A (Legal) Guaranteed Double Digit Return

This is a tough time to retire.  Most new retirees would be more comfortable if they could reduce the risk of their portfolios and increase their income.  Better yet, it would be great if that income could be free of market risk and last a lifetime.  It used to be that pensions filled this role, but most companies have either eliminated or frozen their existing pension plans.  The closest thing most of us now have is Social Security – but therein lays a major opportunity.

Imagine an investment that will yield double digit returns for up to five years while creating an income stream you can’t outlive.  Sounds like some smarmy email hoax doesn’t it?  Well don’t worry, this isn’t illegal – in fact it’s backed by the government.  It is, in fact, Social Security.

Consider someone born in 1947 and retiring this year.  His current earnings are $50,000 so according to IRS tables, his monthly Social Security benefit would be $1318 if he signed up to begin receiving it immediately.   That’s not bad, but it could be a lot better.

Suppose instead he decided to fund his monthly $1318 out of his current savings and then start drawing Social Security next year.  At that point he would receive $1448 a month rather than $1318.  That’s a little over a 12.5% increase and a pretty nice return for waiting.  Also remember, this increased benefit will last the rest of his life.

Part of the hike comes from the annual Social Security COLA which can vary from year to year and the rest is the increased benefit the Treasury offers to those who are willing to wait.  Similar benefits accrue for each year beyond one’s Social Security Normal Retirement Age up until age 70.  In our example, for someone born in 1947, the Normal Retirement Age is 66.  If he delayed the start of Social Security all the way to age 70 (five years from now), his monthly benefit would jump all the way to $2063.

Put in perspective, the retiree’s annual benefit would be $15,814 at age 66 or $24,758 at age 70.  That’s an increase of more than 56%.  With 10-year Treasury Bonds yielding less than 2% and riskier corporate bonds not too much more, it’s hard to find a better or safer fixed income alternative – particularly one not exposed to market risk.

There are, of course, a couple of things to bear in mind.  First, in order to delay Social Security it is necessary to have a way to fund the early years of retirement.  No matter how much an increase can be achieved, it’s all pretty worthless if the retiree has to deplete the rest of his savings.   It’s also not a particularly good approach for someone in ill health.  There’s no benefit in delaying even the largest income stream if you won’t be around to collect it.  Nevertheless, for everyone else with the ability to fund the first few years of retirement, this is certainly an excellent strategy to consider.

Today’s Characteristics of Tomorrow’s Winners

After varied success, many analysts come to believe quantitative screens or factor models are destined to failure. With so much work going into finding the right factors, they conclude the basic quantitative process must be inherently flawed. Before arriving at that conclusion, however, they should stop to consider if the flaw isn’t in the system but rather in their application.

So many times the answer one gets is determined by the question one asks. If one seeks certain characteristics in stocks, a well-designed evaluation will provide results. The key is knowing what the desired characteristics are, and that is where those questioning the quantitative method make their mistake.

Quantitative investors believe there are repeatable patterns in the market. By studying behavior of specific stocks, their cycles, and characteristics during those cycles, it is possible to locate those poised to outperform. Unlike fundamental investors who focus on a stock’s industry, business, and specifics of the company’s management or financials, quantitative investors evaluate the stock’s statistics and trading patterns. The two approaches aren’t completely exclusive as some quants also consider fundamental ratios like price/earnings or leverage, or earnings growth rates.

Popular quantitative factors include index-beating returns for 1,3, and/or 5 years, near or below market beta, positive Sharpe Ratio (risk-adjusted return), low P/E, high ROI (return on investment), and strong earnings growth. All are logically characteristics of successful stocks. This is precisely how one might define a “good” stock. The problem is, quantitative screens or factor models based on these types of characteristics often fail to produce future winners. This is the source of the quants’ disillusionment.

The problem, simply stated is this: Knowing what kind of stocks one wants to own in the future is different than knowing what stocks to own now to get there. A long-term investor would be happy with a portfolio of stocks with the characteristics listed above. Looking back over 1, 3, or 5 years he or she would be pleased with their results. But it’s quite likely that 1, 3, or 5 years ago those stocks had completely different characteristics which set them on course for their stellar results. It’s those characteristics that should be going into the quantitative evaluation models, not the characteristics of the intended outputs.

Quantitative investors who want to start with stocks bearing the characteristics they seek for the future are either assuming these shares aren’t cyclical or are confusing cause and effect. It’s not unlike betting on the winner of the marathon that just concluded to be the winner in one starting in five minutes. Obviously that runner is in excellent shape and trained well, but he or she has already achieved the goal, the potential is not there for a repeat performance against a new set of competitors who may be just as well trained and ready but who have not just completed a similar run. Why would one think it would be different for stocks, particularly if the market is cyclical?

Rather than building evaluation models based on expected results, quants should strive to find the characteristics of stocks that lead to the desired set. In other words, the models should find stocks that have the potential to become the source of market-beating returns, decent levels of risk, and reasonable valuations. The focus should be on finding today’s characteristics that lead to tomorrow’s outcomes, not simply today’s results.

Obviously this isn’t as easy as simply running a screen to find top past performers. It takes more research and testing to find the characteristics associated with potential performance. This isn’t a problem with the quantitative method, it’s a failure of those attempting to apply it.

Tracking the Market or Driving It?

Exchange Traded Funds (ETFs) are often a cost-efficient way to track specific swaths of the market.  Generally less costly than comparable index mutual funds, ETFs trade daily like stocks.  Unlike open-end mutual funds, they’re priced throughout the day and carry no loads or hidden fees although there are commissions for transactions.

When stocks collapsed in 2008, investors seeking steadier uncorrelated alternatives turned to commodity-based ETFs.  Precious metals ETFs saw particularly hot demand.  Although they track specific parts of the precious metals markets, most don’t actually invest directly in the underlying commodity.  Instead, they hold stocks of miners or futures contracts for additional leverage.

The problem with these approaches is that neither truly “tracks” the underlying commodity’s market.  Stocks of mining firms trade more like the S&P 500 than gold or silver.  It’s that old, “Good stocks don’t necessarily make good investments,” thing at work here.  Similarly, due to the structure of the futures market – primarily the fact that futures contracts expire after a relatively short time – it’s difficult to closely track the underlying commodity with any precision.

As a result, a growing minority of ETFs now invest directly in the commodity they track.  This enables them to be more like a traditional stock index fund by simply constructing a portfolio mirroring the target index.  In one sense it’s even easier since rather than thousands of stocks, there’s only one holding to consider.

But it’s one thing to track a market and it’s another to drive it.  Consider copper, a not so precious metal.  Copper is more like silver than gold:  It draws its value more from its industrial uses than from its intrinsic value or desirability.  Nevertheless, copper does have a booming market, particularly when economies are growing and demand is high.  In fact, its fate has been so closely related to the state of the economy that those of us who have been around the market for awhile look to it as an indicator of what’s to come in the equity market.  The accompanying chart shows how it’s (blue mountain) been a leading indicator for the S&P 500 (orange line) over the past six months.  However, ETFs may be about to alter this relationship.

Two market-leading money managers, JP Morgan Chase and Blackrock have filed with the SEC to launch copper-backed ETFs.  According to the filings, between them they plan to initially hold just under 200,000 metric tons of copper.  In other words, they’ll take that amount of copper off the market, store it, and value it to price the ETF.  Keep in mind this is only the initial purchase.  As the funds draw new investors additional purchases will be necessary.

Now here’s the problem:  Although copper isn’t a “precious” metal like gold, it is a commodity and at any given time supplies are limited.  Demand has exceeded supply in three of the past four years, and if the housing market continues to recover, demand will only increase for among other things, copper wire, pipes, and fittings.  This is such a concern that two of the country’s largest copper wire producers, Southwire Co. and Encore Wire Corp., not only objected to the SEC during the comment period for the funds’ approval, they indicated they are willing to contest the ruling in the District of Columbia Court of Appeals.

Like all manufacturers relying on a steady and fairly priced copper supply, Southwire and Encore have a vested interest.  Each ton of copper taken off the market to back the ETF reduces availability and increases prices.  Unlike investors who can sell an ETF when other alternatives look more appealing, their businesses are inextricably tied to copper.

Taken to an extreme, as the cost of copper rises, the value of the copper-backed ETFs will also increase, drawing more investors and leading to more copper purchases. As with any commodity or product, as the costs of production rise they’re eventually passed along to the end users — that’s you and me.  In such a scenario, everyone loses – except perhaps for the ETF sponsors and investors.

One other thing this suggests is the dissolution of the tie between the copper and equity markets.  The connection only exists because of the relationship between copper, stocks, and economic growth.  If copper’s price is more heavily influenced by demand stemming from investors’ ETF purchases rather than demand for copper products, the connection with the equity market will be severed.  In fact, the correlation may turn slightly negative like that of gold and equities.

Of course this is the extreme case.  Perhaps Morgan’s and Blackstone’s copper-backed ETFs will be just as unsuccessful as the only other such product which has already been around for three years.  Even so, the copper product manufacturers are right to be concerned.  It’s never a good thing when investment products drive the market they’re supposed to reflect.

Down But Not Out

Apple stock had a tremendous run from November 25, 2011 through September 19, 2012.  During that time the share price rose from $363 to just over $700.  Perhaps the most remarkable thing about this run was with the exception of a slight setback in April and May of 2012, the rise was virtually uninterrupted.  The stock’s fate quickly reversed over the subsequent five months with an equally uninterrupted 38% decline, all the way back to around $440 by January 25, 2013. 

While the majority of Apple’s run-up has been erased, it will have a lasting effect on those who use quantitative screens or factor models to select mutual funds.  Essentially all top-performing large cap equity funds held a large slug of Apple stock.  That’s also true for multi-cap funds and even some mid and small cap funds, too.  Even though a few were prescient enough to lighten their exposure as the stock lost ground, its impact while in so many portfolios will act to distort quantitative searches.

Many of the commonly used factors for screens and factor models will appear favorable for funds that held (or may still hold) the largest concentrations.  Consider just a few of the most popularly used factors:

• Returns – Even using five-year returns, the amazing run-up of Apple over the past two years will overshadow the earlier years making the largest holders look good by comparison.  Indeed, many managers felt they had to include the stock regardless of their own valuations for fear of being left behind by the pack.  When so much return depended on just one holding, is that really a measure of the manager’s skill?
• Turnover – Analysts often seek to avoid funds with high turnover.  Transaction costs add to expense reducing net return.  Funds measure turnover by comparing the lesser of buys and sells against the starting number of portfolio holdings.  Repeated purchases of one stock don’t count as additional transactions.  Over the past two years, funds wishing to add to their Apple stash sold any number of lesser weighted holdings to do so.  As long as the proceeds were sunk into additional Apple shares which didn’t add to turnover, the fund’s overall turnover fell.  As a result, for the next few years, turnover may actually mask the degree to which funds followed Apples momentum.
• Sharpe and Information Ratios – These measures of risk-adjusted return will also be too rosy given the excess return from Apple up until mid-September of last year.  Up until that point, the extra risk of over-concentration was amply rewarded by Apple’s above-market return.

As time passes – and especially if Apple continues to retrace its gains – these distortions will begin to fade.  But those relying on December 31, 2012 data to evaluate funds for the coming year should be aware of these potential problems and adjust their results accordingly.  Analysts should augment their searches with a variation on the old Watergate question:  “How much Apple did this fund own and when did it own it?”

The Year of the Apple

According to the Chinese calendar, 2012 was the year of the rabbit, but for stocks it was the year of the Apple.  That’s Apple Inc. to be more precise.

During the year, the stock soared 75.6% from its closing low of $401.44 on December 30 (the last day of trading in 2011) to its September 21 closing high of $705.07.  However, as of December 27, Apple retraced a great deal of this run-up, cutting its 2012 gains to 27.4%.  That’s still not too shabby.

Throughout its ascent and decline, Apple had an equally oversized impact on indexes, mutual funds, and their investors.  Here are four of them:

1. Capitalization-weighted indexes and the funds and ETFs that follow them are momentum vehicles.  As Apple became the largest U.S. stock by capitalization (share price times number of outstanding shares), indexes that are cap-weighted were forced to dedicate a greater and greater share to it.  In early April, Apple represented more 20.5% of the Nasdaq 100.  As happened a year before when its weight hit this level, the Nasdaq 100 had a special rebalancing to cut it back by 20%.  As illustrated in the chart below, the main Nasdaq index was also heavily influenced by Apple, as both followed Apple’s lead.  The more Apple went up in price, the greater its share in the indexes.  Ironically, this is the classic definition of momentum investing, something most index fund investors shun.
2. Active managers were “forced” to buy Apple.  Index funds weren’t the only ones adding to their Apple stash, active managers piled in, too.  Many did so not out of conviction or even speculation, but rather because they felt they had to in order to keep up with their benchmark indexes.  This isn’t really the independent thinking fund investors expect of their managers, but it is a fact of life in today’s benchmark-driven market.
3. Diversification isn’t what it used to be.  Advisors and pundits are always encouraging investors to diversify their portfolios in an effort to stabilize returns and mitigate risk.  Whereas an investor in the 1980s might have bought one or two multiclass funds to cover a broad swath of the market, today they own a number of funds targeted at specific investment categories – sometimes multiple funds in each.  The problem with this in 2012 was that many actively managed funds, both in and across categories were loaded up in Apple.  According to Lipper, as of late December 2012, 119 funds held the stock and for 117 of them it represented more than 10% of their portfolios.  Last year an investor seeking diversification needed to ask himself, “How many times do I need to own Apple?”  Most didn’t realize how much they already owned.
4. What goes up must come down.  Until peaking in September 2012, Apple shares had been on a virtually uninterrupted run since their bear market low on January 9, 2009.  While all stocks recovered, Apple’s ascent far exceeded them.  Fanboys loved its products and analysts were equally enamored with its shares.  A lousy antenna design and a stale operating system failed to dent the sales of the flagship handset.  However, the passing of founder and intellectual leader Steve Jobs and a botch-job of a mapping program actually focused criticism on the latest iPhone.  The fact that it didn’t really offer much over its predecessor didn’t help either.  Analysts actually started analyzing the company and its prospects and believe it or not, some actually lowered their outlooks and ratings.  Since September 21, the stock retraced about 60% of its 2012 gain.

Over the short-term more selling may be in the offing.  Actively managed mutual fund managers like to make sure their portfolios are full of current winners on December 31 because that will be the snapshot printed in their annual reports.  Rather than adding to their positions, they may find themselves selling.  Over the longer term, more and more managers and investors will probably come to the realization that Apple is just another stock, subject to the whims and ways of the market.  Oh well, they’ll always have 2012.

Does 70/30 = 30/70?

Several years ago, a mutual fund company’s research reportedly showed over time, a mix of 30% fixed income, 70% equities produced the same return as a more aggressive combination of 70% stocks, 30% fixed income. That’s certainly an attention-getter, especially since investors are always taught riskier portfolios should be expected to produce higher returns over time. Unfortunately, we’ve long forgotten the name of the fund company and the specific time frame of the research. What did stick was the fact that portfolios with such severe differences in risk resulted in the same return.

It’s often said that statistics don’t lie, but if tortured enough, they may bend the truth a little. While we don’t doubt the fund managers’ findings — it was published albeit with a fair amount of fine print — what is worth questioning is the extent of its validity. In this case, how long was the “long term”? Was the research conducted over one specific time period or many? Are the results a trend or more likely an aberration?

It’s would seem easy to recreate the study: Just build two portfolios and compare their historical results. We used the Barclay’s (formerly Lehman Brothers) Aggregate Bond Index to represent a broad base of fixed income and the S&P 500 as proxy for the equity allocation. We used the time period September 1976 through September 2012 to get the most up-to-date results and the longest common time period. To maintain the distinction between the two portfolios, we rebalanced them back to their original allocations at the end of every month.

The results are interesting and do support the fund firm’s findings. On the other hand, they can be quite contrary as well.

The overall results aren’t surprising.   Chart 1 is a typical “mountain chart” that shows the growth of a dollar initially invested in 1976. This is the cumulative return which adds each year’s gains and subtracts any losses. Not surprisingly, the 70/30 riskier portfolio (yellow line) outshines the more conservative 30/70 alternative (orange line). Risk, it would seem, was rewarded.

But there are two very important things to bear in mind. First, the specific time period measured by a mountain chart can have an important bearing on its results. More specifically, the order of returns can play a major role in the outcome. In this case, the riskier assets got off to a strong start in the first few years and were able to ride the lead over the more conservative portfolio throughout the rest of the measurement period. This was true even in the past decade when stocks suffered two bear markets. Had the bear markets come first, the ultimate outcome would have likely been reversed.

Secondly, this is a measure of one specific time period. If you were an investor in 1976 with a 36-year time horizon, you’d have been well served in the 70/30 portfolio. But what if you had a shorter time horizon or started investing at a different point in time? The data graphed in Chart 1 doesn’t address these questions.

You can get a better idea of the extent — and the source of the mutual fund company’s findings — from Chart 2 which shows the returns of 5-year holding periods. Unlike the previous chart which covered a distinct period, Chart 2 is made up of rolling period results. Rolling periods in this case calculated by annualizing returns for each of the 60-months periods from September 1976 – September 2012. The bars on the chart represent the results for the holding period ending on the displayed date. Using rolling periods it’s possible to get a better feel for what an investor with a particular time horizon (in this case 5-years) could expect regardless of the particular starting point.

Chart 2 clearly shows investors in this century with 5-year holding periods were more likely to enjoy better results with lower risk 30/70 portfolios. Wow! That’s a shocker.

Or is it?

After the big runup of the 1990s, stocks suffered a sharp, deep blow-off and subsequent bear market in 2001 and 2002. A recovery followed only to see the major declines from the credit crisis of 2008 leading to the second bear market in the span of five years. No wonder aggressive portfolios struggled while conservative portfolios focusing on bonds — which enjoyed a significant bull market — outperformed. Looking back over the past 12 years, no matter which 5-year holding period is selected, it contains one, if not multiple, down years for stocks. Not only that, the depth of the decline is hard to overcome with such a short investment horizon, just like a bad start on a mountain chart.

So yes, the findings from the mutual fund manager were true, yet that still doesn’t answer the real question. While it may be true investors with short-term holding periods should have invested conservatively in the past decade, it’s equally true you can’t go back in time to join them now. The past twelve years were kind to fixed-income heavy portfolios, but what’s more important is will this continue to be the case in the future? That’s the only place you can take advantage of this finding. It’s also the implication of the fund firm’s advertising.

Unfortunately, history doesn’t bear this out. If you look back at Chart 2 you’ll notice the more aggressive allocation dominated in the years leading up to 2000. If anything, the two sharp bear markets of the 2000s are probably an anomaly along with the superior performance of the 30/70 portfolio.

Could the past twelve years represent a change in the market or a new trend? That’s possible, but not likely. Consider the fixed-income bull market which has been powered and sustained by the Federal Reserve’s easy money policy. At some point, the economy will stabilize and the Fed will let rates rise back towards more natural levels. In fact, if inflation looms as many fear, rates may actually have to go higher. If so, prices of fixed income investments which move inversely with prevailing rates, will decline, taking the 30/70 portfolio along with them. Odds are the recent outperformance of the 30/70 portfolio is more likely a result of the cyclical fixed income bull market than a tradable trend for the future.

Longer-term rolling periods (e.g. 10 or 20 years, not illustrated here) also bear this out. Over these periods there have been extremely few times when an investor with a longer-term investment horizon would have fared better in the 30/70 portfolio. This is critical information for the long-term investor or the retirement plan participant with ten years or more before retirement. Just as the short time frame can color specific results, extrapolating recent 5-year holding periods can be equally misleading.

In this case, neither the statistics nor the fund company lied, but the truth is less than advertised. That, too, should not be surprising.

 

 

The Earnings Myth

Stock and equity fund searches are not always based on technical factors such as trends or momentum.  Instead, buy and hold managers often use fundamental factors with earnings being one of the top choices.  Stocks are, after all, ownership interests in the underlying company. If the company is doing well, its investors should also benefit. For companies in a free economy, “doing well” typically means they are not only profitable, but also growing profits over time. That’s why there’s so much concern in the first month of each calendar quarter when most (those with March, June, September, or December fiscal years) report quarterly profits. When profits surprise on a positive side, the company’s stock often jumps and the opposite occurs with negative surprises Investors naturally view this as a signal for future returns.

That makes a lot of sense, but how well does this approach work?  The analysis is pretty simple. Let’s start with quarterly reported earnings growth on the S&P 500 going back to the first quarter of 1998.  (There’s nothing magical about first quarter 1998 other than that is where the S&P earnings database begins.)  This covers almost fifteen years including two bull markets, two bear markets, and two recessions.  Let’s compare the results with the index’s 3, 6, and 12-month subsequent returns.  The results appear on the charts below.

According to the common belief outlined above, there should be a direct relationship between quarterly profits and future returns. This means when profits are up, future earnings should be as well. If this was true, the charts would have a pattern of red circles moving from the lower left of the chart to the upper right. Instead we have something that looks more like a shotgun blast with circles randomly placed around the axes.

The R-squared term at the bottom of each chart’s axis shows the statistical measure of the relation. If both series move up and down together, the value will be close to 1.0. If there is no relation between the two, the R-square value would approach 0, which is exactly what we have here. Interestingly, the six-month returns have a slightly negative relation which would imply when earnings are up, six months later total returns are slightly down. That’s not exactly what you’d expect to find, is it?

Actually none of these R-squared terms are considered statistically significant. In order to be, they would approach 0.7000 (or -0.7000 for a negative relation), but with readings of 0.0098, 0.0017, and 0.0046, that’s certainly not the case here.

Bear in mind, we’ve only looked at five hundred stocks and one index. The relationship may actually be stronger for individual issues and/or it may change over time. Nothing we’ve done here has addressed that, yet it does make you wonder.

Interestingly, although earnings still draw a lot of attention, it’s done substantially from ten or fifteen years ago. Perhaps investors realize there are a lot of accounting tricks that can be applied to massage quarterly results. Maybe they’ve turned their attention to more macro issues such as domestic and even foreign economic and political policies. Then again, maybe after all these years of expecting to see a relation and not getting one, they’re finally starting to question those basic beliefs instilled so many years ago. If not, they probably should.