by WWM | Jun 13, 2018 | Active vs Passive Management
Do investment analysts provide positive returns for investors? That is, are you better off if you find a top analyst and follow his or her recommendations?
The evidence is not encouraging for those that wish to follow recommendations of analysts.
I think that there are some very good analysts in the business. And I think that the average analyst does a decent job of following the companies in his or her area of expertise. But does that translate into recommending that you find one or more and follow their calls? No.
I shall give you two reasons why I feel this way.
Analysts May Be Too Optimistic
One, analysts may tend to be overly optimistic in their assessments.
There are a variety of explanations as to why analysts tend towards optimism. I am not sure that I fully ascribe to any of them, but I shall point out the common ones quickly.
Existing or potential investment banking relationships between companies and their bankers may result in pressure on that bank’s analysts to provide positive assessments of the company. Usually the pressure comes in the form of employee remuneration or promotion opportunities. In some ways, I can see this occurring, especially when trying to attract new companies as clients for underwriting and other corporate finance work. But investment bankers often separate their finance groups from their research groups to try and maintain an appearance of objectivity.
Brokerage houses make money on investor commissions. Positive research reports may generate increased purchases and greater transaction revenues for the broker. There is some merit in this argument. Maybe I am a little naive, but I am not sure of the long-term benefits in brokers over-hyping stocks. Say I consistently read research reports, bought shares on the recommendations, and then saw under-performance as compared to the recommended share’s target prices. It would not take me long to a) no longer consider the research reports as having any informational value, and b) find a new brokerage house.
The analyst and/or his firm has a financial interest in the company being reported on. Again, this can be a legitimate concern for investors. In many jurisdictions though, there should be statutory disclosure requirements for any potential financial conflicts.
Most relevant professional organizations have ethical requirements concerning this and other issues relating to potential conflicts of interest. For example, the Chartered Financial Analyst “Code of Ethics & Standards of Professional Conduct” has quite detailed standards.
In a word, disclose. When you watch analysts on FOX Business, Business News Network, Bloomberg, etc., there is normally a statement as to whether the analyst, his family, or firm have a financial interest in the securities discussed.
For me, the common reasons as to why analysts are optimistic are a little tenuous.
However, that does not mean analysts are not optimistic in their estimates. In fact, there is evidence to suggest that analysts are indeed too optimistic.
In April of 2010, McKinsey Quarterly wrote that “Equity analysts: Still too bullish”.
“Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.
Alas, a recently completed update of our work only reinforces this view—despite a series of rules and regulations, dating to the last decade, that were intended to improve the quality of the analysts’ long-term earnings forecasts, restore investor confidence in them, and prevent conflicts of interest.”
The authors show that the over-optimism is significant as well as consistent.
“… analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent.”
Even though regulatory agencies and professional organizations are working to strengthen analyst objectivity, there still appears to be a bias (intentional or otherwise) towards inflation of expected performance.
While I do not fully support the complaints outlined above, I think that there is a bit of credence to them as to the reason for bias. The weaker the regulatory environment, the greater the probability for problems.
But I believe the key factor for optimism is less sinister. It likely stems from the fact that the analysts spend much of their time listening to the companies they follow. As a result, they hear positive takes on new products, cost cutting measures, and earnings growth.
They also want to keep a good relationship with companies they track. I know of more than a few stories where analysts have been frozen out of companies that they follow because they questioned a company’s data or gave less than glowing assessments. Given that access to the company is crucial when trying to analyze it, this can have an impact on analysts.
How Can You Determine The Best Analysts?
Two, it may be difficult to identify a “top” analyst whose recommendations you can follow.
Analysts tend to specialize in specific industries. Unless you plan to invest in only one or two industries, you will have to determine top analysts in multiple categories.
Also, with many analysts to assess there are many analysts vying for recognition each year. And there may be substantial change in “top” analysts every year.
For example, on August 6, 2012, Business Insider provided readers with, “The 36 Best Analysts On Wall Street”. I am sure an excellent group.
A year later, on August 16, 2013, Business Insider offered 50 names in, “The Best Stock Analysts In America”.
Maybe I missed a name or two in my comparison, but I think only Betsy Graseck made both lists. In one short year, very little concurrence on who are the top analysts.
The shift from year to year is normal within investment categories.
That much change makes it difficult to try and follow specific analysts who you may believe are best in class.
Is Following the Pros a Waste of Time?
I do not think it wise to develop a strategy of following analyst recommendations.
But you should rely on the research reports in your own analysis. The information contained therein is usually pretty good and can help you form your own conclusions. And if you know the limitations and concerns about research reports as described above, you can factor them into your own analysis.
In the future, we will return to this topic. Specifically, how you should utilize research reports in your personal analysis. We will also consider the suitability of attempting to follow the same investment strategies of highly successful investors (e.g., Warren Buffet). But we will save that for a future date.
Next up, a we begin to look at the passive versus active management debate. Also known as, can fund managers beat their benchmarks? And, as we will see, paying a professional to manage your money is often not the wisest strategy.
by WWM | Jun 6, 2018 | Active vs Passive Management
In my last post, I indicated that investors should normally not compete against professionals.
That does not mean you cannot rely on their skills in an attempt to enhance your own portfolio returns. In fact, many investors follow analyst recommendations and/or invest in mutual funds that are actively managed.
Whether this is a prudent investment approach is something we will look at.
As in all walks of life, some analysts and fund managers have better track records than others. If you intend to rely on their advice or investment decisions, you should try to find the ones with proven track records.
Mutual Fund Managers
We covered the key areas of consideration in a couple of previous posts.
Please review “Mutual Funds: Management” for suggestions on assessing fund management.
To try and separate the upper tier managers from the lower tier, I suggest using the recommendations contained in “Mutual Funds: Performance is Relative”.
Keep in mind that past performance is no guarantee of future results. A manager’s prior results may be suggestive of the future, but many other variables can impact the actual results.
Investment Analysts
Assessing an investment or research analyst is quite similar to evaluating a mutual fund manager.
As in “Mutual Funds: Management”, you want to know a little about the analyst you are interested in following.
How long a history does she have as an analyst? What are her technical credentials? Does she have experience in her area of research? For example, the analyst may have 10 years of experience analyzing European bonds. This may be good if she is still rating bonds. But it may not be a good sign if she is now analyzing Australian mining companies.
How has the analyst has performed in both bull and bear markets? When the markets are up, it is relatively simple to see one’s picks rise in value. But how did she do when the market as a whole fell? That may tell a different story.
You might also want to know the analyst’s financial interest in the recommendation. This can be a two-edged sword though. On the one side, it is nice to see the analyst own the securities she recommends and is putting her own money into the investment. On the other side, perhaps there is a conflict of interest if the analyst has a financial stake in the investment. That is, maybe the security is being recommended in the hopes that individuals will read the positive review, put their own money into the security, thereby driving up the price and enhancing profits for the analyst.
And exactly as in “Mutual Funds: Performance is Relative”, how did the analyst perform compared to her peers and any identified benchmarks?
Note that there may not be any associated benchmarks with selections of individual securities. However, that does not mean you cannot create your own as an assessment tool.
I would suggest something simple. For example, if the analyst is rating Swiss equities, the Swiss Market Index (SMI) might be adequate. The SMI holds the 20 largest stocks in the Swiss equity market.
Or you could use a number of other Swiss indices depending on your investment criteria. The SMI Mid (SMIM) that holds the 30 largest Swiss mid-cap equity stocks not included in the SMI. The SMI Expanded includes the 50 stocks that comprise the SMI and SMIM. And the Swiss Performance Index is Switzerland’s overall stock market index. And that is only a few indices from Switzerland. There are others you can use based on your needs.
Definitely not a perfect match as the risk-return profiles may differ. But a good starting point.
Next week, we continue our look at whether you should follow the investment professionals. We will consider whether investment analysts provide positive net returns to investors.
by WWM | May 30, 2018 | Active vs Passive Management, Mutual Funds
Having an investment professional managing your assets is usually perceived as a big positive. In fact, that is the marketing point for many mutual funds.
But should it be?
This is one of the biggest issues for investors. And a prelude to the active versus passive management debate.
I believe that non-professional investors should not normally compete with professionals.
In some ways, I view it as competing against Dustin Johnson or Jason Day on the golf course. Unless you have the same skills, it is difficult.
The professionals have an unfair advantage over the amateurs and it is not wise to try and beat them in picking investments. Professional asset managers have more technical expertise, better tools and data, and better access to information than you at home on your computer.
So it seems pretty straightforward. Go with the pros. Except ….
Two Types of Investment Professionals
I shall quickly differentiate between two types of investment professionals.
The first is the mutual fund manager. The person who makes the investment decisions on behalf of the fund.
The second is the research analyst. The person who prepares the buy and sell recommendations on specific investments.
There are other investment professionals including individuals who invest for their own livelihood. But for discussion purposes here, we will focus on fund managers and analysts.
Advantages of Investment Professionals
Investment Skills and Experience
It is not a simple process to pick individual stocks, bonds, or other investments. Fundamental analysis requires strong quantifiable skills and an understanding of the business, industry, and economic conditions to properly assess the qualifiable considerations. We quickly looked at Quantitative and Qualitative Analysis previously.
Professional fund managers and analysts should have the financial skills and experience to conduct better investment analysis than the average investor.
Better Information and Tools
Investment professional likely have access to better analytical tools and data than you or I.
They also have better access to the corporations that they follow. This includes access to a company’s investor relations staff or management as well as to special conference calls that companies conduct for investors.
These two areas make life difficult for investors such as myself. I would be considered an investment professional given my technical qualifications and experience. But having less timely access to corporate information and other relevant data puts me at a disadvantage to a financial analyst in a large firm or mutual fund. While I may not mind playing Jason Day for money, I want to make sure that I am not using golf clubs from the 1970s when I do so.
Also, funds with significant investments in companies are often able to shift the company’s business agenda. This is usually done at shareholder meetings where funds hold enough shares to pressure companies to follow strategies the funds prefer.
It’s Their Job
Another problem for most individuals is that they are not full-time investors. Fund managers and financial analysts spend their days researching investments. That is their job.
Some of you are students. Others are lawyers, doctors, dentists, plumbers, government employees, and so on. Whatever you do, you put in a full week at your own job. Any time for investing comes at night or on the weekends.
If you had the time and the tools, you might be better able to compete with the professionals. But you do not. This also puts you at a competitive disadvantage.
So many advantages in having professionals manage your money. Except ….
Disadvantages of Investment Professionals
There are a few potential disadvantages to using fund managers or analyst recommendations when investing. I will expand on a couple of these points in subsequent posts.
Some Professionals are Better than Others
As should be expected, some research analysts and fund managers are better than others.
The trick is to find the good ones and to avoid the poor.
Not always a simple thing to do. In fact, often you see rankings that have one analyst or manager perform highly in one period, then less so the next. And vice-versa.
Reviews of peer group performance and category ranking is the main way to assess relative performance. But they are not always a perfect predictor of future results.
Does Active Management Work?
There is great debate as to whether analysts or fund managers can out-perform their relevant benchmarks.
In some select instances, I believe it is possible. But for the most part, I am doubtful as to whether active management can beat a passive approach to investing.
We will look at the arguments for and against active management later in some detail.
Neglected Market Segments
Professional investors focus on specific market segments. The segment may relate to their area of expertise (e.g., an oil and gas analyst focuses on oil and gas companies) or investment style (e.g., a Swiss large-cap equity fund analyzes relevant Swiss companies).
Often there are neglected market segments that analysts do not follow and/or funds do not invest in.
These may be extremely small segments such as micro-cap mining companies in Australia. Or markets where information is scarce so that analysts and managers do not follow the segment closely. Equity investments in Iraq might be a good example. Or perhaps the local market is relatively inefficient and analysts/fund managers cannot match the local expertise. For example, a New York based real estate analyst trying to assess the residential real estate in Tucson, Arizona.
In neglected or inefficient markets, small investors, especially those with specialized knowledge of the market segment, can out-perform the investment professional.
An amateur investor with sophisticated knowledge in 18th Century art may be equally skilled against professional investors who trade in fine art. Or a geologist working in Calgary, Canada who deals with small oil and gas companies on a daily basis may have an advantage over a professional investor who lacks the local knowledge and contacts.
Fund Management Fees
Like anything in life, if you want a service you must pay for it.
For every dollar spent on management fees, that is one less dollar of performance. And one less dollar that can be reinvested to compound over time.
We have previously reviewed mutual fund operating costs and seen that management fees can be a significant component in a mutual fund’s expenses.
Not surprisingly, management fees can be a relative concept.
Top fund managers command greater compensation levels which impacts fund performance. Is it better to choose a fund without a star manager? You may forego potentially better future returns but you will certainly save money on fees.
Or what about funds that require greater amounts of work by the managers. Investing in developing markets typically requires more work (i.e., management time and other costs) than in developed nations. Is it better to pay greater fees and expenses for access to these markets?
Do the Advantages Outweigh the Disadvantages?
I do not think that the typical investor should compete against the professionals. And by competing, I refer to the selecting of individual securities and other assets.
The typical investor lacks the technical skills, investment and economic experience, and time to be a professional investor.
Unless you have specialized expertise or access to better information in an inefficient or neglected market segment, I suggest avoiding selecting specific investments on your own.
That said, do the costs and performance achieved via active management make use of professionals a wise move? Except in specific circumstances, I generally think not.
I shall expand on why I generally think not in coming weeks. As part of the active versus passive management debate.
by WWM | May 23, 2018 | Mutual Funds
Asset allocation is a cornerstone of successful investing.
As the name indicates, it involves investing one’s capital among different asset classes and investment styles. You want an allocation that best meets your objectives, including expected returns and risk. Diversification and inter-asset correlations are key to success. However, if you allocate incorrrectly, you reduce the probability of achieving your investment goals.
So how does investment style drift figure into this?
Investment Style
Mutual funds should adhere to their stated investment style.
The stated style is disclosed in the prospectus.
The name of the fund itself should also indicate the investment style.
For example, the Fidelity Japan Fund (symbol: FJPNX) invests in Japanese securities. The Oppenheimer Emerging Markets Local Debt C (OEMCX) invests in fixed income instruments of issuers located in emerging markets.
Style Drift
Investment style drift occurs when funds shift from their stated investment objectives.
The shift can be unintentional or intentional.
Unintentional Shifts
An unintentional shift can occur without any physical changes in a fund’s portfolio.
For example, a small-cap fund holds shares of companies that have relatively low levels of market capitalization. Over time, some of these companies grow and become mid-cap or large-cap in size. Think of companies such as Microsoft and Google. They went from being small firms at inception to corporate behemoths today.
The same can be seen as growth companies mature. Revenues and earnings growth slows. As internal growth slows, these maturing companies begin to issue dividends. Before long, they morph into value companies. At one point in time, companies like Pfizer and General Electric were strong growth stocks. Now they are both value plays.
Companies can shift the other direction too. If you want a great example of changes in multiple characteristics, check out the rise and fall of Nortel.
And some companies are still in transition. Microsoft is included in many growth mutual funds. But I also see Microsoft in more than a few value funds.
If fund managers are not careful, they can find their style has drifted without any action on their part.
Intentional Shifts
A manager can manipulate his portfolio to intentionally deviate from the fund’s stated style.
Why?
The main reason is that fund performance is compared against the fund’s peer group and benchmarks. Relatively strong performance means more new investors and better fees for the fund managers.
Some managers will increase their portfolio risk in the hope of attaining greater returns. Or during bear markets, some managers will move from growth stocks (if that is the style) into value and/or defensive stocks to try and minimize the damage from a down market.
Same with bond funds. If interest rates are rising, long-term bond fund managers may try to shorten the duration of their bonds. If rates are falling, short-term bong funds may try to increase their durations.
The 80% Rule
Securities commissions often require some truth in advertising. The so-called “name rule” tries to ensure that fund names match the actual investments owned. In our examples above, you would expect the Fidelity Japan Fund to hold Japanese equities. And the Oppenheimer Emerging Markets Local Debt C to own emerging market debt instruments.
In the U.S., funds need to invest at least 80% of fund assets according to the stated style. Many other jurisdictions have similar requirements.
But that leaves 20% of a fund’s assets that can be invested outside the stated objectives, albeit subject to certain limitations. And that 20% can have an impact on the overall performance and style of the fund.
Picture a typical value fund. It probably has about 25-30% of its assets in its top 10 holdings. With 20% freedom to deviate, the fund could almost equal its top 10 holdings with investments in a completely different style.
Although a fund is required to stick to its style, there is potential for serious modifications within the actual holdings.
I suggest you review the rules in your jurisdiction to see how closely a fund must adhere to its stated style. The less the requirement, the greater the probability of style drift.
Why is this Important?
Ensuring your funds adhere to their stated style is important for two main reasons.
One, investors choose fund styles that meet their risk tolerances.
Conservative equity investors likely prefer funds such as: blue chip; large-cap, value, balanced, blended. They probably avoid small-cap or growth funds that have greater risk. But if a value fund exhibits style drift and starts accumulating growth stocks, its portfolio risk may increase to unacceptable levels for the low-risk investor.
Of course, unless the investor is aware that the fund’s style has changed, he will not realize his portfolio risk-return ratio has shifted.
Two, investors typically diversify their portfolios through asset allocation by purchasing funds in different investment styles and asset classes.
However, if one or more funds exhibit style drift, the diversification impact may be less than anticipated.
For example, you want exposure to to both growth and value stocks. You put 50% of your capital into Meteor Growth Fund and 50% in Slow and Steady Value Fund.
Initially the funds strictly adhere to their stated styles. But over time, some of Meteor’s high flying growth stocks mature begin to mature and become value plays. The economy has slowed and growth stocks are not expected to do well. Meteor’s manager decides not to sell these maturing growth stocks.
Further, given the economic forecast, the fund manager shifts a portion of his capital into value companies. Not enough to run afoul of the securities’ commission, but enough to have an impact on fund performance.
Without realizing it, your growth fund has shifted into more of a value fund than growth. Probably not 100% value, but maybe 50-60%. As a result, your asset allocation of 50% value and 50% growth is now 75% value and only 25% growth.
Not what you wanted and, as we will see when we discuss asset allocation, something that can impair your long-term portfolio performance.
When considering funds for your investment portfolio, do not rely solely on fund names or stated investment styles. Review actual holdings to ensure the fund reflects its stated style. Over time, for funds that you own, review fund holdings as part of your periodic review process. Very important to ensure your desired asset allocation remains accurate.
by WWM | May 16, 2018 | Mutual Funds
When analyzing mutual funds, reviewing fund holdings is useful to ensure adequate diversification within a fund, as well as between different funds.
But you need to be certain that the holdings you review accurately reflect the fund’s investment strategy. If they do not, it may be due to the presence of window dressing.
Historically, the term “window dressing” refers to shop windows you pass while walking down the street. Stores present attractive display cases in the hope that you will be interested in their wares, enter the store, and make a purchase.
With mutual funds, I would describe window dressing in two ways.
The Common View of Window Dressing
Just before a reporting period (i.e., quarter or year end), fund managers will try to make their fund holdings appear more attractive to shareholders. Investments that either have significant unrealized losses or are considered poor investments will be sold and replaced with more appealing assets. These may include investments that are currently performing well or assets that are receiving positive publicity in the business news.
At period end, shareholders receive statements that show the fund made up of popular and appreciating investments, rather than dogs and assets that have fallen in value.
While this is the common view of mutual fund window dressing, I think it is a little simplistic. It also assumes fund shareholders are idiots.
Yes, I like to review my funds’ holdings. And I like to see what I think are appealing investments within the portfolio.
But I am more focussed on fund performance (and ensuring I am adequately diversified).
If the managers are choosing poorly and dumping losers just before period end, their actions will be reflected in fund under-performance. It should not take long for investors to see through this type of fund manager manipulation.
My View of Window Dressing
I am more concerned about window dressing for two other reasons.
Index Huggers
First, window dressing can hide the index huggers.
That is, active fund managers that simply replicate their benchmark index in a passive management approach, yet charge shareholders for full active management.
By slightly altering fund holdings prior to reporting periods, fund managers can appear to show variances between their portfolio holdings and the benchmark. Yet once the new period commences, they revert back to the benchmark holdings.
As I hate to pay for services that I do not actually get, I like to watch for this in funds.
Style Departures
Second, window dressing can hide departures from a fund’s stated investment style.
A fund’s style is crucial to enable individuals to properly allocate their investment assets. Investors need to be certain that the investment style they believe they are investing in is truly the style.
A change in a fund’s investment style is known as style drift.
We will look at that next.