Why Don’t Asset Management Companies Hedge Their Biggest Risk?

I had a great time this week catching up with old and new friends at the annual ETF conference in Florida.  I think I’ve been to just about every one of the eight or so conferences they have had, and it has been interesting to watch the growth from a small venue to about 2,000 people.  We are certainly in boom times for the ETF industry – I think about four firms have been purchased in the past year and there was even a giant 30 foot ski machine in the middle of the booth room – another sign of a seven year bull market as well. (PWC has a new report detailing they expect the ETF space to hit $5T by 2020.)

I was thinking about our booming industry while dipping my toes into the Atlantic, and it reminded me of an old question (and idea) from a blog post way back in 2009 called “A Quant Approach to Private Equity“.  Ironically, you can also read my thoughts on the roboadvisory space six years ago when Wealthfront was still a trading game on Facebook called kaChing.

I posed this question in a blog post, and will quote from it below:

“I always wondered why big investors of private equity (like the endowments and pension funds) don’t hedge their portfolio at all?  If they assume that they are top quartile, which they have to assume becuase otherwise they should be buying SPY and QQQQ, then they are assuming they’re generating alpha returns.  So why not hedge out some of that risk through a static, or better, dynamic hedge?  Hedging against long bear markets is a great idea because not only are their holdings going down in value, but their exits disappear.  Anyways, ping me if anyone does this I’d like to chat with them.  Is there such a thing as a market neutral private equity investor?

We talk a lot about private equity in the book, and a lot about why using the ETFs (ETNs) in the US doesn’t make any sense.  Anyways, below is the 10 month SMA on the not-recommended PE ETF.  Looks like you would have sold somewhere in the 20’s and bought back somewhere around 8.  Not too shabby.”

So while my old post focused on the end investor for private equity (say CALPERs or the endowment funds), this one is going to focus on the actual operating companies themselves.

So follow my thinking for a minute.  Airlines hedge their biggest risk (the cost of fuel), as do food companies (commodity prices, etc).  A recent book titled The Secret Club That Runs the World: Inside the Fraternity of Commodity Tradershighlighted some of these companies and hedging programs.

So, what is the biggest risk to an asset management firm (or PE firm too), especially one that is highly exposed to long only holdings in stocks?  The biggest risk is stock losses, particularly a long bear market.  Assume a nice fat 50% bear market in stocks – that results in the asset management company losing 50% of revenues due to fees declining, but also potentially people selling at the bottom etc.

So why don’t large asset managers hedge not their portfolios, but their business risk?  This could be done simply by a) buying puts or other long-term LEAP style out of the money options on a consistent basis or b) doing the same on a trendfollowing basis?  This would be an insurance style cost in good times, but would help to smooth revenue and ensure the firm survives in a challenging environment the same way hedging fuel ensures Virgin or Southwest could stay in business if oil did goto 150 (or, err, 60).

This situation is particularly timely and personal for me as my firm, while small and growing fast, is mostly exposed to long assets currently (which for a tactical/macro guy like me makes me squirm!)  This seems like a much more anti-fragile way to run your company…

Anyone ever heard of a Legg Mason, Fido, or other such firms hedging their company-wide revenue stream in the financial markets?

The Most (Not) Hated Bull Market

I look forward to reading Leuthold’s Green Book every month and the most recent one was great.

I asked permission to share the following study as I thought it was revealing.  They looked at sentiment levels as published by Investor’s Intelligence – specifically they averaged all of the values for each year to get a yearly reading. Below is a chart of the values.

 

Screen Shot 2015-01-10 at 4.50.00 PM

But does sentiment help with stock market returns?  Below are the 10 highest and lowest sentiment years and the returns of the stock market the following year.  Not surprisingly high sentiment results in low returns of 0.1% per year.  Low sentiment results in whopping 17.4% returns per year.  What was average sentiment in 2014?   2014 was the second highest value ever at 76.3%

 

Screen Shot 2015-01-10 at 4.50.13 PM Screen Shot 2015-01-10 at 4.50.20 PM

The Agony and the Ecstasy of Being a Trendfollower

This one chart shows almost everything – the whipsaws & false breakouts, but also the monster gains.  The emotions are just as difficult for trendfollowers as they are for the buy and hold crowd, they are just at different times and for different reasons…

 

dbe

Travel: Houston, Miami, Tucson, BC, Pittsburgh

A few upcoming events…come say hello!

January 12th, Talk at FPA, Houston

Jan 28th – Jan 28th, ETF Conference, Miami

Feb 12th, Talk CFA Society, Tucson

March 19-25, Vancouver (skiing)

April 15th, Talk CFA Society, Pittsburgh

May 16th, Talk Los Angeles AAII

NY Resolution For You – Don’t Buy a Tesla

Vanguard, like many of the robo-offerings, markets the fee difference as a big reason to use their automated investment service. (Though as Kitces mentions, Vanguard isn’t quite a robo since they employ lots of CFPs.) They compare the difference between their fees (0.30%) and the industry average (1.32%) which sounds high to me, as I think it is around 1% although average mutual fund is 1.25%.

 

 

returns v

 

If you assume a $1M portfolio, let’s look at how much fees eat into your returns over time at 0%, 0.3%, 1.32%, and 2% advisory fees.  We will ignore the underlying ETF costs to try to compare apples to apples, and assume all use low cost index ETFs.  Lest you think there are not people charging 2% to manage a buy and hold portfolio let me remind you otherwise with the chart at the end of the post with a fee summary.  0% is achievable either by investing on your own or using something like our 0% management fee ETF or Schwab’s upcoming offering.

30 bps in fees costs a portfolio only $3k per year, but 1.32% ($13k) and 2% (20k) are much more dramatic.  20k is basically a new Tesla every few years.  This doesn’t mean of course an advisor isn’t worth their fees, I’ve said a million times on the blog that they can we worth their weight in gold if they offer value added services like tax planning, estate planning, insurance, wealth management, etc.  (Or keep you from doing something even dumber on your own.)  But $20k per year is a really high bar to justify. Mentally visualize carrying a briefcase of $20,000 every year to your advisor instead of it being automatically deducted from your account.

For a buy and hold asset allocation portfolio you want to be paying as little as possible.

So, for an investment lifetime of 30 years, assuming 6% returns, how much did the various fee levels cost the investor?

feeeees

Now think about that for a second.  Over your lifetime, if you started with $1M in assets, you transferred anywhere from $240,000 to $1.1 million to your advisor.  (The above table also shows in the fees lost column the difference you lose by not compounding the lost fee assets.)  2% a year means you end up paying your advisor your entire initial investment amount.  When you sit down with your advisor that you choose to have for the next 10 years ask yourself – “Is this advice worth $240k in total (nearly a third of total starting portfolio value) if you’re paying 2%?”

What if markets actually returned 10% per annum?  The figures get even more gross since your portfolio grows to a much higher balance.  At 2% the original $20,000 you paid 30 years ago is now a whopping fee of $200,000 per year.  Even at the average advisor fee of 1.32% that is $160,347 per year.

Maybe your New Years resolution should be to not buy someone a new Tesla this year?

People in red below are over .50%

fees2

Stock Valuations Around the World

I talk a lot about foreign stocks being cheaper than they are in the US.  I’ve shown this on a CAPE basis before (and also in our book Global Value) where the US is the highest valuation (27) relative to foreign stocks (15) ever.  Good news is 27 isn’t awful like 1999, and 15 is downright pleasant.

Below is two more valuation metrics, regular old 1 year PE ratio and PD ratio (dividends).  Both say the same thing, albeit with different magnitude: look abroad for cheaper stock valuations.

Blue line is average over the period, both right around zero!

valuations

 

Source: DataStream, Stansberry Research for concept

Market Outlook 2015

I penned a short market outlook last year , and this year’s outlook is basically the same.  It was correct on a few points (small cap underperformance, dividend stock underperformance), and incorrect on a few points (US stocks charged higher, foreign stocks lagged).  We now have an interesting period where US stock valuations (CAPE of 27)  relative to foreign stock valuations (around 15) will close at the highest level over the past 35 years.  Four out of five of the biggest relative overvaluations resulted in big foreign outperformance the following year.  The only exception?  2014

Below you can see just how fantastic 2014 was (real estate, bonds, US stocks) or terrible (commodities, foreign stocks).

Asset Class Returns 

returns

The moderate portfolio from our old while paper is ending 2014 on a fairly conservative note – only 40% invested in US stocks and real estate, and 60% in cash and bonds (out of commodities & foreign stocks).  As you recall from my old articles, the best environment for US stocks is cheap and in an uptrend.  The worst?  Expensive and in a downtrend.  We are currently in the middle (expensive, uptrend).  When the trend changes, watch out!

However, most of the positive momentum in the world is still in US based assets – stocks, real estate, and bonds.  Most of the value is found in foreign equity markets (and arguably commodities, but with less traditional valuation methods).  My favorite intersection is when value and momentum intersect.  If and when the trend changes I think you could see truly explosive returns for foreign equity markets.  But as we all know, and oil is a timely reminder of this now, trends can last a loooonnng time.  And if US assets are the final shoe to drop….well then all equities around the world will get cheaper.

Summary:

1.  US stocks are expensive, but not quite in a bubble.  Future returns should  be around 3% (nominal) per year.  US bonds likewise should return around 2.2% per year.  Both should return around 0-1% real.  US stocks can continue their strong returns and get more expensive, but if and when the trend changes, it would be wise to be more conservative.

2.  Foreign stocks are priced for higher returns, but currently in a downtrend with terrible momentum.

3.  Here is my allocation for 2015.  As a trendfollower, I like the idea of having half of my portfolio being tactical and able to move to cash or hedges if markets trend down.  As a value investor, I also want exposure to assets that may be cheap over long horizons.  Main changes since last year have been rolling the old private fund assets into GMOM, allocating to new funds (new private fund strategy, new launches GMOM and GAA), and rebalancing to buy more beaten down holdings (GVAL).

 

Broad Groupings

Tactical or Market Neutral Strategies 44%

Long Only Strategies 56%

 

Within those categories:

GVAL 25%

GMOM 23%

Private Fund 21% (Cambria Special Situations – a leveraged, tactical fund investing in US stocks, is 200% gross long and can be 0 to 100% net long)

GAA 18%

FYLD 12%

SYLD 1%

I will update again in 2016!

 

 

December Tweets

My Portfolio for 2015

Note: Please read this old post before the below for background info.

As I have detailed in the past, I think it is paramount for your money manager or advisor to have ‘skin in the game’.  I am happy to be 100% transparent with my holdings, and have detailed my approach to investing my own assets in the past a number of times.  You should ask your money manager what they do with their own money – it may surprise you!  I place all of my assets in Cambria funds.

Not much is different for me going into 2015 as there exist the same themes from the old interview:

“As you can see, my holdings are dominated by foreign stocks, portfolios that can and do have the ability to tactically move to cash (and have a high exposure to real assets), and stocks that are shareholder-friendly and returning lots of cash to investors. I am least exposed to traditional bonds, but for me they are not that attractive at these levels for my time horizon and goals. If stocks experienced a large drawdown of 30% to 90%, I would shift more and more of the allocation to the equity portion. As I’ve mentioned in our new book, I don’t think U.S. stocks are that attractive currently, but I am very positive on foreign stocks.”

 As a trendfollower, I like the idea of having half of my portfolio being able to move to cash or hedges if markets trend down.  As a value investor, I also want exposure to assets that may be cheap over long horizons.  Main changes have been rolling the old private fund assets into GMOM, allocating to new funds (new private fund strategy, new launches GMOM and GAA), and rebalancing to buy more beaten down holdings (GVAL).  I still have a few more allocations to make in January but by month end the allocation should be roughly:

 

Broad Groupings

Tactical or Market Neutral Strategies 44%

Long Only Strategies 56%

 

Within those categories:

GVAL 25%

GMOM 23%

Private Fund 21% (Cambria Special Situations – a leveraged, tactical fund investing in US stocks, is 200% gross long and can be 0 to 100% net long)

GAA 18%

FYLD 12%

SYLD 1%

I will update again in 2016!

 

How did CAPE do in 2014?

Readers know that I am a fan of using long term valuation metrics as a fundamental anchor to pick stock markets around the world.  It worked great in 2013, but in 2014 that worked fairly poorly as many of the cheap markets have gotten even cheaper.  I joked with a friend the other day that I was going to write a new edition of my book called Global More Value.

The median stock market had a negative year in 2013 of -1.33%

The average of cheap markets (defined as cheapest 25%) declined -12.88%

The average of expensive markets gained 1.36%.

The names have shifted around a little bit (I sent updated values to Idea Farm members earlier today) but the cheap ranks are still dominated by the continent across the Atlantic, and Russia and Brazil…

Screen Shot 2015-01-01 at 5.18.53 PM

 

 

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