Is misery back?

The misery index is an interesting economic indicator, courtesy of Arthur Okin, a famous American economist. The idea behind it was a sort of early attempt to capture or measure the misery that one would supposedly experience when the economy was not doing too well. It is basically a combination of the unemployment rate and the rate of inflation combined into a single measure. The graph above plots the misery index for the U.S. over the past four decades with the blue bar representing unemployment and the red bar the rate of inflation. From its peak levels in the 70's and early 80's (high inflation and unemployment), the misery index has been steadily dropping with the occasional short period spikes in unemployment (91-93). Inflation has been far more tamed when compared to the late 70's and early 80's. On the other hand, we note a sharp rise in the unemployment rate, according to the most up to date figures (09), a somewhat worrying observation in the context of dire economic conditions!

The impact of compounding...

Compounding (reinvesting investment gains) can have a wondrous effect on your wealth over the long term. Assume that you invest $1 million that grows by 5% annually for a period of 30 years. If everything goes according to plan, you should actually end up with a whopping $4,322,000 which over the entire period is an appreciation of 322%.

But what happens if you include fees in the equation? Assuming in the above example a 3% all in fee per annum, the final amount shrinks to $1,733,000, for a total gain of 73% over the 30 years and a startling difference of $2,589,000 when compared to the "no fee" version. If we cut the fees to 1.5% per annum, we arrive to a total of $2,746,000, for a gain over the period of 174% which brings the difference with the "no fee" version to $1,576,000.

To conclude, compounding has a substantial effect on the rate of growth of an investment. Because the effect is so significant, chipping into it also has a materially negative impact on the long term growth rate. In other words, if you wish to achieve a reasonable growth rate for your investments over the long term, it is not only important to be aware of the total amount of fees that you are paying, but also to ensure that these fees are reasonable and competitive for the services that you are obtaining.

Finally, the graph below illustrates these exact same concepts but in a more realistic setting: investing into the S&P 500 over the past 30 years. The results are no less startling!

Investing in emerging markets...

The slower economic growth prospects for both the U.S. and Europe have been prompting a growing number of investors to focus a larger share of the investment allocations to emerging markets where a healthier economic environment and sounder policies ensure that growth rates will remain above average for some time to come.

Whilst there is no denying the relative attractiveness of emerging markets at this particular point in time, there is the traditional tradeoff of greater volatility or risk in return for the expectations of higher returns.

There is, however, an additional risk factor that should not be overlooked. The price / earnings ratio (P/E) of developing markets tend to be higher than those of developed markets and right now the difference is rather important given the growing enthusiasm for emerging market investing. The graph above shows the difference in P/E ratios between the U.S. and China. Trouble with high and expanding P/E ratios is that it may be signaling bubble territory which means that there may be a real risk of a sharp correction sometime down the road.

Considering the degree of globalization and integration of economic markets across the globe, a more effective and less volatile way of investing into emerging markets may be through developed market stocks. Given their lower relative P/E ratios, longer history, corporate culture and growing exposure to emerging markets, a number of developed market firms may in fact provide a more effective manner of gaining exposure to emerging markets at a lower volatility to comparable firms in the region. Food for thought.

Rebalancing relative to market values...

Rebalancing a portfolio can be perceived as a contrarian approach to investing and rightly so because what you are effectively doing is selling the asset that is performing well and buying the one that is not. This strategy can be highly effective in a directionless market and much less so if markets are heading in one direction all the time (as they did between 2003 and 2007).
How less effective it is also depends on a number of factors, one of which is the width of the rebalancing bands that the portfolio manager has defined. If they are too narrow and therefore trigger frequent rebalancing in a directional market environment, the portfolio will be less effective in capturing positive returns than say a portfolio with more generous bands or a buy and hold strategy.
On the other hand, if the markets are directionless (i.e. trendless), a rebalancing strategy is bound to be substantially more effective than a buy and hold strategy.
When constructing a portfolio, one of the main tasks is to define the asset allocation for the various asset classes. The main building blocks of an optimal asset allocation portfolio include historical data for the asset classes, the objectives and constraints of the investor, the impact of economic policy and current market values of assets. Among these variables, only one happens to be backward looking (historical data).
Most of these variables can be plugged into an optimizer to generate an efficient frontier on which an optimal portfolio can be devised as a function of the risk/reward appetite of the investor.
Once the portfolio is fully invested, in order to preserve its "optimal" risk profile, it needs to occasionally be rebalanced . A major drawback with this traditional approach to portfolio construction is that it totally fails to take into account the collective market perception of risk. The market values of the various assets in effect reflect the collective market perception as to the riskiness of those assets. By not taking this into consideration, the portfolio manager may in effect be taking greater or less risk than what was originally planned.
As an example, following the severe stock market correction of 2008, managers that followed a stict rebalancing regimen may have inadvertently increased the risk profile of their portfolios. In other words the portfolio may be overweight stocks relative to the markets.
So what are the lessons to be drawn from all this? If we want to ensure that risk profiles are preserved more effectively, we need to somehow find ways to reflect market values in the portfolio. At a strict minimum one should keep track of the market values of the various asset classes and compare their change through time to the same asset classes in the portfolios.

Stealthy inflation...

The Fed seems to have changed its discourse of late and the markets seem to be pricing this in. Bernanke's rhetoric has shifted from coming to the rescue in the event of a slowdown to intervention even if there is no slowdown, and part of the problem may reside with an over reliance on core inflation figures, an indicator that may not be showing the full picture with regards to inflation. Over the past decade, for example, headline inflation, which includes both food and energy, remained substantially above core inflation. Had the bull period continued for a while longer, core inflation may have headed in the same direction as headline and there were already signs of this happening just before the sub prime market blew up.

The Fed's argument for relying on core figures is twofold. They not only see both food and energy as just noise but they also don't feel there is much that can be done to control them in any case. Currently both food and energy prices have been soaring which begs the question as to whether inflation may be around the corner and that it may be just a question of time before it rears its ugly head to an unprepared Fed.

Stuck in a quicksand...

Intervention is sometimes a necessary evil, particular in situations where doing nothing can risk creating a major meltdown in the financial systems. This was exactly the consequences of the "laissez-faire" approach that preceded the great depression of the 1930's. In a similar way, when the sub-prime market collapsed, it didn't take long to realize that the stakes where just too large to do nothing or very little about it. The longer term costs of maintaining the financial system on life support is manifold. For one, it will undoubtedly raise the risk of "moral hazard", particularly with regards to the "too big to fail" group and there is no real solution to this. Another risk that is more specific to the current crisis, however, is the long term negative impact on growth. The amount of liquidity injection and debt accumulation by the various government agencies across developed markets are unprecedented but what really seems to make the situation somewhat unique with respect to comparable situations in the past is that there doesn’t seem to be any effective exit strategies in sight. Confidence is low, unemployment is high, savings are virtually non-existent and leverage is still sky high. To make matters worse, most of the new debt is in relatively short term maturities (3 to 5 years) which kills any prospect of a vigorous fiscal stimulus plan taking hold.
Emerging markets that are structurally in much better shape may offer some degree of hope but this is very limited. At best we could hope for a partial decoupling from the toxicity of developed markets, it is hard to imagine anything else let alone how a market of roughly 2 trillion dollars in consumption (China and India combined) could possibly pull a market of 10 trillion dollars (U.S.) out of its current slump.
So although the latest economic figures are signalling growth, the economies of developed markets find themselves in a sort of quicksand where time is of essence. But this is quicksand and it is a delicate fine tuning balance between doing too much (fostering an environment that is conducive to organic "rotting") and not enough (raising the risks of a double dip recession). In either case, things could turn ugly.

At crossroads (again)?

Inflation? deflation? double dip? protracted recession? The directionless markets are symptomatic of a general malaise facing investors who are increasingly at a loss about how best to position their portfolios in an environment where visibility remains poor.

Pundits have been warning for a while that the long term bond rally has truly ended but bond yields have proven otherwise. They have in fact dropped to such an extent that a number of dividend paying stocks have become more attractive investments when compared to their bond counterparts.

The dangers of an uncertain environment is the risk of getting swayed by a particular strategy. Anticipating a double dip scenario, for example, may lead one to structure a more defensive portfolio that is likely to suffer if, instead, a surprise market rally kicks in. Same goes for targeting inflation/deflation strategies. If the opposite scenario materializes, the portfolio will undoubtedly suffer.
So how does one navigate the choppy seas? The most important point is to avoid getting swayed by emotions, especially when market turmoil is the norm. This can be accomplished by defining clear investment guidelines and ensuring that they are followed at all times. Asset classes should have a mid or "neutral" weight with defined bands around which one can tactically maneuver. By sticking to them, we avoid irrational behavior taking hold of our investments.
Markets move in cycles and attempting to time them can be a very dangerous endeavor. Sticking to reasonable guidelines ensures that we avoid the cyclical traps and instead concentrate the portfolio on the more important longer term secular trends that are more likely to ensure that we attain our investment goals.

The Alpha delusion

Does the systematic outperformance of fund managers relative to their benchmark over a long enough period reflect skill or luck? This is a debate that has been raging on ever since the proponents of the efficient market hypothesis entered the scene. If even the weak form of the efficient market hypothesis holds true, most of the outperformance could very well be attributed to just plain luck. The reasoning goes something like this: at a micro level, even if a gifted manager is able to identify industry trends, it is impossible to anticipate powerful random events such as unanticipated changes in government regulation or even natural events. In other words, there is a significant random component that can creep into and distort the earnings of a company.

This isn’t to say that skill doesn't play any role, it certainly does but the danger is that actual skill may be overestimated. Take the following example:
A hundred people are invited into a hall and asked to perform the simple task of flipping a coin. Those that obtain “tails” are kindly asked to leave the hall whilst the remaining persons are asked to repeat the coin flipping exercise. This experiment is continued until one person, the winner, is left. In terms of statistics, the probability of obtaining “heads” is 50%. Each draw is independent from the other, which means that the probability for each draw are not influenced by any other draw. Taking this into consideration, we can expect about 50 persons leaving the hall after the first draw, another 25 after the second and about 12 after the third etc. After about 6 draws there should remain only one person. Now if we forget about this experiment and try to visualize these results in terms of the performance of a particular fund manager, we could easily get carried away into thinking it was due to skill. As the experiment has shown us, the exceptional results could be a result of just plain old luck but the observers are totally blind to this. They are much likely to attribute the way better than average results to the manager's particular skills. That particular manager will be revered and a large amount of money will flow into the fund but if the results were more luck than skill, it will turn out to be a very bad investment.