Absolute return funds the US experience

Marc,

Take a larger market index like the S&P 500, FTSE MIB, Nikkei or the FTSE All Share, etc, etc.

They all show the same thing - indices that are grinding sideways and unable to breakthrough their previous highs. P/E multiples are regressing lower from the largest bubble in history in 2000.

This is fact, there are multiple graphs on the internet showing the relationship between price and value for these indices. When price gets irrationally high then subsequently value regresses until the index bottoms on sub 10-15 times the CAPE. This regression puts pressure on the market price which has to fall or grind sideways until value becomes reasonable again.

The dow has the largest historical record of prices and earnings, hence it best represents the double decade secular bears of the past.

The Emerging markets have not yet reached P/E multiples high enough since the Asian Crisis of the 90s to signify the top that signifies the end of a secular bull market (India perhaps an exception). On this basis it is possible to say that the emerging markets may still be in a secular bull although there the lack of a long enough time frame of recorded prices and earnings for the indices makes this difficult to prove.

Investing in the mainstream western indexes during a secular bear is a 'probable outcome' (google the book) for extremely poor (sub inflation) total returns.

You have to ask oneself,-

If the stock market has a historical record of returning approx 7% per annum, why on earth has every western index failed to breakthrough the 2000 high?

Why are we still nowhere near many of these highs? Why are some indexes 50-75% down on the 2000 high?

Why did the indices in the late 60s go on a near 20 year sideways movement?

Would the Japanese worker in the late 90s have done well after his advisor recommended 'go long' the index?

Long term investing in the Western indexes only works during secular bull markets. Unfortunately many have been blinded by the 80s and 90s secular bull as being the ticket to long term positive returns.

Long term positive returns comes from investing in markets and companies starting on reasonable valuation metrics.

Many of the western indices are still not yet back to reasonable valuation metrics despite grinding sideways for over a decade whilst earnings rise at 10%+ to pull the P/E CAPE back down to reality.
 
Marc, you may find the attached of interest. Some new research into the secular cycles -

http://www.crestmontresearch.com/docs/Stock-Matrix-Taxpayer-Real1-11x17.pdf

http://www.crestmontresearch.com/stock-matrix-options/

Essentially showing secular cycles of the S&P 500 including real return (inc dividends, transaction costs, taxes).

Clearly the USA market has gone through decade or double decade periods of negative returns (the red) followed by decade or double decade 'above average' positive returns (the green).

The P/E ratio column is of interest, essentially showing how when the market bubble and irrational sentiment peaks in P/E terms, the market subsequently falls for the next couple fo decades.

As can be seen from the horizontal axis, investing into the index during the secular bear takes a rough 20 years to get back towards the 7% average annual return that the financial industry believes to be the typical long term return.

Buying indexes during these secular bears of severe P/E regression downwards is a ticket to negative or very low returns for a very long time.

The P/E in 2000 was the highest on record signifying the 'probable' outcome of further poor returns.

As can be seen, markets bottom on low P/E values. Certainly lower than at present.

In my view investing for the next decade is about income over buying the market and trying to ride the next uptrend, which could still be some way off.
 
February 23, 2011
Seeking the Perfect Wave

New York Times columnist Jeff Sommer, acknowledging recently that he found himself in a "buoyant mood" due to the steady rise in stock prices, sought out someone with a gloomier assessment of the financial markets to provide a counterweight to what he feared could be excessive optimism.

He turned to Robert Prechter, a veteran market analyst who has published The Elliott Wave Theorist in Gainesville, Georgia, since 1979. As Mr. Sommer reported last week in the Times, Mr. Prechter's investment outlook is "as bleak as an ice storm." Based on his interpretation of cyclical wave patterns that he discerns in both financial markets and "social moods," Mr. Prechter believes the current rally is only a minor upswing within a much larger, longer, and punishing downtrend that will "lead the unwary to ruin."

Market forecasters are often accused of doubletalk, couching their predictions in such convoluted language that they can later claim success regardless of the outcome. At least there is little doubt where Mr. Prechter stands—he sees disaster ahead and has been saying so for quite a long time.

In an earlier interview with the New York Times in July 2010, Mr. Prechter suggested the US stock market had entered a decline of "staggering proportions" that would likely see the Dow Jones Industrial Average—9686 at the time—fall well below 1000 over the next five or six years. Although the Dow has surged over 27% since that time to close at 12391 on February 18, Mr. Prechter is unperturbed and argues that the outlook is "much more dangerous today than it was last summer."

Perhaps Mr. Prechter will be proven right. But if not, he appears to have ample reserves of both patience and conviction. If his grim vision of deflation and depression sounds familiar, it should—he was making similar arguments in his book At the Crest of the Tidal Wave, first published in 1995.

Mr. Prechter has made some prescient market calls in the past—notably in the 1982–1987 bull market—but success since that time has proved more elusive. If only we could determine when to follow the advice of a market soothsayer and when to ignore it, we could be exponentially wealthier. But timing the market timers appears to be no easier than timing the market itself.

Jeff Sommer. "Writing 'Danger' in Ever-Larger Letters," New York Times, February 20, 2011.

Jeff Sommer. "A Market Forecast That Says 'Take Cover'" New York Times, July 3, 2010.

Robert R. Prechter Jr., At the Crest of the Tidal Wave (Gainesville, GA: New Classics Library, 1995).
 
It's a difficult pill for many of us to swallow, but sooner or later we need to realise that the biggest obstacle to enjoying investment success often is not the market itself, but our own behaviour.

This tough lesson about investment is never more important than in the volatile markets we have seen in recent years. It is at these times, more than any other, that people tend to make dumb mistakes.

Those mistakes include neglecting to diversify, failing to track expenses and ducking in and out of the market in counter-productive attempts to miss the worst of the losses and capture the sweet spot in the rebound.

The fact is that as fallible human beings we tend to over-rate our own abilities and imagine that we can see things that others can't. In an extremely competitive arena such as the financial markets, this can be ruinous.

Just how ruinous poor individual judgement can be to your financial health is revealed in an annually updated quantitative analysis of investor behaviour by the US financial services research group Dalbar.

These surveys find that returns are far more dependent on investor behaviour than on fund performance and that most fund investors who buy and hold typically earn higher returns than those who try to time the market.

Dalbar concludes that investor returns are markedly different from the returns promoted by fund managers because most people try to time their entry and exit points—and often get it wrong. Secondly, the holding periods of individual investors tend to be shorter than those of fund managers.

Interestingly, they find *that investors are more likely to make 'correct' timing decisions when the market is going up. Correspondingly, they are more likely to mess things up when the market is down.

In other words, most people fail to exercise patience in tough markets. The consequence is they fail to secure the rewards available to them.

It seems that you really can be your own worst enemy.
 


http://www.crestmontresearch.com/docs/Stock-Secular-PE.pdf

Marc you can't hide from the facts. The empirical evidence is clear. 2000 was the largest stock market bubble in history (excluding the Nikkei in 1990).

You suddenly expect the market to grow when the 1980s-90s bull market produced double digit annual growth (i.e. way above the average long term return of approx 7%).

Are you suggesting that we have entered a new age of above average growth? This must be the case if you don't believe or are willing to view the evidence that markets move in secular cycles from above average growth for a number of years to below average growth for a number of years.

Are things different this time? Would you buy a market at any price? I assume that with hindsight you still believe that buying the NASDAQ, S&P, FTSE All share, MIB in 2000 would have been a good idea? How about the Nikkei, has this been a good return over the last 22 years?

Market can spend decades in the dolldrums and do so.

We are in a price to earnings regression stage as has occured on every occassion after a major bull market. On every occassion stock indicies have produced extremely poor returns. There is no hiding from this fact.

It is a fact that markets bottom on single to low double digit P/Es. It is a fact that the market (particularly the USA market) is still in high double digit territory. The USA market is only now, some 12 years since the secular bear started at a valuation level upon which most secular bull markets peak.

Based upon history, a new bull market is a near on impossibility at this level.

For the market to suddenly rise at a decent rate (say the typical 7%) would both defy economic history and defy logic in that the stockmarket would be entering a new era of significantly above average growth for the past few decades.

Possible, but highly unlikely.

Market timing has little to do with it. I am still mostly invested in the stockmarket. Very little is in the Western indicies (exception small allocation in Japan and Europe).

The next 5 to 10 years will be about dividend return (value, solid dividend growth and cover) over capital appreciation from overvalued growth heavy indicies.
 
I think the key to returns going forward will be what happens with inflation. Bond markets are suggesting that inflation is definitely not a problem but the classic policy response to a debt crisis is to engineer inflation.

Attempts so far have not worked but they will keep trying. If inflation picks up and is sustained I would not like to be owning bonds. Inflation is less bad for equities.

As for the debate about indices I agree (for once) with Marc - the Dow is a very unsatisfactory point of reference. It is an indictment of financial journalists that it is still in use.
 
Absolute Return Funds

I tend to side mostly with Marc in this debate. You either buy a business (equity), a property or a fixed interest instrument (bond) or you buy a combination of them in some proportion that suits your risk tolerance.

Value matters as it is the value you buy that delivers the subsequent medium to long-term returns. In that regard, Riggledman's point that the US market remains overvalued relative to history is an accurate one. On the other hand, many of the world's equity markets offer good value at present. The problem is that risks remain above average. Defining those risks is hellish.

Equities and property depend on a healthy economic backdrop. In contrast, hedge and absolute return funds are not dependent on the economic backdrop, so they can generate returns that are uncorrelated to equities and property. But they do not come with a guarantee of that. Strategies employed in hedge and absolute return funds vary but are risky too and my own analysis has found that the hedge and absolute return fund universe has not been able to add much value since 2002. Equities in the developed world have been disappointing in the 2000s but that can be largely explained by the fact that they were grossly overvalued in the late 1990s.

In my view, the Irish private investor's switch to hedge/absolute return funds (such as the Standard Life Gars Fund and others) is a dangerous one. What assets does this or other such funds own (no transparency)? are they trading or speculating in markets - which carries much higher risk - (most likely)? can they repeat the returns from here (no one knows)?

At the end of the day, returns come from owning assets, not trading them. Over the past 100 years, equities have delivered 9-10% annual returns (before costs and assuming dividends were reinvested). By definition, hedge and absolute return funds must generate less (trading costs, derivative costs and higher than average fund management fees). So what's the appeal - Less volatility? But volatility is not risk!

My conclusion is that they have attracted appeal because the industry is full of sellers and can sell this product at this point in time. But this asset class (hedge & absolute return strategies) carries an above average probability of disappointing investors, who by and large haven't a clue what they are buying. Of course, a large part of the investment intermediary market doesn't know either. But sure what the hell....they get paid by the insuarnce company or bank to sell them!

Rory Gillen
Founder
GillenMarkets.com
 
Equity value

The evidence is that most equity markets are not actually that cheap relative to Shiller PE and accepting that earnings relative to GDP are on high ground. However the classical measure of value is DCF and whatever measure of risk-free rate one would use to discount even a reduced level of dividends going forward would strongly support the valuation of equities.

They may not be cheap relative to their own historical valuations but using most of the discount rates which might be put forward (I dont know what the risk-free rate is any more) you find yourself coming back to equities. Plus there is the superior if imperfect inflation- hedging characteristic.

By the way no post mentioning the EMH or Eugene Fama lately - is there no internet access wherever Marc is holidaying?
 

Is the material copyright?
 
EMH and Fama hypotheses have been de-bunked years ago. They forgot to include human psychology, which of course is completely irrational at the extremes creating many anomolies in valuations.
 
EMH and Fama hypotheses have been de-bunked years ago. They forgot to include human psychology, which of course is completely irrational at the extremes creating many anomolies in valuations.

Marc hasn't been persuaded !
 
Buffett says it best;

'The markets are efficient most of the time but the EMH brigade take it a step too far when they suggest it is efficient all the time'.

Nonetheless, supporters of EMH claim that excess returns reflect excess risk. The trouble with this rationale is they define risk as volatility, which of course it is not.

The mice will play while the cat is away, and no doubt we'll pay later for our cheek!
 
I like Howard Marks objective view on the subject in his excellent book.

[broken link removed]

A theory that works in practice on occassions but is not the be all and end all theory to invest by.

Efficient in terms of 'speedy, quick to incorporate information' but not 'right'.
 
Surely the objective in buying an absolute return fund or funds is to obtain returns with low or no correlation with the returns of the major asset classes that comprise your portfolio, i.e to introduce an uncorrelated alpha strategy to the conventional relative return strategies. So you are primarily expecting a diversification benefit rather then significant capital growth.
The fact that e.g the SL GARS returns can be mimicked (post #4) is somewhat irrelevant unless we know the correlation of these returns with those of the major asset classes. (A more interesting challenge would be to simulate the GARS performance target (and not the GARS returns) with a long only portfolio and to do this with a low or negative correlation to major asset classes.) Correlation is the major issue here as there is little point buying an AR fund if it marches in step with major asset classes, i.e. does not provide a diversification benefit.
The main problem I see with GARS and equivalent AR products is that there is a lot of information available on targets, performance and volatility but I’ve yet to see any info on how returns are correlated or not correlated with the returns of the other asset classes that typically make up your portfolio (i.e. euro developed market equities; foreign developed market equities, emerging market equities, etc.). This makes it difficult to decide what % of a portfolio to allocate to AR funds. This is particularly important today as from what I can see Irish financial advisers are currently plugging AR funds as a ‘holy grail’ or investing, suggesting significant allocation to AR funds.
One way to decide on a possible allocation to AR funds would be to clone the allocations of others. The NTMA in its annual report 2011 ([broken link removed]) says that 3.1% of the discretionary portfolio of the National Pensions Reserve Fund is invested in AR funds and David Swensen’s Yale Endowment Fund ([broken link removed]) invests 17.5%. So an IE retail investor it’s probably somewhere between these two allocations, and you would need to question a higher allocation. [Disclaimer: The above is comment / observation and is not a recommendation to follow any particular investment strategy or to buy / not buy any particular fund or stock.]
 
PMU

In another post I pointed out that GARS has a .63 correlation with Standard life's own European Corporate Bond fund.

When I tested it against a simple 60 40 bond equity long only strategy I got extremely close results.

We can therefore conclude that much of the underlying returns are being driven by net exposure to the underlying asset classes.
 
Standard Life are more than happy to give correlation data to investors in the fund.
Marc over what period did you test your long only strategy?
Rory Standad Life are very transparent with the assets the fund holds, with the funds turnover low.
GARS aims to deliver cash +5% after the impact of the funds trading expenses
 
Absolute Return Funds (and hedge funds) cannot generate returns similar to equities in the long run. That equities have been a poor place to be this past 13 years simply reflects gross overvaluation to start with, and comments about a secular bear market are fair but apply solely to the US - the Eurozone markets are most likely now at their secular low, as is Japan.

I would be on Marc's side in this debate (although I too find the language hard to digest). The stated objective of an Absolute Return Fund, in its truest sense, which I feel Marc captures correctly, is to deliver positive returns each year. You cannot achieve that with risk assets - returns are volatile and that is that. So absolute return funds or hedge funds must exploit other areas of risk such as being long & short or using derivatives to limit or protect the downside. But, as far as I am aware, there is no other risk asset or strategy that has been shown to have delivered the same amount of risk premium as equities, when equities are fairly or averagely valued. As I outlined in a separate piece elsewhere in this section of askaboutmoney, equities have delivered an annual return of 9-10% before costs over the past 100 years. That is some 5-6% above the returns from the risk free alternative - long-dated govrnment bonds. That premium return is referred to as the risk premium. Going long a curency with a high interest rate, and short a currency with a low interest rate has over the years provided a risk premium, to mine and many others' surprise. Equally, going long markets, currencies or other financial instruments that are trending upwards and shorting the opposite has also delivered a risk premium. But none have come close to owning simple equities, at least not without the use of debt.

Hence, the ongoing 9% annual return of the GARS fund is unusual and needs to be understood if one is to either advise a client to buy it or to simply buy it yourself. Marc's observation I think is most relevant here - perhaps the GARS fund is simple benefiting from the boom in long-dated bond prices i.e. it is overweight bonds. That would make it a simple managed fund. But, of course, I can't say that for sure. Either that or it is employing leverage to boost returns and that entails much greater risk. As is probably obvious to us all in this debate, it is pretty hard to look under the bonnet of these funds. If even experiencd practicioners can't see exactly what they are about, then they are opaque and should form only a small part of a risk asset portfolio.

In my travels, I have seen clients with 70% of their pension in such funds. That is naive on the part of the advisor and downright dangerous for the investor.

Rory Gillen
 
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