Friday

Active or passive

Active or passive? Choosing WHICH passive index is an active decision. Index funds are just low frequency trading strategies with horrific drawdowns and risk adjusted returns. Active is the only option in the REAL world because "passive" funds track trading decisions of index construction firms. If a list maker rates debt by slapping "AAA" on billions of toxic waste securities how can it rate equity? Should you risk your life savings on lists of stocks or hard working top talent that actually earns its fees?

Prudent men invest in skill. If you think the best stock pickers work at Standard and Poor's, MSCI, FTSE or Russell invest in a "cheap" fund they ACTIVELY trade. If you don't like unskilled long only risk or realize that a skilled stock picker is more likely to be managing a hedge fund, then avoid them. Why tie up YOUR capital in a manager's 500th or 2000th "best" idea?

True buy and hold? The original components of the S&P in 1957 have outperformed the actively managed S&P. That's because the unskilled S&P committee keeps on buying highs and selling lows. Dumb trading. A portfolio of good hedge funds has outperformed all index funds EVERY YEAR net of fees since 1957 on a volatility adjusted basis. Name any business where passive succeeds over time. No-one has investment skill? NO-ONE?

Invest with skilled professionals not list trackers. The only managers that made money for clients in difficult times like 2008, 2002, entire 1970s or 1930s were, of course, quality absolute return strategies. Why invest in anything else? For fiduciaries it's a legal requirement to invest with the best. The top portfolio managers don't run index or long only funds. Therefore such funds CANNOT be part of a truly prudent portfolio. Too risky and expensive.

Why invest in unskilled funds that lost trillions and endured 50% drawdowns twice last decade? And negative REAL returns since the turn of the century. Capital invested on Dec 31 1999 in the total return S&P 500 has LESS spending power today. In contrast a competently constructed portfolio of the world's best hedge funds has risen vastly in value, AFTER FEES.

Academic "experts" love "low cost" index funds despite no risk management, hedging or attempt at capital preservation. Easy to be so wrong when they have tenure and the endowment that pays their salaries avoids "passive" funds due to their HIGH COST and damage they do to the portfolio. Managers that sit idly by watching bear markets destroy capital are unsuitable for any portfolio. Index funds cost too much and YOUR money deserves better treatment.

No risk averse investor need leave their cash in harm's way HOPING for a bull market over the infamous "long haul". Passive funds are too volatile for conservative investors like me with low risk tolerance. Quasi-active "index" funds market themselves as passive because it sells, backed up by "Nobel" economics nonsense. The deadly drawdowns and vicious volatility of index funds are unacceptable.

Alpha is partly about knowing WHEN and HOW to change your beta exposures. Volatility and uncertainty mean portfolio management requires ACTIVELY searching for ACTIVE investment strategies able to make absolute returns in such times. Navigating the FUTURE financial landscape will depend on finding optimal ways to analyze data, deploy capital and hedge away systemic risk. We CANNOT depend on beta so it is alpha we need for RELIABLE performance.

To reduce risk and long only equity speculation it is necessary to move beyond asset allocation. How different strategies are combined and applied to asset classes is what matters. The debate comes down to whether to hire professional portfolio managers to pick stocks or have index constructors pick stocks. It is all stockpicking in the end. "Active" ETFs just got authorised which is interesting considering that non-passive ETFs have been around for over 15 years. Plus ça change, plus c’est la même chose. There is nothing "passive" about market benchmarks. The editor of the Wall Street Journal actively picks and replaces the Dow components. How does he find the time to thoroughly analyze stocks?

Warren Buffett has been a successful hedge fund manager for decades and recently spotted an opportunity to try to make some money reinsuring the municipal bonds insured by MBIA MBI, Ambac ABK and FGIC partly owned by PMI and BX. It is unlikely the offer will be taken up and it does not change the dire outlook for those firms' exposure to structured credit and CDO toxic waste. The stock market is STILL not recognizing the growing problems in the CLO, CDS and LBO debt markets either. How many "secured" loans were genuinely secured? How much "security" was there in securitization? Asset-backed securities need the underlying assets to be somewhere close to their ASSUMED value.

Buffett's offer may sound like a positive development but it is a negative for the monoline insurers. It just signals his interest in stepping in should those firms go under or get split up due to their more exotic liabilities. Out of crisis there is always opportunity and he has been generating alpha out of special situations and distressed credit for a long time. Buying and holding large value stocks is just ONE strategy within Warren's multistrategy hedge fund.

This is not the end of the credit crisis. High credit correlation implies more volatility going forward. The stock market seems to be ignoring the chaos in the leveraged loan markets. The Blackstone BX led Alliance Data Systems problems grow but that is just the canary in the coal mine for other deals. Probably a sensible large private equity LBO last year was the Harrahs deal. On the left side of the Vegas strip after the Venetian there are several older casinos in prime locations owned by Harrahs and all of which would best be demolished and replaced with a modern mega resort. Harrahs needed to go private for a few years and eliminate quarterly earnings scrutiny as it forgoes gaming revenue from those properties and rebuilds for the future. That an LBO with a genuine business case could not raise sufficient debt shows how bad things are.

Elsewhere in the markets, Microsoft would like to buy Yahoo. Both ARE great companies but WERE good stocks once. I doubt Google lost much sleep other than brainstorming deal delaying tactics; its search technology is superior and its "new" competition will take years to integrate their cultures. Industry and product lifecycles are born and die fast these days. Companies, just like investment strategies, have short half-lives and depend on ongoing innovation to keep performing.

Several years ago when AOL was added to the S&P 500 I used the opportunity to get heavily short, selling to the index trackers yet every broker I gave the order to said I was crazy as it was "obvious" AOL was going to "own" the internet and their analyst rated it a "strong buy". It turned out to be almost exactly the top and AOL did not end up controlling the web. There can be no buy and hold when the commercial and technological environment changes so quickly. Today's no brainer buy can be tomorrow's short sell.

Google is more likely worrying about tiny startups like some of the venture-backed new search technologies I saw last week, not Microsoft-Yahoo. Otherwise in 2018 people might be asking what was the name of that stock investors got so excited about back in the 00s? Goggle.com or was it Googol.com? When was the last time you searched on Excite or Altavista? Both were major players not so long ago. Netscape was once the hottest stock around. Ten years from now we will probably have trouble remembering that Facebook ever existed. It's so popular no-one goes there anymore! Facebook fatigue shows yet again how social networks are a fickle business. Anyone still use Myspace.com?

Investors CANNOT be passive when the investment opportunity set is so active. Buy a stock because it is in an index OR because it has good value and FUTURE business growth prospects? The Dow Jones Industrial Index just made the ACTIVE investment decision to bet on Bank of America and Chevron. The Dow is supposed to be representative of the broader US economy and banking and energy already had a fair weighting. It is often better to keep your winners so dumping last year's highest returning Honeywell seems harsh. Altria has been the best Dow performer over several decades. Sad to see the traders that construct the Dow Jones suffer from the disposition effect and make the DISCRETIONARY decision to sell winners but keep some losers.

If HON and MO must go then I would have added Berkshire Hathaway and Google as both bring more diversification to the mega cap index. Dow Jones would probably argue that BRKA is too illiquid and GOOG too "new" but the real reason is that with the absurdity of price weighted indices GOOG would have comprised 27% while BRKA would be over 99% of the Dow at current prices! How silly to limit the world's best known market metric to only those stocks that do stock splits. Surely market capitalization or a fundamental metric would be appropriate. And why is illiquidity an exclusion criterion for what is supposed to be a long term benchmark?

There is a notion that equity indices are passive when each addition and subtraction is an active choice. I have accurate point in time and dividend data going back to 1896 and just looked at the Dow Industrial's worst ever TRADES. The forerunner of Chevron first got added back in 1924 and it might have been better to leave it alone. Back in the 1930s the Dow added Coca Cola and IBM, deleted them a few years later and then re-added them after MISSING several decades of growth. If those two stocks had been in the DJIA throughout, as best I can figure, the Dow would be somewhere around 26,000 today.

But can you blame the Dow for deleting such obvious "losers" at the time? Selling overly sugared soda made from a black box recipe during the depression? Manufacturing international business machines when the future CEO estimates market demand for five computers and most of "international" are preparing for war? Not very persuasive business models at the time. Conversely it is not so long since "blue chips" like Bethlehem Steel and Woolworths were in the Dow and we know what happened to them. Long/short means buying good stocks and shorting bad stocks; is that so dangerous? Is long only really "safer" than long/short?

I would have thought that prudent investing would require funds to be managed by full time stock pickers. The recent changes in the Dow do NOT "fully reflect the market". Are BAC and CVX really better additions than BRKA and GOOG? I realise MO is basically a stub now but Honeywell are right to be miffed just like the bizarre dropping of International Paper IP last time. And is Cisco CSCO really "less" deserving to be in the index than American Express AXP? Far more money tracks the S&P and Russell but the index followed by most people is the DJIA so it ought be as representative as possible given its influence on sentiment and media headlines.

Even that Dow bellwether General Electric GE has been traded before. Whether it is the Dow, S&P, FTSE, Nikkei, Hang Seng they are all managed ACTIVELY. There is no "passive" as index components go bankrupt, fall by the wayside or get bought out and then a trading decision must be made as to what the replacement will be. As equity market barometers these indices have use to measure alpha production by managers but to actually invest in them? Index reconstitutions have long provided profitable pairs trades for those nimble enough to put them on. Who would have thought that beta players handing alpha over so easily? Stock picking is best left to those with an informational edge and vocation in doing that stock picking. Even in the best of times there are plenty of stocks that go down.

Since we live in an active world the only style that really exists is ACTIVE investing. It may be the decades outlook of Warren Buffett or the seconds of a high frequency statistical arbitrage trading strategy but regardless of holding period it is all active decision making. Equity indices that are quasi-passive are those that minimize stock picking discretion. The Nasdaq and TOPIX include EVERY stock on their respective exchanges; they are still active indices though since the equities change. Check out the Nasdaq components today compared to 1999. Lots of ACTIVE natural selection there driven by business success and failure.

Whether an equity index will go up is conjecture. That some stocks go up and others go down is a CERTAINTY. Given that active investing is the sole choice available it would seem to be the best course of action is to hire the managers with the most dedication, skill, talent and incentives to figure out which stocks to buy and which to short and REDUCE risk as much as possible. Economic conditions, products, consumer trends, corporate and human longevity and geopolitics changed rapidly last century and will even more so in this one. How can passive succeed in such an active environment?

Hedge funds outperformed in January and 35% made money unlike all the "passive" indices that lost $5 trillion of investors' hard earned cash. I don't know where people get the idea that January was "difficult and challenging" when it offered so much opportunity and volatility. Often missed by some about short selling is that as the price moves down you need to do more short selling just to maintain the same portfolio percentage weighting. Stock indices might or might not go up but many more individual stocks drop to zero than go to infinity. I wrote in early December how "short only" was probably going to be "the" strategy for 2008 though I reserve the right to change my mind. The only way to survive in finance is to adapt to the CURRENT and forward looking scenario.

There is no inherently reliable return from "stocks" OR "real estate" anymore than "hedge funds". Even dividends and rental incomes are pretty unstable. It is naive at best, dangerous at worst, to "expect" to be compensated with risk premium. So next time your real estate broker tells you houses "always" eventually hold their value or your stock broker/wealth manager/private banker/finance professor asserts that stocks "must" go up over very long holding periods, tell them to write you a 30 year at the money put option on any index of their choice, Dow, Dax, Shanghai Composite, BSE Sensex...whatever. For zero premium. Risky assets "will" go up therefore in their mind there "should" be no chance of the option expiring in the money. If they refuse ask them the reason for their caution.

If you were an animal, what animal would you be? As far as finding good fund managers is concerned, look for an alpha rat. Now it is the new year, why does the twelve year animal cycle in Chinese astrology BEGIN with the rat? Because the alpha rat was smart, small and nimble enough to win the race against the lumbering beta buffalo, goat, horse and others. A bona fide hedge fund manager is an investment rat; able to survive conditions that destroy others, exploit crevices of opportunity amid adversity and outperforming the slower financial fauna. They are often hated by others for their very existence or wrongly blamed for incubating any financial disease that hits the markets.

The investment jungle is still mostly inhabited with soon to be extinct beta brontosauruses strutting around unwilling or unable to do the dirty, hard work of seeking alpha. Rats figure it out earlier than most and take protective hedging action as soon as danger appears. Remember the rat scene after Titanic hits the iceberg in the movie. Military strategy says to advance or retreat; take risk aversion action because passively hoping things will turn out alright usually ends with defeat or worse.

Whether credit and recession strike the market and whatever the economic scenario there is ONLY active investing. Markets change so portfolios must adapt to them. It is staying agile and innovative and keeping up with new opportunities that separates the alphas from the betas. Markets morph, factors fluctuate and drivers deviate. As in any industry, the passive become obsolete while the active thrive.

By Veryan Allen Creative Commons License

This work is licensed under the Creative Commons Full Attribution, Non-Commercial, No Derivative Works 3.0 License

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