How Big is the Hedge Fund Industry?

There is nothing that definitively marks hedge fund managers apart from other investment managers, however. Instead, all asset management firms sit on a spectrum, whether in terms of fees charged, strategies employed, or the types of vehicles offered to investors. The idea that hedge funds represent a clear, separate grouping has never been more dubious.

Depending on the definition of a hedge fund, the assets managed could range anywhere from $800bn to $3.6tn. Furthermore, we find that the $800bn figure accords more closely with the common perception of a hedge fund.

hedge fund

Finding a meaningful number is not only a definitional exercise but also a statistical one, subject to uncertainty. Flows into or out of what others define as the industry should therefore be viewed in the context of such error, which should be calculated and reported.

Introduction

How many assets are under the management of the hedge fund industry? This is a straightforward-sounding question, and it is common to see a straightforward-looking answer: $3.6tn according to the Securities and Exchange Commission (SEC) [1], say, or $3.1tn according to Hedge Fund Research Inc. (HFR), a data provider [2].

This masks the fact, however, that there is no unambiguous boundary between what could be considered a “hedge fund” and an active fund manager. No distinct “hedge fund industry” exists.

This matters on at least two counts. First, pension schemes and other big institutional investors usually have a discrete asset allocation bucket for hedge funds. Given the definitional mess that surrounds the relevant firms, it seems probable that sub-optimal investment decisions may be being taken as a result.

A second issue concerns how asset management firm performance is assessed. There are many different hedge fund indices against which firms are benchmarked. Many of these indices, however, face similar definitional problems and can as a result be poor yardsticks for the firms that use them as a reference.

For any given definition of a hedge fund, it is not possible to determine the assets managed by that group of firms at a given moment with arbitrary precision. It is, therefore, appropriate to report the statistical errors on the estimate. Reports of the magnitude of flows of capital into and out of different types of asset management firms should be viewed in the context of these errors.

What defines a hedge fund?

Those attempting to define hedge funds usually do so by referring to a collection of characteristics. Comments submitted for an SEC “Roundtable on Hedge Funds” in May 2003 set out a range of definitions, highlighting the ambiguity around the term [3].

Generally, “hedge funds” are seen as:

1) Flexible in the strategies they use, with their managers employing leverage and short-selling in order to exploit situations in which they consider themselves to have an edge, while hedging exposure to other risks.

2) Subject to less regulation than, for example, mutual funds, in exchange for limiting the categories of investors they can serve.

3) Charging high fees; famously being described as “a compensation scheme masquerading as an asset class”  because of their traditional fee structure, canonically a management fee of 2% of assets under management (AUM) per year, plus a performance fee of 20% of profits (“2&20”).

These eye-catching fee terms are often referred to alongside estimates of the aggregate AUM of hedge funds, which may be somewhat misleading. According to Preqin, a data provider, “only 17% of active single-manager hedge funds actually charge a strict 2% management and 20% performance fee structure” [6]. HFR also pointed out in March that as of the end of last year, the average management fee was 1.48%, while the average performance fee was 17.4%.

Meanwhile, many funds possessing some of the characteristics listed above prefer not to describe themselves as hedge funds, and a given asset management firm may manage a combination of externally-defined hedge fund and non-hedge fund assets.

Perhaps another way of thinking about what is supposed to constitute a hedge fund is to consider those vehicles that charge both a management fee and a performance fee. We consider this in more detail in our results.

We approached the problem by examining some of the range of possible definitions. The aim was to show how each affects the size of the resulting collection of funds, while attempting to make our assumptions explicit at each stage. We also estimate the error arising from the fact that we do not have complete or simultaneous AUM figures for each fund.

Read rest of the interesting article here

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Business Lessons from Alton Brown

I decided to write a blog post about Alton Brown (“AB”) not just because he is interesting, but because he is an entrepreneur who built a business without venture capital. AB has on several occasions talked about how he needed to get bank loans to grow his business. Since bank loans, together with personal savings, loans from friends/family and cash flow from operations are the way most entrepreneurs finance a business, his story is a great example for aspiring entrepreneurs to learn from. AB is also interesting in that he was forced to deal with gatekeepers (cable channels) to get distribution for the product his business creates since his career began before the rise of streaming. The YouTube option was not available to AB when he was trying to build his business.

AB is a story teller who taught himself to be an entrepreneur so he can tell his stories. AB’s back story can be told with a few quotes from him and two sentences from a Wikipedia entry:

alton brown

“I started off as a cameraman when I was still in college, and moved into shooting music videos in the ’80s, then became a full-time cinematographer and a director-cameraman for TV spots, which I did for about 10 years.”

“I shot commercials, many of which weren’t very good. I was unhappy and cooking made me feel better.”

“I remember I was watching food shows, and I was like, ‘God, these are boring. I’m not really learning anything.’ I got a recipe, OK, but I don’t know anything. I didn’t even learn a technique. To learn means to really understand. You never got those out of those shows. I remember writing down one day: ‘Julia Child / Mr. Wizard / Monty Python.’ That was the mission. I knew I had to quit my job and go to culinary school.”

“Two pilot episodes for Good Eats (“Steak Your Claim” and “This Spud’s For You”) aired on The Chicago PBS affiliate in 1998. The show was discovered by Food Network when an executive saw a clip of the show on the Kodak website.”

The usual quotes from the subject of this blog post (AB) are:

  1. “Because I was executive producer, writing the show, directing, all this stuff, I was so busy doing the work that I didn’t think about getting famous. There was no social media. So there was no feedback.” “When I did my first season of 13 episodes I didn’t know if people were even watching until we got renewed.” 

Feedback is fundamentally important in any healthy system, particularly if someone is trying to make it grow. What the internet and connected customers have done is enable businesses to create systems that harness feedback. These systems now overwhelmingly reside in the cloud and are more powerful interpreters of customer feedback than the world has ever seen before. The availability of cloud services enables businesses to create innovative products and services for a fraction of what it would have cost just ten years ago. By combining relatively inexpensive web services with modern data science it is now possible for businesses to run many thousands of experiments that utilize the scientific method. Most of these experiments will fail, but some will be spectacular successes. The people who can operate these cloud based systems (e.g., data scientists and artificial intelligence experts) have become the new high priests of the business world. The businesses that have the best systems which harness customer feedback and the most talented high priests are outperforming the business that don’t. It’s that simple. This phenomenon is just getting started and will become even more pronounced as the years pass.

When AB started making television, the primary feedback system was the Nielsen ratings. Businesses today like Netflix know vastly more about what their customer’s  consume than businesses that rely on Nielsen as their primary source of feedback. One implication of the increased value of data is that providers are increasingly going direct to customers and cutting out distributors. For example, you see businesses like Disney deciding that they must directly stream their own content in order to capture the customer data. As I said above, control of the customer usage data is increasingly what gives businesses a competitive advantage. If a distributor sits between the creator and the end customer that data often can’t be captured.

Social media is obviously a big source of customer feedback. AB has mastered the transition to the social media era as well as anyone. One of the more interesting questions about this new “connected customer” era is whether AB would have been able to sell his show to a network today. How effectively would AB have been able to compete in today’s business world if he was just now starting out? There are so many people trying to get traction on streaming network would he ever have been able to get traction? The number of cooking shows YouTube is astounding. That number isn’t 24.5 million, but it is a lot. Even my neighbor’s dog has a cooking show on YouTube.

Read the rest of the interesting article here

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Two Most Important Investing Decisions

There are so many interesting things to debate in investing. The active vs. passive debate has been the subject of more articles than I can count. Although the conclusion that most people should invest passively is clear, there are many nuances to it that continue to be debated every day. And for those people that do decide to be active, there are a variety of decisions that come along with that. For example, whether to invest in value or growth, and which manager to pick within that style. For factor investors, which factor or factors to follow can be another significant decision.

The interest in these types of decisions is very high and so they are all widely covered in the financial press and on blogs like this. We write about many topics on our blog and have written over 3000 posts since 2009, but our article on whether the Price/Book factor is cheap two weeks ago was the most read post we have ever produced by a wide margin. It also generated more back and forth debate than any post we have ever done. Neither of these was due to my amazing writing (although I wish it was). It is more a sign of how much interest there is in these kind of topics.

investing decisions

But there is a problem with focusing on the more detailed decisions in investing: none of them are the decisions that will primarily determine your ultimate success.

Investing success comes down to two major decisions. If you get them right and have the correct expectations, you are likely to meet your goals. If you get them wrong, you are not.

The two decisions are very simple:

  • How will you allocate your money among asset classes?
  • Will you stay the course during tough times?

Let’s tackle them one at a time.

Decision #1 – What Assets Do You Invest In?

The most important choice you can make in investing is which asset classes you invest in and your allocation among them. This is true for a couple of major reasons. First, in aggregate, asset allocation determines essentially 100% of a portfolio’s return in the long-run, while selection of securities within each asset class has almost no impact. In individual cases, this can obviously not be true, but when all investors are summed up, it is.

To explain why, it is important to understand a basic investing theory. By definition, the total of all managers, both active and passive, will match the return of the asset class they invest in before accounting for fees. Active managers will underperform the passive managers on average by the difference in fees between the two. So on balance, investors will achieve the same return on their equity portfolios as the overall market and bond investors will do the same. As a result, the way to alter long-term returns is to change the allocation between the asset classes, not what you invest in within them.

Read the full article here

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Investing your money in a tracker fund

The rising popularity of “passive” investing has seen savers put hundreds of billions of pounds into cheap tracker funds. These funds allow you to invest in the FTSE 100, for example, for less than 0.1pc a year. There is a general assumption that, relative to stock picking, tracking an index is a simple task that can be run entirely by computers. But what exactly happens to your money when you put it into a tracker fund? Telegraph Money spent a day at the London offices of Vanguard, the world’s second largest asset manager – and a major proponent of passive investing – to find out. It’s not all computers – but there aren’t many people

Vanguard’s trading floor is not a row of computers. The desks are occupied by people, albeit just a small number of them managing an astronomical amount of money. The space is compact – and quiet. Vanguard’s equity index group, the people involved in actually running its stock index tracking funds, consists of 60 people: 35 portfolio managers, plus traders, analysts and those in leadership positions. Between them they run £1.9 trillion, spread across a few hundred portfolios. That equates to £32bn per person. There is no one set manager per portfolio, and responsibilities regularly rotate.

tracker fund

On the bond side, more people are required. In the fixed-income group there are 160 people managing £900bn. There are still only 45 portfolio managers, but more than 100 traders and research analysts are needed. These teams are spread across the company’s US, European and Australia-Pacific regions, surrounded by the thousands of other staff who make up the Vanguard machine. The end investor is discussed frequently, but handling incomprehensibly large amounts of money is part of the day-to-day. One member of the foreign exchange team said she put through more than £100bn in currency orders last month.

What actually happens to my cash?

A surprising amount of spadework is involved in following an index. Say you give Vanguard £1,000 to put into a fund that tracks an index of 100 stocks or 100 bonds. It’s easy to imagine a computer algorithm splitting up that £1,000 neatly and buying £10 worth of each stock or bond. Then, as the index changes, the algorithm makes the necessary updates. For a host of reasons, including transaction costs, access to certain markets and liquidity, that isn’t possible or efficient.

Instead, your money is pooled with all of the other money the firm takes in. Portfolio managers then work out – with the help of many digital tools – the most efficient way to invest that cash to keep a tracker fund in line with the index in terms of performance and risk, while keeping trading costs to a minimum. While active managers compete on performance, passive managers compete on “tracking error” – the accuracy with which their fund tracks the relevant index – and at Vanguard their pay is based on it too. A tracker fund can deviate from an index for a number of reasons, including trading costs and accounting technicalities.

In some cases, a tracker’s holdings may not actually match the index exactly. Its job is to deliver the same performance as the index without taking extra risk, which can be possible without exactly replicating it. Melissa Tuttle, a senior equity portfolio manager, said her team tended to use incoming cash to top up holdings that had ended up “underweight” compared with the index. Their aim is always to fully invest new cash. Events such as the FTSE 100’s quarterly review, when companies enter and leave the index, also have to be anticipated, and predictions made. Combining trades together keeps transaction costs down. If 11 different Vanguard trackers need to buy HSBC shares, there is little point in them doing so separately.

Portfolio managers put in orders, which are then carried out in whichever region the stock in question is listed in. If a manager in London needs to buy Apple stock, the order is sent to the US team and bundled with any other Apple orders. That said, Vanguard is clearly pushing to automate as much as possible. “It’s fair to say we’re growing systems now, rather than people,” said Dr Alla Kolganova, head of equities for Europe. With shares, 95pc of trading is carried out electronically, with a high degree of automation. There is still 5pc where a portfolio manager may have to go hunting for a broker, however – particularly in the more difficult-to-access markets such as the Middle East. In some cases, this could still mean picking up the phone.

On the bond side, things are different.

Paul Malloy, Vanguard’s head of fixed income in Europe, said only 5pc of bond trading had been significantly automated – largely for small trades in highly liquid government bonds. The other 95pc is still done “over the counter” – meaning between two parties away from a stock exchange. “Bigger trades, or trades in less liquid areas such as corporate bonds or emerging markets, still require picking up the phone or some sort of electronic auction. There’s still someone on the other side,” Mr Malloy said.

He added that, thanks to the sheer number of bonds being issued and the number that have relatively little trading activity, buying every single bond issued by every single company in an index would incur huge costs. Instead, his team buy samples that represent the index, balancing tracking error, risk and cost. “You need to own about half the bonds in an index, representing about 95pc of the companies. We don’t need to own every JP Morgan bond to track the index – I can pick the one I like best. It’s a lot like active management, but you’re controlling risk and cost to avoid losing value, rather than trying to add value,” he said.

Risk

Sitting between the equity managers and the bond managers – both passive and active – is the risk team. Brian Wimmer, head of risk management for Europe, said there is a slim initial tolerance for a fund being out of line with its benchmark index. If that figure is breached “a conversation starts” – and there is then an absolute maximum tolerance allowed. This team is also in charge of ensuring that no financial regulations are breached. Colour-coded systems are used to keep track. Today, everything is running smoothly for the firm’s LifeStrategy range of ready-made portfolios.

When something is out of line, analysis tools enable a risk manager to look at where that error is coming from, and action can be taken to push things back into line. One option at Vanguard’s disposal is to suggest changes to an index itself, through its relationships with index providers, when it thinks improvements can be made.

– Telegraph

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Warren Buffett on Tax Reforms, Markets & Investments

Well, valuations make sense with interest rates where they are. I mean, in the end you measure laying out money for an asset in relation to what you are going to get back, and the number one yard stick is U.S. governments. When you get 2.30 on the ten-year, I think stocks will do considerably better than that. If I have a choice of the two, I’m going to take stocks at that point. On the other hand, if interest rates were on the ten-year were five or six, you know, a whole different valuation standard for stocks. And we’ve talked about that for some time now.

tax reforms

Interest rates are gravity. If we knew interest rates were going to be zero from now until judgment day, you could pay a lot of money for any other asset. You would not want to put your money out at zero. I would have thought back in 19 — I mean, 2009 that rates would not be this low eight years later. It’s been a powerful factor, and the longer it persists, the more people start thinking in terms of something close to the rates they’ve seen for a long time. The one thing I’m sure of is that over time stocks from this level will beat bonds from this level. If I can be short the 30-year bond at 3 percent or something and long the S&P 500 and just have it put away for 30 years, stocks are going to far outperform bonds. The question is which variable is going to change. Everybody expects interest rates to change. But they’ve been expecting that for quite a while.

I don’t try to guess the stock market: I find businesses I like. But if I were to guess: if interest rates — if the ten-year moved up to 5 percent, stocks would be somewhat cheaper.

It’s been so wide I’ve written about it in annual reports. Stocks have been so much more attractive than bonds for a long time now and that’s partly intentional on the part of the fed. I mean, they want assets to increase in value and the way to do it was to reduce that gravity force of higher interest rates.

I think they expect it to increase, but the question is how much. If three years from now interest rates are 100 basis points higher than this, stocks will still be cheap at these prices. If it’s 300 or 400 basis points, they won’t look cheap. Janet Yellen doesn’t know what she would do three years from now. She’s got more of a job than –that’s a simple factor of the stock market. It’s interesting because the fed has said that they would like to see 2% inflation. That’s fairly recent. Paul Volcker would not have slept if he’d ever heard that in the 80s.

If the U.S. government is borrowing at ten years from you at 2.3%, and their own instrument, the fed, is saying ‘we would really like money to become more 2% a year or less,’ they’re not promising you very much in terms of real terms for saving.

Read the full interview here

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Did Warren Buffett Kill Value Investing?

From 1957-1969, Warren Buffett’s partnership returned 2800%, or 29.5% a year*. Over the same time, the S&P 500 rose 153%, or 7.4% a year. Warren Buffett has been crushing the market for seven decades, but his early success went largely unnoticed. His name didn’t appear anywhere noteworthy until Adam Smith’s Supermoney, which wasn’t written until 1972. While his name gained traction in the investment community, it took many years before it became what it is today. Buffett is synonymous with investing, and If you type his name in the Amazon search bar, the machine spits back 1822 book results. His rise to ubiquity can be traced back to 1984, when he destroyed an efficient market hypothesizer.

value investing

On the 50th anniversary of Security Analysis, Buffett wrote an article in the Columbia Business School Magazine called The Superinvestors of Graham-and-Doddsville . A few weeks prior, Buffett faced off against Michael Jensen, a professor from the University of Rochester and the school of efficient markets. In the speech, which was translated into the article, Buffett told a story that would remove any doubt that value investors outperformance should be attributed to skill rather than luck. Imagine that 225 million Americans all flipped a coin. If you landed on heads, you lived to flip another coin. If this was repeated twenty times, 215 people would be expected to remain.

But then some business school professor would probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise, the results would be much the same…I would argue, however, that there are some important differences in the examples I am going to present. For one thing, if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were onto something. So You would probably go out and ask the zoo keeper about what he’s feeding them….A disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville.

From 1926 until the time that Buffett wrote this article, the Fama French U.S. Large Value Index, which did not exist until the early 90s, crushed the S&P 500. But you can see that until 1970, the red and black line were neck and neck. So all of the outperformance over this 58 year period came in the 14 years leading up to Buffett’s coin-flipping speech.

Read rest of the article here

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Planning for a Non Retirement

Much of financial planning focuses on retirement. But what if your client isn’t planning to retire?

Trish Wheaton, former global managing partner of one of the world’s largest communications groups, is grateful that she could work 30 years in advertising — an industry notorious for employing youthful “mad men.” She wasn’t surprised when she was told that her time was up at age 65, but she also wasn’t ready for a traditional retirement.

Wheaton mused:

“Sixty-five is the new 45. I had to ask myself ‘what’s next?’ I realized I didn’t have a clue. When I talked to my female peers in the same situation it turned out that they were feeling the same way. We were all used to being successful. People still want to invest in their passion . . . it’s just a question of where do they invest it now.”

retirement

She decided to form a Leaning Out™ salon: a gathering of high-achieving women who discuss finding post-career success and purpose. “With the same energy, goal orientation, and drive that propelled them to lofty career heights,” Wheaton explained, “these female professionals are radically redefining ‘post-career’ and turning it into a time of abundant purpose, goal redefinition, and personal well-being while over-turning some well-entrenched approaches to ‘retirement’ in the process.”

I participated in one Leaning Out session, where we discussed a host of topics, including what motivates women to non-retire. Most successful women truly enjoy working. That message came through during our salon with comments like:

“I hate saying I’m retired.”

“After my job ended, I would go to my computer in the morning and when I looked at my email, I would feel like I don’t exist.”

“I miss the intellectual stimulation from work.”

“I want to do something different now . . . something that will matter to me.”

Opting out of retirement might even be good for longevity. Shigeaki Hinohara, a Japanese physician, worked 18 hours a day, seven days a week until his death at the age of 105. He spoke to Judith Kawaguchi of The Japan Times about the secret to living a long life:

“There is no need to ever retire, but if one must, it should be a lot later than 65. The current retirement age was set at 65 half a century ago when the average life-expectancy in Japan was 68 years. Today, people live longer so they can work longer.”

Five Non-Retirement Scenarios

1. Boards of Directors

Many professional women assume that after they move on from their roles as senior executives, they will immediately be asked to sit on corporate boards. They have heard that women directors are in demand, and they expect to be invited to serve based solely on their experience and gender.

“Be careful. Don’t make the grand assumption that you will be in demand the day after you move out of the executive suite!” says Joanne De Laurentiis, a corporate board member and former president and CEO of The Investment Funds Institute of Canada (IFIC).

“Often people think that the simple fact that they have been an executive qualifies them to sit on a board. But the skill set required can be quite different from their work background. Board members must have a strong combination of skills such as strategic thinking, problem solving, and leadership, but perhaps most importantly . . . they need to have specific expertise related to the business dealings of the organization.”

If you are planning on sitting on a corporate board, you need to have developed the full spectrum of skills required and should be known for your expertise.

The best way to plan for life on boards?

As De Laurentiis explains:

“Start developing your board skill set in the early years of your career. I started volunteering on boards right out of university and I have been on boards throughout my entire working life. When the time came for me to leave my traditional job, I didn’t need to seek out any board positions, I was already well-known as an expert in my field.”

  • Read the full article here

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How To Reduce Risk in Stock Markets

Leverage – Debt increases risk. The easiest way to reduce your risk is to not have leverage, especially margin leverage, in your portfolio. Margin leverage is one of the few ways that you can be correct in your investment analysis, and ultimately in the result, but still lose money. It’s not worth it.

The second easiest way to reduce your risk is to not invest in companies that have excessive leverage. Having excessive debt on a company’s balance sheet can lead to problems. Having excessive debt also limits opportunities. One of the key components to the “Balance sheet to income statement investing” that I advocate is the ability for a company to take on debt when they see an unusually attractive opportunity. Better to buy a company with little debt and a strong balance sheet that can use that strength to safely take advantage of those opportunities by adding a reasonable amount of debt. They can’t do it if they are already overleveraged.

risk in stock markets

Margin of safety – Let’s go to Michael Mauboussin quoting Warren Buffett, “We believe the best and most practical way to restate the margin of safety
concept is to think about discounts to expected value. The combination of probabilities and potential outcomes determine expected value.”

Says Buffett, “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”
A large margin of safety is helpful for many reasons. One, it gives you the opportunity for outsized gains. Two, it mitigates the effects of mistakes in analysis. And three, it helps protect against unknowable and unforeseen market and company-specific stresses.

Know your investment well – In order to know if you have a margin of safety, you must know your investment well enough to roughly determine its intrinsic value. Or, if you want to take the Mauboussin approach, determine the expected value. Clearly you must have the skillset to analyze a company. You also have to have the humility to recognize that the intrinsic value cannot be determined for some, perhaps most, companies. Other times the intrinsic value can be determined, just not by you. There is no shame in having a “too hard” pile. Mine is high.

I am attracted to companies where there are a low number of variables that are at least somewhat measurable. This is easier to do if you are relying on a company’s balance sheet rather than their income statement. It is also far easier for a company to manipulate their income statement, so this approach has the added benefit of higher predictability. Some investors believe that just because a company is small, it is more risky. This isn’t true. Those investors think that because a stock price moves more rapidly, a stock is more risky. They’re mistaken. Intelligently investing in smaller companies can dramatically reduce your risk. Most of the least risky companies I have invested in have been small. They were not risky specifically because of their low price relative to their actual value. They also were much easier to analyze.

Temperament – Here is where the self-awareness and Intellectual honesty fit in. This is a never-ending process and it is not easy. Nearly every investor, including the best, have succumbed to the market’s excitement and depression at one point. I don’t think it makes me a hippy to say that it is vital to protect your psychological wellbeing. Effective analysis consists of thousands of small judgments while researching a company. It’s a big risk if you can’t make those judgments with a clear head. This is also where ideology can blind you, and being blind as an investor is a dangerous thing. An investor always has to be mentally prepared to the idea that he is wrong, and if so, be willing to change his opinion.

Read the full insightful report from Arquitos Capital Management here

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There They Go Again…Again – Howard Marks Memo

Some of the memos I’m happiest about having written came at times when bullish trends went too far, risk aversion disappeared and bubbles inflated. The first and best example is probably “bubble.com,” which raised questions about Internet and e-commerce stocks on the first business day of 2000. As I tell it, after ten years without a single response, that one made my memo writing an overnight success.

Another was “The Race to the Bottom” (February 2007), which talked about the mindless shouldering of risk that takes place when investors are eager to put money to work. Both of those memos raised doubts about investment trends that soon turned out to have been big mistakes.

howard marks

Those are only two of the many cautionary memos I’ve written over the years. In the last cycle, they started coming two years before “The Race to the Bottom” and included “There They Go Again” (the inspiration for this memo’s title), “Hindsight First, Please,” “Everyone Knows” and “It’s All Good.” When I wrote them, they appeared to be wrong for a while. It took time before they were shown to have been right, and just too early.

The memos that have raised yellow flags in the current up-cycle, starting with “How Quickly They Forget” in 2011 and including “On Uncertain Ground,” “Ditto,” and “The Race Is On,” also clearly were early, but so far they’re not right (and in fact, when you’re early by six or more years, it’s not clear you can ever be described as having been right). Since I’ve written so many cautionary memos, you might conclude that I’m just a born worrier who eventually is made to be right by the operation of the cycle, as is inevitable given enough time. I absolutely cannot disprove that interpretation. But my response would be that it’s essential to take note when sentiment (and thus market behavior) crosses into too-bullish territory, even though we know rising trends may well roll on for some time, and thus that such warnings are often premature. I think it’s better to turn cautious too soon (and thus perhaps underperform for a while) rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits and cut losses.

Since I’m convinced “they” are at it again – engaging in willing risk-taking, funding risky deals and creating risky market conditions – it’s time for yet another cautionary memo. Too soon? I hope so; we’d rather make money for our clients in the next year or two than see the kind of bust that gives rise to bargains. (We all want there to be bargains, but no one’s eager to endure the price declines that create them.) Since we never know when risky behavior will bring on a market correction, I’m going to issue a warning today rather than wait until one is upon us.

I’m in the process of writing another book, going into great depth regarding one of the most important things discussed in my book The Most Important Thing: cycles, their causes, and what to do about them. It will be out next year, but this memo will give you a preview regarding one of the most important cyclical phenomena.

Before starting in, I want to apologize for the length of this memo, almost double the norm. First, the topic is wide-ranging – so much so that when I sat down to write, I found the task daunting. Second, my recent vacation gave me the luxury of time for writing. Believe it or not, I’ve cut what I could. I think what remains is essential.

Read the complete article here

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The Dangers of Quantitative Value Investing

In recent years, quantitative stock analysis has taken the investment world by storm while qualitative analysis has been given a back seat. Value investing however — as Benjamin Graham would remind us — is both an art and a science. A new study in the CFA’s Financial Journal showed the underperformance / diminishing alpha of stocks chosen purely based on their quantitative value, and explains why value factors taken alone aren’t great indicators. But first, a quick trip into the value investing time machine.

quantitative value investing

Quantitative Value Investing History

Benjamin Graham’s and David Dodd’s 1934 Security Analysis is the seminal book on value investing. Security Analysis offers investors a comprehensive guide to analyzing companies to find value stocks which are priced below their intrinsic value. Graham & Dodd advise a number of strategies to find value stocks, ranging from qualitative factors like identifying industry trends and a company’s management team to quantitative factors like book value, P/E ratio, and sales-to-price. As Graham’s value investing ideas gained popularity in the investing community with disciples like Warren Buffet and Mario Gabelli, a ton of portfolio managers and private investors began mining his work to develop their own investment strategies.

With the advent of powerful computers, databases, and stock screeners it has become increasingly easy for investors to implement Graham’s quantitative strategies, while the qualitative study of companies remains nearly as time consuming and research intensive as it was in 1934. This imbalance of effort has generated a dangerous proliferation of quantitative investing without qualitatively studying stock fundamentals.

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