Monday, 26 March 2012

Sobering Views of Future US Stock Returns

Those thinking "phew! thank goodness stock markets have returned to normal and happy days are with us again" may want to read John Hussman's A False Sense of Security on the Hussman Funds website and James Montier's What Goes Up Must Come Down on Both articles just published in March 2012 make a compelling argument that US stocks are richly valued since corporate earnings are artificially (government stimulus) and unusually high, distorting the P/E ratio and prospective returns.

Hussman's bottom line: "... we project total returns for the S&P 500 of just over 4% annually over the coming decade"

Montier's: forecast annual real total return for the S&P 500 over the next seven years of only 0.4% (see Exhibit 2 in his article)

That is woefully weak compared to the long term historical annual average of 6.2% for US stock returns documented in Dimson, Staunton, and Marsh's Credit Suisse Global Investment Returns Yearbook 2012.

Tuesday, 20 March 2012

Fundamental vs Cap-Weight Portfolio: Still Neck and Neck after 20 Months

No Clear Winner Yet - Last time I reported on the contest in August 2011, the cap-weight portfolio had jumped into an inconclusive lead. The contest between portfolios made up of either fundamentally-weighted or cap-weighted ETFs continues without a clear winner. The portfolios, shown in detail in the Google Docs spreadsheet at the bottom of this blog page, have been updated with all distributions up to and including February 2012. The $85 separating the two portfolios' values is a miniscule 0.07% difference. Three of the fundamental ETFs are in the lead against their cap-weight rivals while four of the cap-weighted ETFs are ahead, but by lesser amounts.

Every Asset Class is Up - Our contest start date of June 2010 must have been a good time to get into the market since every ETF is above its initial start value. The portfolio as a whole has gained 16%, a very satisfactory result for less than two years in the market.

No Rebalancing Yet Required - None of the ETFs has deviated beyond the limit (more than 25% away from its target allocation e.g. a 4% holding can go up to 5% or down to 3% before our rule kicks in) we set for forced rebalancing. That has been the case since the start. Both portfolios are quite maintenance-free. There is cash building up however, and come the June anniversary date, it will be time to invest that cash into the ETFs that lag their target the most.

Lack of Automatic Reinvestment Warps the Comparisons - One of the difficulties with making head to head fundamental vs cap-weight comparisons between ETFs within an asset class is that the cash distributions do not get reinvested within the ETF. The market hype of the ETF providers use total return calculations which assume that the distributions do get reinvested when received. Our growing cash pile includes an important part of the ETFs' returns but the cash doesn't show in the current market value of the ETF shares that we use to do the Red vs Green who-is-ahead comparison. Since the ETFs do not distribute the same amount of cash, the total returns can be a fair amount out of whack with the Red vs Green indicator on my spreadsheet e.g. PXF distributed USD$404.82 in 2011 while its counterpart VEU paid out USD$644.80; VEU is much further ahead at the moment than the $124 showing in the spreadsheet. The truest comparison of my test is at the total portfolio level.

The best direct head to head matchup is between Canadian equity ETFs CRQ and HXT since in those cases, the dividends do get reinvested. In HXT's case, the construction of the ETF itself as a total return swap ensures that HXT's value reflects reinvested distributions. In CRQ's case, Claymore's free DRIP program buys new shares for the investor so all but a few dollars each quarter gets reinvested. Right now CRQ, despite its much higher MER, is winning the race by 2.6%.

Wednesday, 7 March 2012

Luck or skill? Ray Dalio of Bridgewater

Do investors like Warren Buffett succeed through luck or skill? The statistical argument is that such success cannot be distinguished from luck so therefore we cannot believe in skill. Yet ... when we encounter successful people in more tangible pursuits like sports or music, we don't say they are just lucky.

The other day I came across Principles, the exposition of what uber-rich investor Ray Dalio believes and lives by. Dalio is the founder of Bridgewater Associates, the world's biggest hedge fund according to Wikipedia. (Interestingly, Bridgewater manages some of our pension money as one of the Canada Pension Plan Investment Board's private investment partners). Principles isn't flowery imaginative writing - just plain, matter-of-fact, direct statement - but what it says rings true. It also isn't about investing principles he follows - that may come later he says. Though meant primarily as a management bible and indoctrination tool for new employees at Bridgewater, there is much value for self-reflection on what it takes to be successful e.g. "everyone has weaknesses. The main difference between unsuccessful and
successful people is that unsuccessful people don’t find and address them, and successful people do".

Dalio evidently (e.g. see John Cassidy's Mastering the Machine in the New Yorker of last July) lives by his principles with a ruthless and implacable discipline. It's the same as in any other human endeavour. To become highly successful, let alone the best, requires enormous unstinting effort.

Interesting is his take on ability since most people including me believe that talent must be there too. His reply is "... if you are motivated, you can succeed even if you don’t have the abilities (i.e., talents and skills) because you can get the help from others". In investing terms, that could mean using an advisor but then Dalio's principle 187 kicks in - "Have good controls so that you are not exposed to the dishonesty of others and trust is never an issue. A higher percentage of the population than you might imagine will cheat if given an opportunity, and most people who are given the choice of being “fair” with you and taking more for themselves will choose taking more for themselves." Or it could mean a person should take the passive index ETF route where talent and ability aren't required at all.

Dalio unintentionally provides support for the argument that there really is investing ability. First, as he says in principle 31,"People who have repeatedly and successfully accomplished the thing in question and have great explanations when probed are most believable. Those with one of those two qualities are somewhat believable; people with neither are least believable". The phenomenal success of Bridgewater is a hefty track record and this book is a pretty good explanation.

Second, in footnote 38 on page 21 he says "Luck—both good and bad—is a reality. But it is not a reason for an excuse. In life, we have a large number of choices, and luck can play a dominant role in the outcomes of our choices. But if you have a large enough sample size—if you have large number of decisions (if you are playing a lot of poker hands, for example)—over time, luck will cancel out and skill will have a dominant role in determining outcomes. A superior decision-maker will produce superior outcomes". Investing is very much an activity where there really is luck or true uncertainty at play so one cannot expect always to be correct, no matter how much data one collects and analyzes. Now, it is true that the world's biggest hedge fund may have got there merely by gathering assets and snowing all those giant pension funds about actual investment performance but there is some direct performance evidence cited in Wikipedia.

As the ancient Greek Aeschylus said "Call no man happy till he is dead". Dalio's investing prowess is only as far away as the next market shift that he has not anticipated which runs contrary to his investments. He does claim not to be too concentrated and is aware of the danger per principle 197 "make sure that the probability of the unacceptable (i.e., the risk of ruin) is nil ... knowing what you don’t know is at least as valuable as knowing" and principle 195 "Constantly worry about what you are missing. Even if you acknowledge you are a “dumb shit” and are following the principles and are designing around your weaknesses, understand that you still might be missing things". The New Yorker article also says he deliberately does not make any concentrated bets to avoid the possibility of being wiped out.

A blowup by Bridgewater / Dalio would no doubt make the skeptics happy, strangely including blogger Pension Pulse. I prefer to think investing is like sports - champions do exist because they are better than everyone else at the time but they all have their day.

Monday, 5 March 2012

TurboTax Giveaway Winners

The draw announced last week for the three packages of online web-based tax preparation software courtesy of TurboTax has been done and the winners are:
  • Skip
  • JonE
  • Pandaincanada
Congratulations!! To claim your prize please contact me via email using the "email me" link under Have a question or an idea for a blog post in the column on the right hand side of the blog. I will send you the code that is good for any online version of TurboTax. The code is entered at the end of your data entry when you are ready to file and the payment step comes up. Your email address will not be used for anything else.

Thanks to all for participating and may your 2011 tax preparation be painless and quick. Again, thank you to the folks at TurboTax.

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