Consider the Alternatives (Part 2)

What are the different types of alternative investments?

Muskovy Duck. Photo: Matt Lemmon. Source: Animal Photos

Alternative investments can be split into two types of assets: different ways to manage, and different types of assets. I’ve written before how all wealth really depends on the economy. A huge pile of gold or a robotic factory that churns out flying cars are both worthless if they’re stranded on Mars.

Alternatives are just different ways to tie in to the economy’s wealth. Within management-alternatives are private equity, angel investing, and venture capital investing. These are different ways to have equity ownership, and they focus on young companies or companies that are in unique circumstances, like distressed firms in turnaround situations. Because so many startups fail, execution here is critical. Fund managers need to be able to provide management support along with their cash.

Private equity focusses on more mature companies. It provides a different level of accountability to company executives than public ownership. If private investors are suspicious of a firm’s accounting, they can bring in their own accountants. If a privately owned firm’s management behaves badly in the morning, they can be fired in the afternoon. That’s one reason why there are fewer scandals involving private firms. They can be held to a higher standard.

Source: NY Fed

Hedge funds are a different breed of alternatives. They aren’t really a different type of asset, they’re a different type of fee structure. They typically have a higher management fee, and they also take a share of a portfolio’s gains. Hedge fund managers are also free to invest in all kinds of things, to concentrate their portfolios, to use leverage, to short different assets, and so on. The theory is that by providing more compensation – and more flexibility for fund managers – the best ideas will emerge. But sometimes, hedge funds run out of ideas. Then they end up doing silly things, like putting most of their money into one stock.

In the long run, these management alternatives depend on the stock market for many of their activities, whether it’s IPOs to get cash out of a startup, or market multiples to figure what the value of a company might be in a mezzanine-funding round. So it’s no surprise that correlations are pretty high, even if their performance is better.

Management alternatives aren’t really different assets, they’re different ways to invest in assets. Using different managers is like listening to a different musician perform a song you like. Sometimes you get an entirely different take on the music. But sometimes, it’s just a different rendition of the same old song.

Photo Quicksandala. Source: Morguefile

Douglas R. Tengdin, CFA

Chief Investment Officer

Consider the Alternatives (Part 1)

What are alternative investments?

Duck-billed platypus, an egg-laying mammal. Photo: Klaus. Source: Wikipedia

Alternative investments are assets that don’t fit into the normal asset-class categories of stocks, bonds, or cash. They include private equity, hedge funds, managed futures, collectables, commodities, and so on. They’re related to the standard asset types, but they have a slightly different twist. So physical gold is an alternative investment, while gold mining company stocks are not. Real estate is an alternative investment; Real estate investment trusts that trade on an exchange are not.

Alternatives are hard to value and are less liquid than conventional assets. It’s a lot more work to buy or sell an apartment building or a 200-year old bottle of wine than it is to move 1000 shares of Apple stock. There aren’t as many buyers and sellers, each asset is distinctive, and there are high transaction costs. But because they’re so unique, their prices aren’t so closely correlated with stock and bond markets. As a result, many institutional investors have begun to use them as tools to diversify their holdings.

Stock Market, Gold, and Fine Wine Indices. Source: Bloomberg

But the goals of institutional investors—like endowments or large retirement plans—aren’t the same as individuals. These investors want to maximize their returns, like everyone else, but they also have ongoing liquidity needs. They need to pay cash to current pension beneficiaries, or fund current operations, at the same time that they try to maximize growth. Individuals who are saving for retirement 20 years out can “set it and forget it.” It doesn’t matter to them if the market zigs and zags along the way. As long the market is there for them at the end, they’re in good shape.

If an institution with current cash flow needs has to sell something to fund their commitments, though, they risk turning temporary fluctuations into permanent losses. They don’t just need to maximize their returns—they need to do this with as little variability as possible. The destination matters, but how rough the road is along the way matters almost as much. Because a big pothole could make the transmission drop out.

There’s no magic to the markets. Assets grow in value because they participate in the economy—and represent different claims on the economy’s cash flow. There are really only three types of economic assets: stocks, bonds, and real estate. Bonds are a senior claim on cash flow; stocks are a junior claim; real estate comes in between. Alternatives are some form of derivative—either a different way to manage the assets, like hedge funds, or a way to capitalize on household wealth, like old master paintings or antique cars. But everything still depends on how much wealth the economy is producing.

Alternative assets are a way for managers to try to reduce the volatility of their portfolios. Investors should be aware of them, but should also be very careful how they use them. Anything with limited liquidity and not-very-transparent prices that suddenly becomes trendy is likely to be abused. And as bees are drawn to honey, crooks are drawn to money.

Douglas R. Tengdin, CFA

Chief Investment Officer

Unhealthy Economics

Should the market try to be fair, or efficient, or both?

Photo: James Hellman, MD. Source: Wikipedia

Life isn’t fair. We know this. But something inside us recoils when a drug-maker buys the rights to a product that used to cost about $50, then raises the price to $600 over the course of 9 years, even though nothing has changed other than the market has gotten bigger.

In 2007, Mylan Pharaceuticals bought the rights to make and market the epipen, a device that injects an emergency does of epinephrine to people who are undergoing an anaphylactic shock. It can save someone’s life. It’s no fun to get anaphylaxis—a Esevere allergic reaction to a bee sting or eating a peanut or taking the wrong medicine. The symptoms come on suddenly: a rash, shortness of breath, and sever swelling in your tongue and throat. It kills a few hundred people per year.

Epipen. Photo: Tokyogirl79. Source: Wikipedia

Mylan isn’t the first company to do this. Valeant bought the rights to a couple of heart drugs and raised their prices by several hundred percent in few years; Pharma Bro did the same thing with an AIDs drug. This strikes most people as deeply unfair. These companies aren’t innovating and expanding the market, they’re just taking advantage of our patent law system.

Folks on the left see these as examples of corporate greed; those on the right see them as part of a poorly designed health-care system, with opaque pricing and government set-asides. Economists see it as rent-seeking: not payments on a lease, but attempts to extract income from others by manipulating the social or political environment—like a landowner who puts a chain across a river on his property and charges a fee on boats that pass through.

These hedge-fund-managers-turned-pharma-CEOs are like roving bandits, extracting rents wherever they can, contributing nothing to drug research. They fight among themselves for increased shares of the economic pie, rather than increasing the size of the pie itself. Eventually, rent-seeking can lead to a collapse in the political system, like what happened in Japan in the ‘90s. Political revolutions can actually be good things if you start with a clean slate.

One thing is certain: if you want to seek rents, victims of anaphylaxis aren’t the ones to extract it from. If these rogues wanted to feed a political revolution, they couldn’t have picked a more in-opportune target—or time.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Elusive Steady-State

Will the economy ever get back to normal?

Source: Wikipedia

Everyone wants the economy to normalize—normal interest rates, normal economic growth, normal inflation. The Fed is talking about that issue this week in Jackson Hole, Wyoming. But we never seem to get there. Something always seems to come up.

Ten years ago, the economy crashed during the financial crisis. Five years ago we had a Euro crisis and fears of “Grexit.” Now “Brexit” and the most bizarre presidential contest in memory are roiling expectations. Economists debate whether we’re in a “new normal” or secular stagnation or if the rising “gig economy” will turn us all into innkeepers, taxi drivers, and dog-walkers.

Some see the market as a complicated machine, with levers and buttons for policy-makers to push and pull. All we need to do is find the right mechanism to increase output. But it’s really a complex ecosystem, with stresses and stimuli from invasive species, new adaptations, over-harvesting, and an infinite number of other internal and external factors. If you walk into a forest, nothing is ever stable. It’s always in a transition from something old to a new new thing.

Photo: Petr Brož. Source: Wikipedia

The economy never has been nor ever will be in equilibrium. The economy we have is the economy we need to work with: first to understand it, then to encourage increased, sustainable growth. Markets are always shifting, challenging the most nuanced and elegant models. But markets don’t do elegance. If you want elegance, see a tailor.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Ups and Downs of Index Investing

What are market indexes?

Source: The Reformed Broker

A market index is just a group of securities. With 7000 investable stocks in the US, there are 2 7000 possible combinations. But actually, with different weighting schemes, there are more. This means there are now more indices out there than there are large-cap stocks. With index-based Exchange Traded Funds (ETFs) widely available, index investing has come to resemble particle physics, with quantum creation and destruction, spooky entanglement, and a fund’s success often predicated on its spin, strangeness and charm.

The first index was created by Charles Dow in 1896 as a simple average of stock prices. Index methodology moved towards using market capitalization—the stock price times the number of shares outstanding—as the principal means of weighting equities in an index. Now, there are over 130,000 global indices calculated and tracked by S&P / Dow Jones—from the Philippines Property Index to Philadelphia Oil Services. Many observers have noted that there appears to be a “bubble” in indices.

Indexes help investors evaluate a manager’s skill relative to a benchmark, and give them the opportunity to put their money into a widely diversified portfolio if they choose. Now, what used to be looked at as the value-added of stock picking can be reduced to quantitative factors, and individual managers’ approach can be simulated and back-tested. Even Warren Buffett’s portfolio—with his preference for “wide moats” and consistent cash flow—has been cloned and replicated. So even after he passes away, his methodology can live on.

Source: Frazinni, Kabilla, and Peterson

But cap-weighted indices aren’t really neutral. They have their own biases. The gradual dissemination of new information into the market—and its incorporation into securities prices—means that these indices carry a certain amount of momentum. Also, since the priciest stocks are weighted the most heavily, they also have a growth tilt to their composition. So index investing is really growth-portfolio momentum investing.

In addition, cap-weighting creates its own paradoxes. When a company buys back its shares—everything else being equal—its price goes up while the number of shares goes down. Individual shareholders will profit as their ownership stake in the company increases, while index investors would not—the market cap doesn’t change. The converse holds true for companies that issue new shares, diluting the ownership of their shareholders. Individual shareholders would be hurt; index-holders would not.

Finally, technical issues related to index investing can lead to significant short-term price volatility. The flash crashes of May 2010 and August 2015 caused a lot of turmoil, and the Crash of 1987 was also linked to index-based portfolio activity. While the fundamentals of the market and economy had not changed, it appeared for a while as if the market was anticipating serious problems.

All this is not to suggest that indexes and index-based investing are bad. On the contrary, cap-weighted indices have been helpful for investors and are now central to modern money management. Like most areas of life, however, it’s important not to go too far. “When you find honey,” Proverbs says, “eat just enough. Too much, and you’ll get sick.”

Douglas R. Tengdin, CFA

Chief Investment Officer

The Tyranny of Norms

Will the economy ever get back to normal?

Source: New York Fed

Fed officials keep telling us what they want. But that’s not their job. The Fed was established to support the banking system—to serve as bankers to the bankers. Part of that job involves managing bank reserves, the money supply, and short-term interest rates. The 1978 Humphrey-Hawkins legislation specifically instructed the Fed to pursue two goals: full employment and price stability. This is sometimes called the Fed’s “dual mandate.”

So it is understandable that policy-makers would look at developments in the economy positively or negatively, based on whether they represent progress towards reaching these goals. If you listen carefully to what they say, however, you can learn a lot about the FOMC members’ plans, intentions, and expectations – beyond these narrow confines.

They talk about positive and negative developments in the economy, in the markets, about what policy should do, and where they want interest rates to go. This is understandable—economic statistics represent financial reality for hundreds of millions of people. When the economy goes south, our plans and hopes and dreams may have to change. No one wants to see others suffer because of policy errors.

But it’s dangerous for officials to discuss where the economy “should” go, about what they “want” policy to do. The wish is father to the thought, as Shakespeare wrote. By saying what they want, Fed chieftains constrain what they might be able to do. And hindsight bias means that they are at risk of finding what they’re looking for in the data—whether it’s really there or not.

The economy we see is the economy we have, whether the leaders gathered at Jackson Hole this week want it to be that way or not. We may all hope that things get back to normal—whatever “normal” means. But this isn’t Oz: we can’t just click our heels together and wish our way home.

Photo: Chris Evans. Source: Wikimedia

Douglas R. Tengdin, CFA

Chief Investment Officer

Reforming Money, Tightening Money

Are money markets doing the Fed’s job?

Photo: Jon Sullivan. Source: Public Domain Images

The Fed is in Jackson Hole this week, discussing how to design a monetary policy framework that enhances the global economy. Luminaries from all over the world will be there—from other global central bank leaders to politicians to academics. On Friday, Janet Yellen will speak, and she is expected to offer some hints as to how she—and by extension, the rest of the Fed—sees the economy, and where Fed policy might go next.

But what if new regulations have already done the Fed’s job?

The spread between 3-month T-Bills and 3-month LIBOR–known as the TED spread–has been a good indicator of financial stress. When banks are reluctant to lend money to one another, the spread widens. During the run-up to the financial crisis, the spread climbed from 0.20% in 2006 to 1.50% in 2007 and topped out at 3.0% in September of 2008, just after Lehman went bust. The higher the TED spread, the more borrowing costs.

But that was then, this is now. For the past several years, the index has been on auto-pilot. There haven’t been many real threats to the banking system. Concerns about loans in the oil-patch didn’t show up in the TED spread. But lately the spread has moved a lot higher. Why?

TED spread. Source: Bloomberg

Mostly, this has to do with reforms to the money market that are part of the Dodd-Frank legislation. In order to prevent a repeat of the financial crisis, when a big money market fund “broke the buck” and caused a modern-day bank run, Congress decided that all credit-sensitive money market funds have to be flexible in how they price themselves. They can no longer guarantee a stable market price. So as much as $1 trillion held in money market funds is moving into government funds. As a result, banks and other creditors have to pay up for short-term money. Since regulation has permanently changed the money-market landscape, these spreads may be permanently higher.

As a result, financial conditions have tightened. Not as tight as they were during financial or Euro crisis, but certainly tighter than they have been. At Jackson Hole the Fed will talk about the right time to take the punch bowl away. But Dodd-Frank’s money market provisions may have already put a lot of water in the punch.

Douglas R. Tengdin, CFA

Chief Investment Officer

Risk, Return, and Investment Fads

Do low-risk stocks have higher returns?

Photo: Chamomile. Source: Morguefile

That’s what a lot of people are thinking. It’s kind of counter-intuitive. After all, it’s always been taught that in order to get returns, you have to take some risk. Bonds are more risky than bank deposits, but they pay more. Long-term bonds are more risky than short-term bonds. Stocks are more risky than bonds—their prices are more volatile, and if a company goes bust, stock investors usually don’t get anything back. For example, when after the financial crisis, investors who owned Lehman’s shares were wiped out, while those who owned senior Lehman’s senior debt received around 30 cents on the dollar. That’s not a lot, but it’s a whole lot better than nothing.

The assumption that risk and return are linked is central to much of modern finance. It is assumed that your total investment returns are generally limited by your risk tolerance. In fact, this has become a central tenet in most asset-mangers’ education. You won’t pass the CFA curriculum if you put a risk-averse 100% into stocks. The theoretical foundation of this practical norm is the Capital Asset Pricing Model, first formulated by Bill Sharpe in 1964. He won the Nobel Prize in Economics for his insight.

But academics began documenting anomalies to the CAPM almost as soon as it was proposed. They discovered a “size effect,” a “quality effect,” and a “value effect.” These factors capture the fact that small companies, well-run companies, and cheap stocks tend to do better than the general market. Lately researchers have been looking at a “low-volatility” effect—the notion that stocks where the price doesn’t jump around as much seem to do better than shares of jumpy firms. This turns risk/return thinking on its head. If the “low-vol” effect is right, then the least risky stocks are better investments—more return for less risk.

Source: Eric Falkenstein, “Finding Alpha

The financial industry has capitalized on this notion, creating a host of low-vol funds and ETFs. These appear to be pretty successful. The five largest funds have almost $40 billion in assets under management, gathering $25 billion in the last two years. Year-to-date, they have returned over 11%, while the S&P 500 is up only 8%.

But on further examination, much of the low-vol effect turns out to come from other factors. High-volatility stocks historically have been penny stocks and the most speculative shares. Penny stock marketing was reformed in the early ‘90s, and when the tech bubble burst, a lot of non-income “concept companies” went away.

Lately, low-volatility stocks have done well, but much of that can be attributed to the recent outperformance of dividend-growth companies like utilities, consumer products firms, and pharmaceutical corporations. Since bonds don’t pay much—if anything—any more, income-oriented investors have shifted their funds from bonds to stocks, pushing the prices of dividend-growth stocks to record levels. The PE ratio of the Dow Jones Select Dividend Index is now 37% above its average level.

Source: Bloomberg

Financial fads come and go. In the late ‘90s it was tech stocks. Before the financial crisis it was China. Now it’s dividend growth. Investors rush into a concept and rush right back out again, leaving disappointment and disillusionment in their wake. Technology and China and dividends remain important investment themes, but not at any price. If you pay too much for anything, your performance will suffer.

In a portfolio, as with clothes, fashion is what you’re offered. But style is what you choose.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Upside of Debt

Is all this borrowing good for us?

Source: St. Louis Fed

A growing level of debt in an economy can be a good thing. By borrowing money to pay for capital, we can become more productive and everyone prospers. Think of the US borrowing massive amounts of money to build the interstate highway system in the ‘50s and ‘60s. The important thing to remember is that the return on investment has to be higher than the cost of the borrowing.

That’s why today’s persistently low interest rates are so puzzling. In normal times, low interest rates would spur investment spending on a host of capital projects. That spending would itself spur economic growth, as the money cycles through the economy. Capital spending makes an economy more efficient, making everyone better off. The borrowing is easily serviced by a growing economy.

But these aren’t normal times. Companies are reluctant to borrow to finance capital investments. They’re worried that there may not be enough final demand, and their projects may get stranded. Apple may be spending over $10 billion per year on research and development, but they’re funding this out of their massive cash flow. Corporate borrowing is being used for financial engineering: CFOs are borrowing money to finance stock buybacks. If they can borrow at 3% to buy their stock with an earnings yield of 5% (a PE of 20x), that’s positive for shareholders. But what are shareholders doing with the buy-back cash? They’re buying more stocks—and share prices are increasing.

Source: Spottradingllc

Rising asset values may encourage some economic activity, but it’s not a very effective transfer mechanism. Ongoing subpar growth requires fundamental change—not just tweaks to monetary policy. Monetary policy can only shift growth around—from country to country, via exchange rates, and from one time period to another, through interest rates. Lower rates pull growth forward; higher rates push it back.

But there has to be growth to push or pull. That’s why fundamental change is needed. Regulatory reform can make it a lot easier to do business. There’s little need, as far as I can see, to make hair braiders get a license in cosmetology. But that’s what many states require. Tax reform can also level the playing field by eliminating special set-asides and lowering the statutory rate.

Debt can be profitable, but only if it’s used as a tool to become more productive. Otherwise, it’s just rearranging the financial deck chairs on an economic steamship headed into the fog.

Douglas R. Tengdin, CFA

Chief Investment Officer

Lucky or Good?

Was it skill or was it luck?

Official Finish Cam. Source: BBC

It was one of the most exciting finishes ever. Two top rowers battled for first place down the 2000 meter course. Damir Martin of Croatia led most of the way. Towards the end, Mahe Drysdale of New Zealand—a former gold medalist—closed the gap. In the final seconds, Martin seemed to hold Drysdale off as they crossed the finish. But it was too close to call. The officials had to examine the finish camera to tell which boat was in front in the final instant.

It came down to the narrowest of margins. Only a fraction of an inch separated the two—less than a hundredth of a second. Martin was the first to applaud as Drysdale was announced the winner. How did Drysdale come out on top?

At the finish, Drysdale happened to be at the end of his stroke—the fastest point for the boat—just when they crossed the line. Martin was in mid-stroke, still applying power. At that point, Dysdale’s boat has a brief moment of maximum acceleration. That was enough to give him the miniscule edge over his rival. Over the 230-or-so strokes that both took to get down the course, the winner’s timing was aligned to be absolutely perfect.

Source: Bleacher Report, NBCOlympics.com

Drysdale was lucky. There’s no way he could have timed his strokes to give him that final edge. But both rowers were incredibly skilled. It was a delight to watch the fluidity and grace that they demonstrated—a perfect blend of technical skill, superb conditioning, and intense concentration. Drysdale wouldn’t have been in a position to be lucky if he hadn’t been good in the first place.

A similar thing is true when we invest. We may own a company that gets taken over, or one that has a blowout quarterly earnings report, and feel lucky that we’ve received a windfall. But you have to put yourself into a position to be lucky—whether it’s through exhaustive research or broad diversification or disciplined investment processes. As Samuel Goldwyn, the famous movie producer, once said: “The harder I work, the luckier I get.”

Douglas R. Tengdin, CFA

Chief Investment Officer