sarwesh

Investment pros have tried numerous methods to protect
their clients against the occasionally vicious whims of
market volatility. They all lead to one rather unconventional
conclusion: Hedge funds and other alternative investments
are better suited to generate exceptional returns than
their more traditional mutual fund progenitors.


THE ULTIMATE INVESTMENT


The current state of investment management has a lot more in common with
the prescribed burns than most professionals would care to admit. In an
effort to curtail naturally occurring disasters, such as the 1998 Russian rubleinspired
stock market meltdown or the equally vicious Nasdaq carnage of
late 2000, investment pros have tried numerous methods of protecting their
clients against the occasionally vicious whims of market volatility. Much like
the Forest Service, it remains questionable whether these attempts have
resulted in any positive consequences.
Sadly, investment managers have been as unsuccessful in adding value
during bull markets as they had during bear market periods. As a result,
actively managed funds have become increasingly correlated to passive
indices. What solutions are available to those truly committed to producing
excellent risk-adjusted returns?
The purpose of this chapter is to describe the components necessary to build
an actively managed fund capable of generating consistent, market-beating
returns. In this context, the term “market beating” is defined in two ways:
1. A return in excess of a broad representation of the U.S. equity market.
2. A return on par with the U.S. stock market but achieved with less volatility.
The previous requirements assume that the fund is considered in lieu of
an investment in the stock market. If the fund is to be used as a diversifier
in a traditional portfolio, it must be non-correlated with the return of either
the stock or bond market. The fund should also generate an absolute return
that is large enough to keep from dragging down the performance of the
overall portfolio.
As we shall see, the requirements for building such a fund are vexing.
Factors at the root of this difficulty include dealing with the issue of idea
generation, the problems of asset size versus performance, and the question
of determining which parts of the investment landscape are best suited for
that most illusive of quarry—tradable market inefficiencies.
This exercise will lead us to a rather unconventional conclusion: Hedge
funds and other alternative investments are better suited to generate exceptional
returns than their more traditional mutual fund progenitors



A DUBIOUS TRACK RECORD
Financial gurus have a term for adding value to the investment process: alpha
(
). If the underlying market gains 10 percent for the year and an active manager
is able to generate a 12 percent return, the alpha is 2 percent. This
example is much more the exception than the rule: Over the last decade,
there has been only one year when more than 25 percent of actively managed
mutual funds beat the S&P 500 Index.
Of course, this period coincided with the most spectacular bull market
in history—a point not missed by proponents of active management. Fans
of the approach claim that it is during periods of tumult that investment pros
add the most value, perhaps by holding a larger cash position or avoiding
certain stocks that have such deteriorating fundamentals that the only direction
possible for their stock’s price is south.
The year 1998 was the perfect year for evaluating the promise of active
management to produce attractive returns during periods of declining stock
prices and increased market volatility. Instead of the broad market advances
that made indexed funds the investment of choice in the last decade, 1998
proved to be a year in which a select handful of stocks performed spectacularly
enough to take the market indices to new highs. According to Morgan
Stanley equity analyst Leah Modigliani, 14 companies accounted for 99 percent
of the S&P 500 Index’s returns for the first three-quarters of the year.
Moreover, just a handful of stocks made up the gains in the S&P in the fourth
quarter of 1998, and two stocks alone—high-fliers Microsoft and Dell
Computer—produced one-third of the year’s gains.
Thus, 1998 should have been a stock picker’s dream—an environment
where a portfolio consisting of a selected few issues would have trounced
the returns of the overall market. So how did active managers fare?

sarwesh

FULLY REFLECTED


Investment managers use a variety of methods in their attempt to generate
outsized returns. The most common method is the use of company fundamentals
in discerning the fair value of a firm. This style of investing was inaugurated
in 1934, when the landmark text Security Analysis, by Benjamin
Graham and David Dodd, was published. According to this text, securities
that trade below their fair value can be purchased and later sold for a profit
as prices are eventually corrected by the marketplace to reflect a company’s
true financial performance.
Like many great ideas, fundamental analysis is much easier to perform
on paper than it is in the real world. This is partly due to the large herd of
investment professionals who use the method to manage billions of dollars
in client assets. The resulting plethora of suspender-clad fund pros chasing
the few incorrectly priced stocks that boast enough trading volume to buy
and sell in large chunks makes a difficult game nearly impossible to win.
This simple fact has not stopped the throngs of Ivy League MBAs from
trying. There are some winners, but so few have generated consistently outstanding
results that the term “random walk” starts to rear its ugly head.
Curiously, the group most enamored with fundamental analysis is its
biggest customer. Institutional investors seem absolutely giddy about discussing
various fundamentally-based methodologies with investment management
candidates. Yet, it seems that this fundamental fetish shared by
many big-time consumers of investment advice is a response to the bad reputation
of the other school of investment philosophy: technical analysis.
Market technicians believe that all of the information necessary to make
a valid buy or sell decision is contained in the price of the security in ques-
tion. As a result, an examination of sales growth, profit margins, or other
company-specific metrics is deemed to be unnecessary for predicting stock
price movement. A cursory examination of price trends, trading volume, and
other market indicators is all that is necessary, proponents of the approach
argue.
Even though security prices have an occasional tendency to move in
trends, the financial witchcraft associated with technical analysis is anathema
to the gatekeepers of pension assets and other sizable pools of money.
Perhaps my investment manager is not keeping up with the market indices,
these investors seem to be thinking, but at least they are not reading price
charts.
Fortunately for technicians, there is about as much academic evidence
supporting the use of price charts as there is touting the scrutiny of a firm’s
financial statements. Unfortunately, this evidence amounts to a molehill compared
to the mountains of data that suggest the market-beating potential of
human intervention in the capital markets—regardless of the approach used
—is close to nil.