Why Are Investors Mistrustful?

In reading the July/August edition of the CFA Institute’s magazine, an article called “Fragile Trust” by Susan Trammell caught my attention. There’s no doubt that popular confidence in financial services firms was sorely shaken by the 2008 crisis. But it’s still sobering to consider the results of a 2013 survey by Edelman Trust  showing that only 46% of respondents expect financial services firms to do the right thing, dead last out of 18 industries considered.

A survey by the Economist Intelligence Unit last year asked financial services executives about the benefits of improving ethical conduct at their firms, and the most popular choice was that it would improve their ability to “withstand unexpected and dramatic risks”. People who work in Finance recognize the value of high ethical standards, and yet the public doesn’t perceive that the industry operates in this way.

Part of it relates to confusion or simply misunderstanding of the difference between brokers-dealers versus investment advisors, or “sell-side” versus “buy-side” in Wall Street parlance. And indeed, why should non-institutional investors even need to know the difference? The structure of  U.S. financial regulatory oversight need not be a concern of those outside it. Most investors simply want to invest their money through people whom they can trust. And while that does qualify a pretty healthy majority of finance professionals, the lower standard applied to broker-dealers (sell-side firms) versus investment advisors (buy-side) can expose unwitting investors to abuse.

Broker-dealers don’t have a fiduciary obligation to their clients, simply a requirement to meet a lower standard of suitability and disclosure. Their clients are regarded as being responsible for their own decisions, so while a broker can offer advice (“I think this is a good investment”) he’s not under the fiduciary obligation of an advisor to put the client’s interests before his own.

Many investors find this subtle distinction meaningless or are unaware of it. But it’s what enables, for example, unlisted registered REITs (Real Estate Investment Trusts) to be sold to clients in spite of underwriting fees that can reach 15% of the invested amount. I wrote about just such an example, of Inland American Realty and its underwriter Ameriprise, last year. The fees were in the prospectus so deemed to be disclosed, although it’s expecting a lot to think people will wade through 100+ pages of a legal document. And the regulators were not totally absent as subsequently Massachusetts settled civil claims with Ameriprise on just this security, complaining of high fees and conflicts of interest. The conflict of course comes from the fact that the broker recommending (i.e. selling) the security to their client is receiving the egregious underwriting fees. A fiduciary standard would disallow such a transaction. Such applies to investment advisors but not to broker-dealers.

It seems to me that for the financial services industry to raise itself from being 18th out of 18 industries in surveys of public trust, more and more individuals will need to willingly behave as if the fiduciary standard applies to them even if it does not. Every profession needs to retain the trust of its clients, and Finance needs to as much as any other. The CFA Institute’s Future of Finance Initiative is a good place to start, and professionals on both the sell-side as well as the buy-side can choose to conform to its principles voluntarily. Many already do – the rest ought to.

How Fund Managers Who Invest Elsewhere Exploit Their Clients

If you didn’t have the data, you might reasonably assume that any fund manager worth his salt was heavily invested in his own fund. This ought to apply to an overwhelming percentage of all the actively managed funds out there. In fact, as a recent article in Barron’s points out, it’s the exception rather than the rule. Using data from Morningstar, they find that almost half the funds tracked were led by a manager with no money invested at all. This sorry bunch may think they’re good, and their marketing materials presumably make the case, but by investing their own money elsewhere they tell you what they really think.

And of the 7,700 funds tracked by Morningstar, only 910 had a personal investment by the manager of at least $1 million. This isn’t a high hurdle; less than this threshold either means the manager doesn’t have $1 million to invest, a paucity of personal resources that should give any potential client pause, or chooses not to.

It’s not just that it feels right to know your manager is invested alongside you. For the client, this is the only way to ensure alignment of interests and protect themselves from the principal-agent problem so prevalent in finance. If you’re a fund manager only managing OPM (Other People’s Money), your compensation is fully linked to the size of the fund you manage. The most reliable way to grow your fund is to outperform your competition. A seductively simple way to outperform is to take more risk than the others. Because if you take more risk in a rising market, you will assuredly do better than most and money, which chases performance, will follow. If the market goes down and you underperform, you haven’t lost much because it’s only your clients that suffer the returns. And if performance is really bad, you can always start a different fund.

The money manager who’s invested elsewhere has a free option at the expense of his clients. He has far more to gain from outperforming than he has to lose from underperforming. For the investors, their risk is linear. Bad returns hurt, and good returns help.

The analysis of the Morningstar data supports other research which shows that active managers in aggregate take more risk than the overall market. They are biased towards stocks with more volatility than average, and as a consequence their actions underpin the Low Beta Anomaly, the tendency of low volatility stocks to outperform over the long run. This is because high volatility stocks draw more demand from active managers which raises their prices, thereby depressing future returns. An active manager owning low volatility stocks is failing to exploit the optionality that his role as agent provides at the expense of the principal (i.e. client). It’s one of the reasons we like low volatility stocks – because although they’re widely owned, they’re not widely owned by active managers. And we think that active managers under-invested in their own funds are likely to continue exploiting their advantage which will cause the low volatility bias to persist.

For the investor, it’s not a bad rule to simply eliminate from consideration any investment manager not personally and significantly invested in his own strategy. It makes intuitive sense but it also provides for an alignment of interests. Don’t let the uninvested take advantage of you.

Why Dividend Payers Aren’t Boring

Recently the Financial Times (FT) noted that the number of U.S. companies raising their dividends had hit the highest level since 1979. Much research has been done on the merits of companies that pay out a large percentage of their profits in dividends (high payout ratio) and those that retain most of their earnings so as to reinvest in their business. Payout ratios have been falling steadily for decades and currently the FT notes that S&P500 companies pay out only 36% of their profits. However, share buybacks have increased over that period so one can’t conclude that the total cash returned to shareholders as a percentage of profits has fallen.

Buybacks are a more efficient way of returning cash because they create a return (through a reduced share count and therefore a higher stock price) without forcing each investor to pay tax on the cash distributed (as is the case with a dividend). Theoretically, publicly listed companies need never issue dividends since any shareholder desiring, say, a 2.5% dividend can always sell 2.5% of his holdings.

One might think that companies with low payout ratios are retaining more of their earnings so as to invest in the high return opportunities they see in their business. This ought to lead to faster dividend growth in the future as the projects provide their payoff. I’m currently reading Successful Investing is a Process by Jacques Lussier, PhD, CFA. The author kindly sent me a copy as I’ll be speaking at a CFA event in Montreal he’s organizing later this year. Mr. Lussier notes some interesting research by Arnott and Asness in 2003 that sought to compare low dividend payout ratios with faster subsequent growth.

In fact, they found just the opposite, that low dividends don’t lead to higher dividends later on. In too many cases it seems that managements are overly optimistic about the opportunities to deploy capital either internally or on acquisitions. And in fact this is the real power of stable dividends with a high payout ratio. Rather than suggesting the company has few interesting projects and therefore nothing better to do than return capital to owners, it imposes a level of capital discipline on management that ultimately leads to higher returns. Companies that return more cash to shareholders have less to squander on ill-judged investments, and the shareholders ultimately benefit.

Incidentally, Master Limited Partnerships (MLPs) represent an extreme case of this. Since they routinely distribute around 90% of eligible cashflows they have very little retained earnings and therefore have to raise new debt and equity capital for any project. This imposes a wonderful discipline on MLP managements in that they’re always having to explain to underwriters and investors what exactly they’re planning to do with the proceeds of a debt or equity offering. It’s one of the reasons MLPs have had such consistently strong performance; so many of their management really focus on return on capital.

It’s all part of the Low Beta Anomaly, the concept that low volatility (or low Beta) stocks outperform on a risk-adjusted basis and even on a nominal basis. So far this year the returns to low volatility investing have been good (for example, the S&P500 Low Volatility ETF, SPLV, is +8.6% through June) as many of the high-flying momentum names crashed during the first quarter. Slow and steady dividends with growth may not appear that exciting, but boring is often better where you’re money’s concerned.

How Central Banks are Ruining the Insurance Business

Denis Kessler, CEO of Scor, a large reinsurer, is the most recent critic of today’s low interest rate environment. It’s not only the stereotypical retiree clipping bond coupons that is suffering from current interest rate policy. Insurance companies typically hold substantial amounts of their investment portfolios in bonds, both because of regulatory requirements as well as the need to respond to claims whose timing is often unpredictable. Kessler claimed that central banks were “ruining” the insurance industry, and claimed that insurers were the unwitting victims of the aftermath of the financial crisis even though they didn’t create it (AIG and its credit derivatives portfolio presumably notwithstanding).

Warren Buffett has described an insurance company’s “float”, that is, the premiums they receive in return for making payments in the future, as akin to being paid to borrow money. This is true to the extent that insurance companies can operate with a Combined Ratio below 100% (that is, the sum of underwriting losses plus operating expense as a % of net earned premiums). If they spend more than their premiums then of course the float costs money and the difference needs to be made up on the investment side.

Most insurance companies either through poor underwriting or competitive pressure slipped into just this model, whereby positive investment results were needed to cover a Combined Ratio above 100%. One of the capital disciplines practiced by Warren Buffett’s Berkshire Hathaway (BRK) in its insurance business is to separate out the management of the float from the underwriting, so as to prevent success at the former from compensating for poor execution of the latter. BRK’s insurance businesses have generated a net underwriting profit for eleven straight years. One clear benefit of separating underwriting from investing is that the insurance executives at BRK have  little incentive to grow via unprofitable business expecting to rely on strong investment results as support.

However, for many insurers persistently low interest rates have heaped pressure on one side of this equation. One might have expected the market to adapt, through a “hardening” market (insurance-speak for rising premiums) given lower investment returns, and while this has happened to a degree pricing hasn’t adjusted as much as needed. This is why so many insurance companies trade at a discount top book value – because while profitable, they’re not yet earning an appropriate return on equity.

Aspen Insurance (AHL) is one that we have liked in the past because of their well regarded management but it still trades at only 87% of book value (we don’t currently own AHL). Another name we have owned in the past but don’t at present is CNA also at 87% of book value. We continue to own AIG which is valued at 83% of book value excluding unrealized investment gains (or only 76% of book value if you include such mark-to-market gains, which isn’t an unreasonable approach). And we also own BRK, which trades at around 140% of book value but is of course a diverse conglomerate with  large operating businesses and a substantial investment portfolio. You don’t often hear them complaining about low interest rates, either.

Our Hedged Dividend Capture Strategy is designed to extract dividend income from equities while mitigating equity market risk through hedging. It’s designed for investors used to better returns from high grade bonds.

Why the Fed Likes Bonds a Little More

FOMC YE FF June 18 2014


The chart above doesn’t look like much, but it represents a snapshot of the thinking of the Federal Open Market Committee (FOMC) on interest rates. Their communication has come a long way since the days of cigar-chomping Paul Volcker in the 1970s, when they went out of their way to disguise their intentions. Alan Greenspan inherited this culture and while in his early years he clearly relished confounding Senators with his unintelligible responses during Congressional testimony, over time he initiated a move towards greater transparency around the Fed’s decision making process and objectives. Ben Bernanke continued this and no doubt the trend will be maintained under Janet Yellen.

On the chart above (reproduced from the Fed’s website), each dot represents the view of a single FOMC member on the year-end level for short term interest rates (specifically, the Fed Funds rate). There are 16 voting members and each provides a forecast for the end of this year, 2015, 2016 and the long term. I’ve been watching these releases for nearly three years because over time they provide a fascinating picture of their evolving interest rate views.

The first three annual forecasts (2014-2016) can almost be used to construct a yield curve. Indeed, interest rate futures contracts are now often described as priced above or below the Fed’s forecast. Of course, their rate forecast can be wrong, just as the economic forecasts on which it’s based can be. Circumstances change, and there’s nothing intended to be inflexible about these figures. But it does allow us to see more clearly whether economic events alter their view. For example, U.S. GDP growth in the first quarter was quite weak at -1.5%, due largely to the harsh winter those of us in the north east endured. However, the FOMC has a reasonably positive view of growth for the remainder of the year (2.1%-2.3% for all of 2014 which implies around 3.4% on average for the remaining three quarters). As a result, they very modestly tweaked their rate forecasts higher over 2015-2016 (by about 0.07%-0.10%).

More significantly in my view, their long run forecast of interest rates fell from 4.0% to 3.75%. This is the equilibrium rate at which they think rates should settle assuming they had no bias to run monetary policy with either an accomodative bias (as it is now) or a restrictive one. 3.75% is neutral. It takes account of their long run estimate of inflation and of GDP growth.

Back in early 2012, their median long run forecast for rates was 4% and they raised it to 4.25%. They brought it back down to 4% last Summer and then 3.75% yesterday. If their forecast is right (and their forecasts are more important than anybody else’s) it means the fair value yield for, say, a ten year treasury security is a little lower. An investor now ought to be willing to hold it at a somewhat lower yield than before since in theory a ten year bond represents roughly the average short term yield over that period of time.

Steve Liesman from CNBC picked up on this and asked Janet Yellen in her press conference yesterday what was behind this shift. She noted that the composition of the FOMC had changed since the last forecast in March which might make the comparison less meaningful (two voting members were replaced according to a rotating schedule). But she conceded that it also probably reflected a more modest view of long term GDP potential in the U.S. economy.

For investors, it confirms what we’ve long felt, which is that interest rates are likely to stay relatively low for a long time. The Fed’s not about to make bonds more attractive by pushing rates sharply higher, so they will remain a fairly unattractive investment choice. And while you can’t infer too much about equities from the Fed’s interest rate view, it still seems likely that stocks will provide superior long term returns compared with bonds over the medium term.



Are Leveraged ETFs a Legitimate Investment?

Recently Larry Fink who runs Blackrock waded into the debate over leveraged ETFs at a Deutsche Bank investment conference. Fink was highly critical of such products, which he said had the potential to “blow up” the industry one day. The other side of the debate includes Direxion, a provider of leveraged ETFs (Blackrock has none).

There’s probably little disagreement about how they actually work. Take the Direxion Daily S&P500 Bear 3X Shares (SPXS) for example. $1 invested gives you three times the inverse exposure to daily swings in the equity market. So if stocks are -0.25%, you should be up a little less than 0.75% (there are fees, after all). The leverage can sound attractive, but comes with an insidious long term result. Because the ETF targets constant leverage of 3X, it is always having to rebalance. And this rebalancing is always in the direction of the market’s most recent move; if the equity markets falls (causing the ETF to rise in value) its leverage will drop below the target of 3X. At day’s end it will need to increase its short equity position by selling stocks (or index futures) at lower prices. Conversely, if the market rises causing the ETF to lose money it will become over leveraged and will need to reduce its short position by buying stocks, just after they’ve gone up.

The perhaps surprising result of this is that given enough time and enough up and down moves, the value of the ETF will inexorably trend towards 0. There are certain special cases in which this may be delayed or (theoretically anyway) not happen, such as an underlying market that moves steadily in one direction with no fluctuations (i.e. the rebalancing causes less harm), but in the real world such things don’t exist. And it can lose money over time even if the underlying equity market moves as the holder expected (i.e. falls) because of the rebalancing. It is, curiously, an investment product that will cost you money with greater certainty the longer you hold it.

This is fully understood by the providers and Direxion’s prospectus (for those who read such things) provides ample warning that this is a short term, “tactical” fund. Although they do use the word “investment” as it relates to “daily investment returns”, they don’t describe it as an investment product.

So why do such things exist? The answer, of course, is that investors are consenting adults and if full disclosure is given then who’s to say that an “investor” (since real investors couldn’t possibly use these) shouldn’t be allowed to buy one? In aggregate, the holders of inverse ETFs will lose money with virtual certainty, but of course they won’t all lose money. In this regard, they are very much like blackjack or sports betting. A minority of users with skill (or luck) can profit but we all know that the casino always wins. But at least visitors to the blackjack table or the track presumably don’t for one minute confuse what they are doing with investing. Do inverse ETFs users possess the same sense of reality?

Such products no doubt sell themselves, such is the interest in short term market direction and tools with which to bet on it. In fact, one would hope that being sold by themselves is the only way they are ever used. For while Direxion and other such providers can point to the ample disclosures in their documents which almost (but not quite) advise you to not use them at all, what of the brokers or advisers who recommend them to their clients?

It’s hard to fathom why anyone would recommend that a client risk money in something that really is structured like a gambling bet. And in fact the Investment News article referenced above notes that many brokerage firms place strict limits on sales of leveraged ETFs. For those that still recommend their clients use them, one must presume that their business and demand for commissions need only satisfy the minimal standards of (1) is it legal, and (2) did the client agree.

The CFA Institute’s Future of Finance initiative which, among other things seeks a finance industry that puts investors first, clearly has plenty of opportunity.



The Power of the MLP GP

Yesterday was Williams Companies’ (WMB) Analyst Day. The company gave a strong presentation across each of their divisions. It highlighted the many opportunities to build new infrastructure in response to the shale developments, especially in the Marcellus. WMB’s dividend yield is 3.3% but such is the earning power of the assets they control that management extended their dividend growth forecast of 20% out to 2016 (from 2015) with further strong performance expected beyond that. Much of this is driven by assets held at WMB’s MLP, Williams Partners (WPZ), since WMB owns the General Partner are therefore receives 50% of each additional dollar of distributable cashflow.

WMB controls Transco, a pipeline network that runs from the NE U.S. down to Texas. One of the more memorable pieces of information came when Rory Miller, SVP of the Atlantic-Gulf Operating Area, noted that he’d once asked his team to estimate the cost of rebuilding the Transco system and the figure they came up with was $100 billion (for comparison, WPZ’s enterprise value is $33 billion). This pipeline was first laid 60 years ago, and decades of population growth and development all along the route make the cost of building something similar today prohibitive.

Interestingly, today Goldman upgraded Kinder Morgan (KMI) from Buy to Conviction Buy. Kevin Kaiser of Hedgeye, a small research firm in Connecticut, has been a long-time critic of MLPs and the Kinder complex in particular. KMI owns the GP for Kinder Morgan Partners (KMP) and El Paso (EPB) and while it doesn’t sport the type of growth prospects of WMB we think it’s a similarly attractive security leveraged to the continued development of energy infrastructure in the U.S. Kaiser has long argued that firms such as KMI skimp on maintenance, something not supported by metrics such as operating performance or accident statistics. But the Transco example above suggests that in at least some cases MLPs own assets that are substantially undervalued, at least on a replacement basis.

KMI has been a weak performer over the past year or so, providing at least some vindication for Kaiser (although their business performance has been fine and his negative call on MLPs as a whole has been dead wrong). For our part, we think both companies are very well positioned and are long both WMB and KMI.

The Problems with Reported Inflation

The CFA’s bi-monthly magazine includes an article on the gradual mis-reporting of inflation that’s taken place over the years (“Double, Double Toil and Trouble”). Criticism of how the government calculates inflation is not new, and I included a chapter on this in my latest book Bonds Are Not Forever. For a start, it’s hard to take seriously an index which assigns a 24% weighting to Owners Equivalent Rent (OER), a wholly unsatisfactory solution to the problem that owned housing represents an investment that happens to provide a service (which is shelter) whereas the CPI seeks to measure the consumption of goods and services (including shelter) but not the return on investments (such as real estate). OER relies on estimates of what owned housing would rent for if rented, a concept with which very few homeowners have any familiarity. It’s just one example of the white-coated statisticians in their inflation laboratory concocting mathematical potions that have no relevance to the outside world.

John Williams runs ShadowStats.com, and he’s probably one of the better known critics of current practice. One has to acknowledge that the inflation critics are something of a fringe group, and at their most extreme mutter about a widespread conspiracy to cover up the Federal government’s impending bankruptcy. I can’t say I align myself with such extreme views, but nonetheless I do believe that beating inflation as reported is a dangerously low hurdle for an investor to set when planning their retirement.

In the 1990s the calculations were altered to allow for substitution and quality improvements. Both of these can make sense and need not be controversial as long as the user understands what the resulting altered figures mean. Substitution recognizes that the basket of goods and services from whose fluctuating price the CPI is derived changes in real life, and therefore allows that the CPI should reflect these changes. Consumers shift from, say, steak to chicken when relative prices change but also bought fewer vinyl LP records when CDs became available. Clearly, not changing the weights to account for this would mean that the cost of horseshoes would still be a component.

Quality improvements are more subjective in my opinion and rarely seem to include quality deterioration. Commercial flying is a perfect example. When I describe some of the subtleties of calculating inflation in presentations and note that the inflation statistics have incorporated a modest quality improvement in flying in recent years (due to easier cancellation terms) the audience typically laughs at the absurdity of the notion. Longer security lines, poorer food and sometimes surly flight attendants may not resonate with the statisticians who measure such things but are assuredly part of the flying experience for most users of inflation figures.

John Williams gets to the heart of the matter when he argues that in combination, substitution and quality improvements have altered the CPI from measuring the cost of a constant standard of living to the cost of a constant level of satisfaction (constant utility is the economic term). Although the difference may seem trivial don’t be fooled; since living standards generally rise over the time you care more about the cost of maintaining a constant standard relative to your peers and the larger economy. If your lifestyle includes buying the latest ipad you want to maintain that standard, and falling ipad prices (which don’t occur in reality but do occur for inflation statisticians once new model quality improvements are factored in) may give you more utility, but utility isn’t always fungible and you may not have asked for it.

It also occurred to me that in the debates among academicians and government departments about how to calculate inflation, the beneficiaries of the lower inflation camp are invariably well represented. Lower inflation flatters the government’s finances through reduced cost of living adjustments on entitlements as well as tax-bracket creep (since the income bands at which higher tax rates kick in are adjusted up more slowly than they would be otherwise). The tangible and political benefits no doubt invigorate those arguing for a lower-resulting methodology while the benefits to those sincerely advocating a higher-resulting methodology would seem to be far more prosaic.

It’s one more contributing factor to increasing income inequality (since those most exposed to the vicissitudes of inflation calculations rely disproportionately on entitlements and welfare) but it will be no surprise that different inflation calculation methodology has never been much of a hot-button political issue. For investors, you take the world as you find it. Fixed return securities such as bonds provide scant compensation for inflation risk. Someone asked me just the other day what I thought was the best protection against a steady increase in inflation (whether it’s inflation as measured by the government or simply the higher version as experienced). The best answer we have is to invest in equity securities whose underlying businesses possess built-in protection in the form of pricing power. Stable companies with consistently high operating margins; midstream Master Limited Partnerships (MLPs) who often own fee-generating assets whose pricing is inflation linked. These are two of the best forms of defense an investor can adopt. While it’s probably a stretch to assume a government conspiracy, it’s hard to identify participants in the debate whose interest is to err on the side of higher (i.e. more conservative) inflation calculations.

67th CFA Institute Annual Conference

Earlier this week I was at the 67th CFA Institute Annual Conference in Seattle. It enjoyed a record attendance of over 1,800 and I have to say was one of the better organized events I’ve been at, situated in the cavernous Washington State Convention Center. One thing I particularly liked was that the networking doesn’t involve people trying to sell you something, and the fact that delegates are overwhelmingly CFA charter holders results in a good probability of an interesting conversation.

Sheila Blair, former head of the FDIC, gave a very good talk on the regulatory landscape and improvements she would like to see. Canada avoided any sort of financial crisis and in response to a question she concurred that being “a little more Canadian” would be a good thing in the U.S., pointing to campaign finance reform as one area that could reduce the ability of Wall St to influence the legislative process.

I also like the CFA’s new initiative, The Future of Finance which includes as one theme Putting the Investor First. The CFA is a great organization to be taking a leadership role in the debate about the financial services industry and how well it is meeting the needs of clients. As long as unlisted registered REITs, with their egregious underwriting fees, and closed end fund IPOs (which invariably trade to an immediate discount) are part of the landscape there is much room for improvement.

I gave a presentation titled, “The Fallacy of Hedge Funds” which relied on my book, The Hedge Fund Mirage. The audience was very generous with their attention and questions.

Afterwards I did a couple of interviews with the FT, one on hedge funds and the other on High Frequency Trading. HFT was the major topic of conversation at the conference.