Sunday, October 8, 2017

Our Biggest Risk: Change - Weekly Blog # 492



Introduction

The proper function of active portfolio management is to be aware of possible forthcoming change and to anticipate its arrival.  It is this very function that we are least prepared to accomplish well and therefore the biggest single risk that we and our investors share. They at least have the benefit of being able to blame their professional managers, but since they selected the managers this is self-deception.

Why are we so unprepared to anticipate and take some advantage of future changes? In an over-simplification, the description is the differences between Art and Science. There is a great amount of art in what scientists do, and artists utilize science, often well. The difference in its simplest form is the scientist starts with existing formulas and focuses on what is there. Some artists focus on what is not apparent and perhaps what in their mind should be.

In the portfolio management world the scientists are guided by specific or at least implied facts that have repeated themselves enough so that they become rules, laws, or the current term - factors. All of these are a product of a mental prison. The prison can be labeled EXPERIENCE. If the timing of these “portfolio scientists” is propitious they may make relatively small gains.

The gigantic gains in terms of rewards or avoidance of pains comes from sensing what is not readily seen by most at the time. In the recent two weeks I became focused on long-dead geniuses. The first was the Nobel Prize for the efforts led by professors and laboratories of the Jet Propulsion Lab that Caltech manages in proving Albert Einstein’s 100 year old theory as to the impacts of gravitational waves in space. (This achievement only took over 1000 people and over $ 1 Billion NASA dollars and a strong contrarian view.) Nevertheless within a few weeks after the beginning of its operations, they were able to detect a number of collisions of black holes that release a huge amount of measurable energy.

Last night my wife Ruth and I enjoyed a magnificent musical performance conducted by the incomparable Xian Zhang and the New Jersey Symphony Orchestra playing Beethoven’s Emperor Concerto for Piano and Orchestra. Beethoven is another example of a genius well ahead of his times. What I didn’t  know was when Beethoven composed this piece in 1809 he anticipated the development of the modern piano different from the one of his day. It would take a half century before the present day piano arrived.

Today we are the beneficiaries of these geniuses’ work; one and two hundred years ago they saw what was not  seen by the rest of their professional colleagues. Perhaps for us in the portfolio management business the lesson is avoiding some of the penalties from using outdated instruments and thinking.

I have been concerned as to how to prepare for future changes and how they will impact future generations of beneficiaries of the art of portfolio management.

Future Political Changes

In last week’s blog I alluded to both the French and Russian Revolutions and that the early leaders of dramatic changes were replaced by more radical leaders who appeared to be able to more quickly accomplish structural changes that were promised. Today on every continent we have leaders who have sold themselves to the voters and other decision-makers as change agents that are being bogged down with the lack of sufficient political power to accomplish their promised goals. At some point, if the inability to make major structural changes continues, the present crop of change agents will be replaced either through the voting box or more violent means either from the Right or the Left. My fear is that due to technology and global economics we could enter a post-national world that may look like City/States with defense, military, and economic alliances. In such a world, the force of law on contracts may be quite different than what we are enjoying today. 

I don’t know whether the changes will be good or bad or more likely both. Neither do I know who will be the winners and losers. What it does suggest is that it may be prudent to be widely diversified not only in terms of geographies, but economies, and perhaps most importantly, the rule of law and taxation.

Financial Structure Possible Changes

Most of the readers of this blog and I are much more focused on equity investing than fixed income investing. The historic reason is that stocks are where we can profit the most. We tend to forget about the bond market. This is a mistake for three reasons:

1.  The bond market is bigger than the stock market around the world.

2.   Equities are leveraged directly or indirectly by the borrowings of governments, businesses, and individuals.

3.   The basic contractual laws were developed to establish “fair dealing” between lenders and borrowers which is also the basis for rules for equity owners.

Today, the size of unfounded  and contingent obligations question to the lenders that each and every future dollar or equivalent will be paid on a timely basis without significant increases in taxes and other transfers.

One of the tenets of being a contrarian investor is to get increasingly concerned about one sided markets. In many countries, (including the US) there has been more money going into bond funds than stock funds. These funds and many retirement funds are buying bonds pushing their prices up and yields down. Historically the differences in yields were an indicator of perceived risk. What are the financial markets saying when the yield on US Treasuries are 2.3% which is the same yield as the market is placing on emerging market stocks? Now the best thing that can happen to the owner of Treasury paper is to get paid the maturity value upon its liquidation, nothing higher. Over the next ten years the dividends on Emerging Market stocks can rise or fall. Clearly the Emerging Markets have trade, product, and currency risks that the Treasury paper does not. The equity market appears to be much more discriminating as shown in the yield table of equity indices below:

Below 2%
2-3%
3-4%
Above 4%
India
Japan
France
Australia
S. Korea
Mexico
Italy
Russia
China
Germany
Sweden

US
Brazil
United Kingdom


Canada
Spain


South Africa



Each list starts with the lowest yield, the most favored country in the yield range.

The stock markets appear to make significant distinctions that bond aggregates do not. There are some skilled bond investors working in the emerging market space. One that came to my attention this week has top three holdings in Kenya, Senegal, and Iraq. For lots of political, social, and religious reasons some investors might object to investing in these or other countries, their withdrawal as potential investors could reduce the number of buyers and make higher yields available to other investors.

As a contrarian I expect the flow of money into bond funds will be at best counterproductive,  if not producing meaningful losses. I am also concerned that the brokers and advisors who put investors into bond funds will lose face and clients for  their actions. Much of the flow into these funds comes from large broker dealers and large registered investment advisors. As much of the flows have gone into fund companies that also offer stock funds, hopefully the fund houses will be able to convert a significant portion of the residual bond investments into stock funds to preserve wealth and give the investors a chance to recover some of the expected losses. If this exchange happens now the scenario may work. There is a dreadful chance that the switch will happen concurrent with an eventual top of the equity market.

Equity Market Structural Risks

The European Union in January will put into effect rules that will have the effect of reducing payments for brokerage delivered research that may impact institutional trading around the world. From an investor standpoint this will likely remove the research support for many smaller companies which will lower their potential market value. This is occurring at the same time that in the US for various administrative rules and tax implications, the number of publicly traded stocks has been cut in half from the number of publicly traded stocks of years ago. It is much too early to tell whether the currently discussed tax bill and the desire of the Administration to reduce the burden of regulation will have a positive effect on stock prices. It would not be the first time that the unintended consequence of changes has the opposite impact to the government’s desires.

Investment Policy Considerations

As we may have entered a world where the historic factor type of rules based management may produce competitive results, it could be the time to drastically increase diversification. This is not just adding to the number of securities in the portfolio. It means having an increase in the number of themes used in the portfolios. It could well mean to begin a position in some of the currently worst performing segments such as agricultural commodities. It may mean to invest in local securities around the world. For us who manage portfolios of funds we may need to add new managers who think differently than some of our very successful present managers.

Bottom Line

We may have entered a period of structural changes that we need to recognize and begin to take actions to protect the assets of future generations.

Question to Dwell on: Can you evolve your thinking ahead of the headlines?    
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A. Michael Lipper, CFA
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