Investment Management In Reality 101

Includes: DIA, IWM, QQQ, SPY
by: Lloyd Clucas


•There are a lot of ways to be duped – including, especially: in investments and healthcare.

•Sometimes that is by those who are not really trying to do that; they believe their own….whatever.

•These folks are easier to believe than the usually strident “Act now!” TV pitchmen. That is because they are true believers. That usually impresses all of us.

•Outcomes are all that count. Whether that shows Medical Error as the third leading cause of death, or the investment results of Blackboard Economists and Investors heading to ruin.

•In the investment world, a real debate is over what period of time is significant for the level of performance. But when you know, it may no longer matter.

Having respect for someone's thinking or their memory has nothing to do with whether you want them to manage your money.

Think of your friend who does really well, at home, answering quiz show questions. He or she may know lots of market facts, too, but likely knows nothing of how markets work in the real world. That can be the difference between memory and reasoning ability. But it can also be the difference between knowing economic "data" and understanding human behavior. Also, the "at home" part matters. That is the difference between studying battle and actually engaging in it - whether it be physical or in the investment world. Academia is calm (except for grant-seeking and internal departmental politics). The battlefield, street corner and markets are not.

That is part of my reason for often deriding Blackboard Economics and Investing - professors without hands-on investment experience. It is exemplified by the apocryphal about the Efficient Market Hypothesis advocates who mightn't bend down to pick up a $20 bill off the sidewalk. Why? Because their theories and models say it couldn't actually be there! Someone would have already picked it up. [That is only partly a joke.]

Would you want such people managing your life savings? Or even driving your kids to school? We're not talking perverts, here. They might just be distracted by a shiny object or an interesting hypothesis on the way. Focusing on objectives often eludes them. In this case: Getting your kids to school safely and on time.

The investment world is populated with legions of them. They spend a lot on marketing and publicity in general - as the latter is often the best way to accomplish the former. As everywhere, and in most all industries, the investment media follows the money. Investors should not.

Investors need to understand the actual investment process at a firm before hiring them. Easy to say; tough to do.

What is their valuation process? How do they use derivatives? Do they use leverage? How does momentum in fundamentals and price figure in what they do? Are they marketing their constrained "investment style"? How long has the lead manager held that position?

That brings us to a couple of examples to make the point. I actually have considerable respect for both Jeremy Grantham (GMO) and John Hussman (The Hussman Funds). They have both been bearish for some time, though Grantham is backing off a bit recently. Process adapting to reality - finally?

Grantham, et al, delivers; albeit at levels that I personally think are too low for this past cycle. But it is by design, with a low R-squared. That may not be OK, but it is rational and adapts at least somewhat to reality. Hussman does not deliver - at least for investors. But he is great at the Blackboard! I've read much of his stuff. Unfortunately Dr. Hussman is also really consistent. I haven't bothered to measure his R-squared, for reasons obvious in the chart below. His investment process seems stuck on the blackboard. It seems unconnected with reality. His valuation measures seem bizarre. But I admire his courage and thoughtful attempts to impose history on the present. Really, I do. And he presents as a nice guy, too.

Here is a chart for Hussman's Strategic Growth Fund. Love his use of the word "Growth" - almost as much as I loved Bill Miller's use of the word "Value". Remember Bill? Try to even find his Legg Mason Value Trust today. Not there. Oh, the old ticker symbol is there, but the name is different and the record "starts" again in early 2012. Bill is not on board. Washed overboard in a wave of reality? Probably.

The WARAX chart (in gold) depicts the performance of Grantham's GMO firm with an "unconstrained" fund, publicly visible. That is hard to find for them. The "unconstrained" part matters a lot because objectively-destructive consultants and bumbling in-house administrators have presumably not put limits on what GMO could do with that fund. If you understand what GMO is trying to do, that might not be bad for the period measured. Not for us, either in the real world or theoretically, but apparently OK for them.

The Hussman flagship fund (in black)? You tell me. Dr. Hussman is nothing but consistent. I do not understand his acolytes on this site. And, at this point, I don't care to. The search for, and felt-need for, "certainty" in a fear-ridden world is as understandable as it is unreal. And so it goes.

The important part of all this is to understand the actual investment process a firm is using. It is often very difficult to figure out what that really is. As the Bill Miller example shows, labels can be misleading. And it surely is not a Morningstar rating or "style box" assignment.

All of us want easy answers. Me, too! But, sorry folks, there aren't many. Do your own boring, laborious homework, or pay the price - which can be substantial: E.g. Calendar 2008? Bill Miller -55%; S&P 500 -37%; Our portfolios: -25% (our worst year ever, by far) since we started at the inception of 1974. But those are the differences that make long-term records. Especially when one always remembers to increase one's equity holdings (with very modest leverage if necessary) when valuations are good and panic levels are measurably high. We have.

The leverage in our case is removed relatively early in any market recovery. We know we are doing it "early". We don't care. That leverage is simply being used to pick up those $20 bills off the sidewalk that the EMH crowd says can't be there. The "free" money.

When valuations are not so good, but panic levels are high, we do not use any leverage. We invariably will have raised some cash to moderate portfolios' risk levels before a crunch at such elevated valuation levels. We just use that cash. Today, cash ranges from 24% to 34% for most of our portfolios. We suspect, but surely don't know, that equity markets are headed higher before the next belly flop. But we are guessing we know the risk levels and are allowing for them in our cash holdings. At these levels, we tend to stress momentum a little more than valuation. Finding a combination of the two is best in our view; very tough to do, today.

The one other thing we sometimes do is boost portfolio "beta" near emotional lows with portfolio security swaps. That is: adding portfolio volatility, without leverage, when stocks may not be undervalued.

That depends on our assessment of global risk levels at that time. Right now, risks seem too high for even beta- boosting swaps.

For others, circumstances and judgments about risks may differ. That's fine. That makes markets.

This is not investment advice to anyone. Nor is it marketing; it would be surprising if a new client were accepted. We have just used part of our investment process as examples of what one needs to know about before hiring a manager for their life savings.

Be careful out there!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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