El-Erian, The Only Game in Town

Although central banks take center stage in Mohamed El-Erian’s The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse (Random House, 2016), the action that occurs, or should occur, in the wings is the more interesting and challenging part of this book. Unless, of course, you’re a central banker.

The world, El-Erian argues, is traveling toward a T junction (or, if you prefer statistical models, will be confronted with a bimodal distribution). The road we are currently traveling on, “one engineered and maintained by hyperactive central banks, will likely end within the next three years, if not earlier, to be replaced by one of two roads that fundamentally contrast in their implications and destinations. One road … involves a restoration of high-inclusive growth that creates jobs, reduces the risk of financial instability, and counters excessive inequality. It … also lowers political tensions, eases governance dysfunction, and holds the hope of defusing some of the world’s geopolitical threats.” (p. 22) This is the utopian road. The other road would undermine all of these ideals. It is the task of governments, companies, institutions, and households—the task of all of us, to steer ourselves onto the better road.

Right now the advanced economies are trying to cope with ten critical issues. These issues are (and I quote El-Erian in each case because I assume he spent considerable time getting the wording just the way he wanted it):

1. “Repeatedly inadequate and unbalanced economic expansion, reflecting cyclical/secular headwinds, highlights the extent to which many advanced economies still lack proper growth models.”
2. “Unemployment remains too high in far too many advanced countries; and it is getting more deeply embedded in the structure of those economies and, therefore, will become that much harder to solve.”
3. “Fueled by an unusual combination of cyclical, secular, and structural factors, the worsening of income and wealth inequality has been so pronounced within countries that it now also undermines opportunities.”
4. “The loss of institutional credibility is part of a more generalized erosion of trust in politicians and the ‘system’ as a whole.”
5. “National political dysfunction is still a headwind to overcoming economic malaise and restoring genuine and durable financial stability.”
6. “As national dysfunction undermines global policy coordination, traditional core/periphery relations fail and geopolitical tensions escalate.”
7. “With systemic risks migrating from banks to nonbanks, and morphing in the process, regulators are again challenged to get ahead of future problems.”
8. “When the market paradigm changes, as it inevitably will, the desire to reposition portfolios will far exceed what the system can accommodate in an orderly fashion.”
9. “Yet none of these uncertainties and fluidities seemed to disturb financial markets that, operating with unusually low volatility, went from one record to another. As such, the contrasting gap between financial risk taking (high) and economic risk taking (low) has never been so wide.”
10. “All of this adds up to considerable headwinds for the better-managed part of national, regional, and global systems.”

How can we address these issues? Central banks, however willing they may be to do whatever it takes, cannot deliver the desired outcomes, cannot effect systemic and lasting change. Instead, every decision maker in both the public and private sectors must pitch in.

El-Erian sets forth some specific recommendations for achieving the better alternative. As an investor, however, he has to accept the high probability that things could go either way, that the distribution of potential outcomes is bimodal. In light of this distribution, how should investors position their portfolios? Here are a few of his ideas. Beware of liquidity traps, trade up in quality, barbell risk exposures, and hold relative (e.g., foreign exchange) as well as absolute positions.

The stakes are high, but “where we actually end up is still a function of choice rather than destiny.” It is up to all of us to help improve the prospects for good outcomes, “in the process also increasing our ability to better navigate bad outcomes should the world come out of the T on the wrong road.” (p. 242)

Moore, Digital Wealth

Robo-advisors have become increasingly popular wealth management services, although they still represent just a sliver of the wealth managed by human advisors. Automated, algorithmic programs can construct portfolios, rebalance them, and even harvest tax losses. They cost a fraction of what a typical financial advisor charges, and they do a better job of asset allocation and fund selection. What, of course, they can’t do is to hold the nervous investor’s hand in times of trouble, although they can send soothing messages.

Simon Moore is the CIO of FutureAdvisor, one of the largest digital asset managers. In Digital Wealth: An Automatic Way to Invest Successfully (Wiley, 2016) he explains the basics of constructing a diversified, cost efficient, tax efficient portfolio using ETFs. And, as might be expected, he argues that financial software is superior to human beings in setting up and managing an investment portfolio.

What should be of interest to all investors who have not committed to a digital service, whether they manage their own money or rely on a financial advisor, is how the FutureAdvisor algorithms go about rebalancing a portfolio. Moore argues that “if and when any rebalancing does occur, it should ideally be combined with other portfolio considerations such as tax efficiency, cash and dividend investment, and consideration of whether the initial fund selection is still valid in the presence of current expense ratios, commissions, and bid-ask spreads.” (p. 123)

There are two basic ways to go about rebalancing: a time-based system and a threshold system. In the former, the portfolio is rebalanced every quarter, let’s say, quite independently of market conditions. Threshold-based rebalancing, by contrast, “makes moves when they are large enough to matter to the portfolio. … “[I]f your portfolio is set up to rebalance once a quarter, then you’ll get a rebalance once a quarter whether the market is virtually flat or experiencing the largest volatility in history. However, in those same environments threshold-based rebalancing would avoid rebalancing in a virtually flat market and potentially balance more than once during a period of high volatility.” (pp. 123-24)

FutureAdvisor goes a step further, using a tiered rebalancing approach. “[I]t appears optimal to use threshold-based rebalancing but to implement it in a tiered fashion so that trades are made only when there is a deviation that matters at the level of portfolio construction. However, the need for rebalancing also interacts with other features of the algorithm in minimizing trading costs, so often rebalancing trades is combined with other trading goals, resulting in less portfolio turnover. For example, sometimes rebalancing can effectively be done for free if a tax loss harvesting trade is occurring or there is sufficient cash in the account to be invested and the algorithm can see those opportunities and take advantage of them.” (p. 125)

I have no doubt that wealth management algorithms will become omnipresent, whether as stand-alone products or as must-have tools for human financial advisors. It’s time for investors to understand them better and decide what role they should play in their own long-term wealth management.

Murray, The Mark and the Void

Paul Murray’s comic novel The Mark and the Void was briefly noted in this week’s New Yorker, and I thought it might be a welcome change of pace from the volatile markets. What can I say? I abandoned it halfway through. Rather than write a whiny post about stereotypes, I’ll simply point readers to the review in The Guardian. Even though it’s critical, it’s more favorable than mine would have been.

Faber, Invest with the House

Meb Faber, a popular blogger and CIO of Cambria Investment Management, got on investors’ radar screens with The Ivy Portfolio. Since that first co-authored book, he has written Shareholder Yield, Global Value, and Global Asset Allocation. His latest book is Invest with the House: Hacking the Top Hedge Funds (The Idea Farm, 2016).

The same general strategy that informs this book is the rationale behind AlphaClone, a company Faber helped cofound in 2008 but in which he is no longer actively involved. That is, piggyback on the stock picks of the best investors.

Any investor can access the SEC’s EDGAR database and, 45 days after the quarter’s end, view the holdings of every institutional fund with assets under management of over $100 million. Yes, this information may be stale; it provides insight into funds that hold stocks for a reasonably long time (mainly value managers), not those with a high turnover rate. Moreover, the 13F filings list only long positions, so the individual investor has no idea whether or how these long positions are being hedged and what “stand-alone” shorts the fund may hold.

Even so, can the individual investor gain an edge by cloning? Faber answers this question by analyzing the 13F quarterly filings of twenty prominent value investors, going back to January 2000. He creates historical stock portfolios, equal weighting the top ten holdings of each manager’s portfolio. And he rebalances quarterly, adding and deleting holdings and calculating performance as of the twentieth day of the month.
The annualized performance of the S&P 500 from 2000 through 2014 was 4.31%, with a volatility of 15.24%, a Sharpe ratio of 0.16, and a maximum drawdown of 50.95%. This is the benchmark against which Faber measures the performance of his cloning strategy.

Although Faber no doubt cherry-picked the twenty funds (plus, in appendices, more funds that don’t have such a long track record) to ensure that his cloning strategy would be successful, the results are impressive. Cloning Berkshire, for instance, using Faber’s methodology, investors would have had an annualized return of 10.53% with a lower drawdown. Cloning David Tepper’s Appaloosa, the return would have been 20.94%, though with more volatility and a higher drawdown.

Faber’s book not only offers investment ideas but is fun to read. Each chapter introduces the reader to the hedge fund manager and his philosophy before crunching numbers.

And lest the individual investor think, for whatever reason—ego probably topping the list, that he doesn’t need to imitate others, here’s a sobering statistic: “Simply picking a stock out of a hat means you have a 64 percent chance of underperforming a basic index fund and a 39 percent chance of losing money!” (p. 13)

And now, write a book

Newport, Deep Work

Cal Newport, an assistant professor of computer science at Georgetown University, moonlights as an author of advice books. (Actually, “moonlights” is the very wrong word because he keeps his evenings work free.) In addition to three books for students—How to Be a High School Superstar, How to Win at College, and How to Become a Straight-A Student, he wrote So Good They Can’t Ignore You: Why Skills Trump Passion in the Quest for Work You Love. Now he is out with Deep Work: Rules for Focused Success in a Distracted World (Grand Central Publishing, 2016).

Although I admit that reading a book about deep work may itself be a distraction from actually doing deep work, it’s a worthwhile distraction. Newport’s book is a quick, inspiring read, although consistently implementing its rules is much, much tougher to do. Because, let’s face it, most of us spend the bulk of our time in the shallows, a word Nicholas Carr memorialized in his 2010 book. When I read Carr’s book I vowed to do something about my penchant for being distracted. Instead, five years later I may be even more distracted. And so, like a yo-yo dieter, here I go again, with good intentions and a new guidebook to turn those intentions into best practices.

Newport defines deep work as “professional activities performed in a state of distraction-free concentration that push your cognitive capabilities to their limit. These efforts create new value, improve your skill, and are hard to replicate.” (p. 11) By contrast, shallow work refers to “noncognitively demanding, logistical-style tasks, often performed while distracted. These efforts tend not to create much new value in the world and are easy to replicate.” (p. 13)

By and large, to thrive in the new economy a person must have the ability to quickly master hard things as well as the ability to produce at an elite level, in terms of both quality and speed. (p. 28) And these abilities depend on the person’s ability to perform deep work.

Routines and rituals help foster a deep work habit. These routines and rituals must fit the individual’s circumstances, personality, and type of project being pursued. The author himself adapted the 4DX framework from the book The 4 Disciplines of Execution to his personal work habits. The four disciplines he embraced were: focus on the wildly important, act on the lead measures (as opposed to lag measures), keep a compelling scorecard, and create a cadence of accountability. And his own fifth habit, regularly rest your brain. “When you work, work hard. When you’re done, be done.” (p. 107)

To avoid the siren call of email or Google searches, Newport recommends that people schedule Internet blocks, both at work and at home. It is important to learn to resist switching to an online distraction at the slightest hint of boredom. The author also recommends that people give up time-consuming social media. Instead, he suggests they put more thought into their leisure time, offering themselves a quality alternative. Like reading a book.

Scheduling is a recurrent theme in this book. In fact, Newport recommends that people schedule every minute of their day. Well, not minute by minute of course, but in blocks.

And the reward for following this path? “A deep life is a good life, any way you look at it.” (p. 69)

Enjoy, be merry, read a book