Making Money with Money

Posted by on Monday, Sep 9, 2013 in Featured Slide | 0 comments

Making Money with Money

Most professional  managers fall short of client expectations.  They do well to match the popular averages. Still, the track record of these professionals is far better than what happens when individuals try it on their own — academic research has shown that individuals managing their own investments underperform the popular market averages by 2%-3% a year!  That, of course, makes a huge difference over time.

Even among professionals, those who consistently add value (what is known as alpha) are quite rare because (1) investment management is exceptionally difficult and (2) there are a few key concepts about investing which everyone follows, but are unproven and wrong. Here are a few of the big ones:


Financial Markets follow Economic Trends. When we Analyze These Trends Correctly, We’ll get the Markets Right;

The Link is Weak, at BestIn the long run, financial markets are indeed “weighing machines” as Warren Buffett has told us.  Over shorter time frames of one or two years, they are definitely not. They are instead “voting machines.” So, even when those brilliant analysts get their economic predictions right, they struggle to translate these insights into investment success.  Our firm, to the contrary, begins with the observation that “no one really knows anything,” and we instead focus our energies analyzing the “voting machine” —  the internal dynamics of the market.  Put another way, we follow the money.


Wall Street Research Helps Us Find Investments that will Outperform Others;

Research is of Little ValueAcademic studies suggest that individual company research generated by Wall Street contributes some value, but that this value is relatively small, fragile, and dissipates rapidly between the time the analyst in the field reaches a conclusion and the time the customer in Minnesota reads the research note.  Yes, there are some great stock pickers, those who can truly get ahead of a big idea, but they usually don’t work at Wall Street firms and their work is not accessible by the public. When it comes to traditional Wall Street research, we believe it important for the functioning of the markets that someone reads these reports, but we don’t see them as a productive use of our time.

Market Disruptions such as those of 1987, 1990, 1998, 2001-2002, 2008, or 2011 are Just a “Normal Part of Investing.” Since no one can Predict these “Black Swan” events, Investors have no Alternative but to Remain Invested for the “Long Run;”


Wall Street Never Talks About the Next Market Crash This is the biggest elephant in the room.

Bear markets are extremely destructive in two ways: (1) the magnitude of losses far exceeds the psychological comfort level of the investor, causing them to liquidate at the wrong time and (2) when a conservative portfolio experiences a big loss, the mathematics simply stop working  –  you cannot inject  a -20% or -30% negative return into a sequence of reasonable gains and end up with a worthwhile long-term return. It is absolutely critical that an investment manager make a serious effort to manage those devastating and recurring financial tsunamis — even if this effort is only partially successful.

Our trend analysis models cannot predict black swan events, but they can identify environments when these are much more likely to occur— the hurricane season if you will.  When defensive measures are implemented with discipline over time, portfolio drawdowns can be greatly reduced and Sharpe Ratios improve dramatically.


The Secret to Great Performance is Great Ideas — Finding the Next Amazon;

Individual Investments Don’t Matter Much / Market Exposure Does This is a big one. When we watch CNBC or Bloomberg, at least 90% of the commentary is about the performance and prospects of individual companies. The clear inference is that investing is all about stock selection — looking for that next big idea.

In fact, the opposite is true: 80-90% of the performance of an investment portfolio is explained by the performance of the market itself.   Market trends are the dominant driver of portfolio returns, and money management should really begin with a disciplined effort to analyze and identify these market trends.  It seldom does. The study of market trends  also takes experience and hard work, but this is what we do.


Thank You, Paine Webber. Finally, the more experienced among us will recall a “Thank You, Paine Webber” television campaign from the 1980s. The implication, slightly tongue-in-cheek, was that clients of Paine Webber might experience especially favorable investment performance. More so than, say, the clients of Dean Witter.

We don’t have the data, but probably not. While there were surely pockets of brilliance among the brokers at Paine Webber, it is improbable that the firm delivered special or unusual gains, or what we have now come to call alpha. What they did deliver, along with the reps at Dean Witter and Merrill Lynch, was beta — participation in the great bull market that launched in 1982.

Nothing wrong with that. Performance is performance regardless of whether it comes from a rising markets (beta) or a particularly skilled stock-picking manager (alpha). Investment managers should certainly never stand in the way of a rising market when the portfolio can experience beta.  Now, if we can manage market exposure (beta) in a disciplined way, we can experience improved long-term returns (alpha) simply by managing the portfolio’s beta exposure and not necessarily from identifying special stocks.  As a bonus, the volatility experienced by clients in beta-managed portfolios will tend to be much more acceptable.

At the end of the day, all investment managers should work hard to deliver non-symmetrical returns — more upside or less downside than what is available from the market.  Such non-linear return patterns are typically promised, but not always delivered, by hedge funds. They are rare and rightfully deserve a premium management fee. The packaging of beta on the other handmarket returns in a convenient packageoffered by all our friends in the financial services industry, is available to everyone and should be priced as a commodity.


Werner Keller CFA

June 2017

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