The economic and financial market calamity of the early 1930s traumatized the investing public for decades thereafter, leaving an entire generation viewing Wall Street’s activities with skepticism, if not downright antipathy. Even those born long after those harrowing times came to share their elders’ condemnation of the stock market as a disreputable place, a “rich man’s game” dominated by insiders and manipulators. Given the experience of the Depression years such attitudes might not be surprising, but they were illogical, self-defeating, and economically costly—illogical because the returns from equity investments remained superior to almost anything else available to the average person over time, and self-defeating because investors, both individual and institutional, denied themselves an important avenue for achieving financial security for themselves or their beneficiaries. The economic damage came in the form of a higher cost of capital for business than would otherwise have been the case.
What brings this chapter of financial history to mind are reports offering evidence for a continued lack of enthusiasm for the stock market on the part of individuals, despite the dramatic rise in prices following the bottom of the market plunge in March 2009. Since then the S&P 500 index has gained over 170% through year-end 2013. A few figures reveal the extent of the disillusionment: from 2006 through 2012, individuals withdrew $451 billion from stock mutual funds as they added over $1 trillion to fixed-income funds. A turn in investor sentiment occurred in 2013 when about $60 billion was invested in stock vehicles, but enthusiasm waned over the course of the year. In contrast to traditional mutual funds, increasingly popular Exchange Traded Funds (“ETFs”) attracted $354 billion between 2006 and 2012, with another $86 billion being added through November 2013. Still, the public’s interest in stocks remains relatively weak, and anecdotal evidence gleaned from “man on the street” interviews indicates continuing distrust. This data has puzzled market observers, since an upward-trending market usually helps people overcome their doubts.
History shows that market participants eventually get over the periodic episodes of market apoplexy and regain confidence (greed is a powerful incentivizing force), but not before inflicting considerable damage on themselves. Self-defeating behaviors are repeated as we saw most recently in 2008-2009 when fearful and distressed sellers exited stocks at low prices. Seeking “safety” or protection from the previous calamity, market participants typically flee to cash or unwisely flock to “concepts” that are largely speculative, whether the “Nifty Fifty” of the early 1970s, “portfolio insurance” of the late 1980s, or dot-com sure-things a decade later, all of which ended badly. This time around, participants looked to gold and other commodities, “hedge” funds, and above all the “safety” of fixed-income for their salvation.
The consequences of these choices are already being felt. Gold prices fell over 25% last year, the first down year since 2000. “Hedgies” added to a string of mediocre performances. A mini-rout in bonds occurred last summer after the U.S. Federal Reserve hinted at the beginning of an end to its easy money regime. The “reach for yield” by some individuals will likely cause much grief—a portent of things to come appeared in a recent Bloomberg piece reporting the experience of investors who purchased shares in a certain type of real estate investment trust (a kind of security typically marketed to income-seekers) yielding 12%. That generous-sounding return came to naught when the shares lost 43% of their value in reaction to the anticipated changes in central bank policy, and a dividend cut is now possible. We sympathize with those who are in need of income and face the challenges of a zero-interest-rate world, but we have always felt that it is far better to spend a little capital if need be, that run the risk of losing a lot more.
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Speculation about the aforementioned changes in Federal Reserve policy dominated the financial news last year. Just mentioning the possibility of a cutback in the level of monetary stimulus—not a tightening—brought disarray in fixed-income markets and a small setback for equities during the summer months. In one of those odd twists so incomprehensible to the uninitiated, when Fed officials actually did announce plans for “tapering” moves in December, stocks rose smartly and finished the year with gains ranging from 25% to 39% (depending on the index you favor). Thus continued the extraordinary run-up in stock prices since early 2009. During 2013 alone over $3.5 trillion was added to the aggregate value of the S&P 500 stocks.
Bonds were not a good place to be in 2013. From 1.8% at December 31, 2012, the yield on the 10-year U.S. treasury note rose to 3% a year later, indicating that bond prices declined. Returns on U.S. debt overall were negative, down 2.6%, while long-term U.S. bonds lost about 12%. This modest back-up in rates was not enough to cause much alarm; on the contrary, demand for debt securities remained strong across the spectrum and issuance of corporate obligations reached new records. Investors apparently now perceive a strengthening economy to be a more important factor than slightly higher interest rates, as an improved business environment usually means less credit risk. Significantly higher costs for debt might be a different matter, but that is not in the cards, according to the consensus view on Wall Street.
Looking ahead, rear-view-mirror analysts and money-managers see more of the same for the markets in 2014, although with greater “volatility,” perhaps less robust gains for equities, and “corrections” on the way (In other words, stocks might go up, but they could go down, too). Almost universally, bonds are held in disfavor, a fact that in itself would make them interesting were it not the case that fixed-income assets are still selling at or near record prices (sometimes the consensus view turns out to be correct after all). In keeping with our usual practice, we prefer to maintain silence when it comes to soothsaying, taking instead a wait and see attitude. As Will Durant once wrote, “One of the lessons of history is that nothing is often a good thing to do and always a clever thing to say”—lessons lost on most of Wall Street.
Economies of Scale
In a December piece reflecting on the issue of financial “liquidity”—the ease with which assets can be bought or sold, or the availability of credit—The Financial Times’ John Authers writes, “scale in finance is not necessarily a good thing.” The context of this comment was a discussion of how in its drive to enhance liquidity, expand the availability of credit, and increase the size of transactions that financial institutions can execute, finance suffers a loss of “local knowledge” that it sooner or later lives to regret. For example, in the process of “securitization,” computer models define how mortgages on many different properties may be pooled into one “asset,” against which securities are issued using cash flow from the pool to fund payments to buyers. Investors benefit from having access to a “homogenous” security that is relatively liquid and easier to deal with than the underlying mortgage contracts it represents. Mortgage lenders are able to sell their mortgages to the securitizers, freeing-up their balance sheets so they can offer more loans. More homebuyers are able to access credit to purchase their dwellings. Everyone is happy, but knowledge of the individual borrowers is lost in the shuffle, and that can cause major problems, as we saw in the financial crisis that began in 2007. Pressures and perverse incentives that became part of the homogenization and securitization process led to practices that resulted in not even mortgage originators having “local knowledge” of their mortgagees.
We believe this basic observation applies to other areas in finance (perhaps to other endeavors as well), including that of investment management. Like many people, we have often noticed a negative correlation between the size of a business and the customer’s quality of experience. Take something as mundane as shopping at a local hardware store versus a big-box retailer. The larger operation is efficient, moves a lot of goods, and may offer modestly lower prices, but there is nothing quite like dealing with someone who knows exactly what kind of equipment you need and can offer advice on how to use it.
The consolidation of the investment business into ever-larger entities has created pressures for homogenization and uniformity in order to create “products” that can be easily pushed by armies of customer representatives and advisors of every stripe. The investing public is led to believe that these products are designed to meet the individual’s goals and so-called “risk preferences.” In reality, information is fed into computer-run statistical packages that organize customer data according to well-defined categories and spit out model portfolios designed to be appropriate for each. Such is the cookie-cutter approach that has come to characterize an industry organized to operate on a large scale—an impersonal process that fails to produce a true knowledge and understanding of individuals, and, conversely, does not give those individuals real insight into how their funds are being managed.
Homogenization reaches its apex in fund management, in which, from the investor’s perspective, no pretense of investment in individual companies remains. A single fund can own shares in hundreds of businesses whose individual characteristics can be subsumed in a single title such as “growth.” Gone is the “local knowledge” of company prospects. Such products, if used properly and simply, may be useful for individuals of limited means seeking a home for savings over a long period of time. The danger lies in investors’ using such products more aggressively and not getting what they think they are buying. ETFs, for example, are offered as a way to invest in various markets (or slices of markets) as a whole, much as traditional index mutual funds have done over a longer period, but with greater “liquidity” and ease of entry and exit. But when an ETF offers exposure to an obscure, illiquid market (a so-called “frontier” market, for example), purchasers may find that their holding is not as easy to get out of as they expected.
Size and scale of operation are not necessarily impediments to good investment practice. We have long been convinced that knowledgeable individuals have powerful advantages when it comes to investing. If a fund is managed in the same manner as such an individual would manage his or her own money, the advantages can be maintained. Unfortunately, investment operations conducted on that kind of scale are few and far between.
Dennis Butler, MBA, CFA