70%, with the average fund allocating 40% to equities at target date. Last year I started a company with 2 partners to benchmark target funds, called Target Date Analytics. We just recently teamed with PLANSPONSOR to create the PLANSPONSOR On Target Index Series.One of the key considerations we had to tackle is the appropriate level of risk, especially at target date. Our considered opinion is that there should be as little risk as possible at target date, so our signature index is entirely "risk free" for what has come to be called "current" or "income" funds, which are funds whose target dates have passed, like 2005 funds. The industry is currently taking the view that target date funds can somehow morph at target date from accumulation to distribution, but we think this view is wrong. Our view is that the investor needs to make a whole new set of decisions in the distribution phase of life, and that there is a real potential role in this phase for annuities and a whole new suite of distribution funds that are springing up. In other words, most target date funds are too risky, but we think this will change. The pain that can occur from too much risk has recently been experienced, and is shown in the following exhibit.The exhibit shows the performance of the 3 largest target date families – Vanguard, Fidelity, and T. Rowe Price. These 3 providers currently dominate the target date fund industry, representing about 85% of this $200 Billion market. As you can see, investors in near-term current and 2010 funds have lost 2% and 6% respectively in just the past 6 months, and those in longer-dated funds have lost more than 9%, underperforming our benchmarks by about 5% across the board. Most of the recent underperformance of these funds, in both absolute terms, and relative to the benchmark, is explained by aggressive equity allocations.
Posted by Ronald J. Surz at 02:31 PM | Comments (0) June 02, 2008 The only thing that is customized in "Custom" Target Date Funds is the cookie cutterDespite all the hoopla surrounding custom target date funds, there is actually very little customization in these offerings. I personally consider it deceitful to use the word "Custom". Worst case, custom target date funds are merely packaging of DCIO (defined contribution investment only) families of funds offered by a single investment management company. These are closed architecture packages comprised solely of funds provided by a single investment firm, clearly designed for asset gathering rather than superior results. Best case, the custom fund is open architecture, but even then the glide path is usually licensed from a consulting firm. In the hierarchy of what matters in target date funds, asset allocation is paramount, and this means that the glide path is critical. Cookie cutter glide paths are not customized, and not all cookie cutters produce good cookies. Of all the benefits that are commonly touted for custom target date funds, the only one that may stand up to scrutiny is lower fees, but this is certainly not always the case. Let's get these important offerings right, and be honest about their descriptions. Target date funds are growing in dollars and importance, so the stakes are high for plan beneficiaries and their fiduciaries. Posted by Ronald J. Surz at 03:34 PM | Comments (0) March 17, 2008 Professional Bingo Players Take HeedHiring a consultant to select an investment manager is like paying a professional Bingo player. The chance to win is unchanged but the fun of playing is lost, as is the consulting fee. This analogy could improve if consultants stepped up their game. Antiquated manager due diligence tools fail to differentiate between winners and losers, so losers are hired and winners are fired. It's like evaluating Tiger as a bowler. Indexes and peer groups do not work, but there are newer 21st Century scorecards that can help. For those who are willing to think outside the box, custom benchmarks and custom peer groups separate the winners from the losers. Those worn out Bingo cards could be replaced with Ouija Boards. Then we got game. Posted by Ronald J. Surz at 11:20 PM | Comments (0) March 13, 2008 The BLOB Attacks Investment Manager Due Diligence:There are many biases in peer groups, some of which can be controlled. But one obscure bias just won't go away, and it's raising havoc with investment manager evaluations. It oozes out from compromises that all peer group providers must make, and invades evaluators' judgment, unbeknownst to its unwitting victims. This perilous perpetrator is called classification bias. Note it well. Peer group providers establish rules for classifying managers as large or small, value or growth, etc. and then populate their peer groups with managers that meet these criteria. Classification bias feeds on the lack of similarity among the funds that meet these classification rules, enveloping manager evaluations with scary ratings. It is an amorphous bias that cannot be made to go away, try as we may. We need to think outside the box to rid ourselves of this blob. Most are aware of survivor biases in peer groups and choose to ignore them. But only a few understand classification bias so the decision to ignore this perilous problem is unintentional. Classification bias distorts traditional peer group rankings and invalidates hedge fund peer groups. At CLICK HERE I provide details on recent effects of classification bias in traditional peer groups, and then explain why it is a very serious problem for hedge funds. Posted by Ronald J. Surz at 01:05 AM | Comments (0) January 04, 2008 Award wining market commentaryAward winning market commentary with 17 important pictures Please visit click here for an extensive commentary on recent and long term market behavior. The 2006 version won IMCA's prestigious Kessler award. This year I've added discussions on target date lifecycle funds and anomalies in Morningstar's peer group rankings. You'll find plenty of graphics that you can use throughout 2008. Highlights The U.S. stock market returned 5.5% in 2007, and long term corporate bonds earned 3%. Both are below historical averages. Inflation averaged 4%. The U.S. style pendulum swung to growth in 2007. The Chindia effect has propelled infrastructure stocks around the world. There is a 5000 basis point spread between the best performing U.S. sector in 2007 and the worst, and a 6500 basis point spread between the best performing non-US region and the worst. The range of returns in 2007 is huge. Value managers no longer look like schmucks. Unlike 2006, when more than 90% lagged their indexes, this year the majority have outperformed their indexes. There's a good explanation for this turnaround, and it's no surprise that it's not skill. Target date lifecycle funds are poised to become the darlings of DC land, even though most sponsors don’t know how to evaluate them. There are new benchmarks that can help. Emerging Markets, Australia & New Zealand, and Asia ex Japan have all returned more than 15% per year in this century. EAFE lags substantially with a 6% per year return, and the U.S. lags EAFE with a 3% per year return. Dividing our 82-year history of stock and bond returns into two 41-year periods reveals that stock markets have maintained their efficiency while bond markets have become markedly less efficient, providing less return per unit of risk. Posted by Ronald J. Surz at 04:46 PM | Comments (0) August 09, 2007 Everyone Loves a CloneHedge clones replicate factor exposures, both long & short, so the underlying presumption / hope is that these exposures will pay off. Do you see it that way? If so, are you strategically over-under weighting the cloned strategies? Based on what? As you can see, I'm thinking that the key to using clones is developing some forecast of factor payoffs. Without this it's just a crap shoot, and with it you don't need the clones - just make the factor bets. Like most things in this business, what sells doesn't work & what works doesn't sell. Posted by Ronald J. Surz at 01:52 PM | Comments (0) June 24, 2007 Making a lewd clone fallHedge fund cloning is catching on. The investor appears to get the essence of hedge funds through replication of the performance of a hedge fund index, representing a collection of hedge funds. But isn't alpha the essence of hedge funds? Can you replicate alpha? Perhaps, but not with technology designed to track an index. If it's low correlation that you really want nail your assets to a tree, and save all of the fees. Hedge funds are a better structure than long-only for managers with skill, but the risk lies with the unskilled, who simply have more ways to screw up when they offer hedge funds. Unfortunately, investors have come to believe that all hedge fund managers are skillful, confusing form with substance. Saving the 1 and 20 hedge fund fee by purchasing a replicating fund is another case of getting what you pay for, but it may still be a bargain if you don't know who is skilled and you insist on investing in hedge funds. Posted by Ronald J. Surz at 07:46 PM | Comments (0) March 04, 2007 Pure Folly of Hedge Fund Peer GroupsThere's a good chance that the recent stock market correction will generate renewed interest in hedge funds, so now is good time to revisit hedge fund due diligence. Most acknowledge that the current reliance on peer group comparisons is fraught with peril: we're more likely to be misled than enlightened. Last year professors Burton Malkiel and Atanu Saha documented the deficiencies of peer groups, and received a lot of press for their efforts. Now this year Professors William Fung and David Hsieh, of the London Business School and Duke University, have announced their intention to create the first pure hedge fund peer group. Like Malkiel and Saha, Fung and Hsieh exhibit naivete despite their academic credentials. Creating a pure hedge fund peer group is like breeding a puppy that won't mess on the floor. Try as we may, there is no way to make the myriad biases in peer groups go away, especially hedge fund peer groups. Continue reading "Pure Folly of Hedge Fund Peer Groups" Posted by Ronald J. Surz at 08:32 PM | Comments (0) |
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