In This Issue
As we review the performance of 2008 we should step back and consider what lessons are to be learned.
The Worst of Times
The three months ending November of 2008 was among
the worst 3-months for capital markets ever.
As highlighted in the table below showing
annual results, equities around the world in
all sectors and sizes were negative. US
Government bonds were the only safe haven,
with even investment-grade corporate bonds
falling. Commodities, after an explosive
beginning, ended the year down 36%. The
flood (tsunami?) of money into short-term US
Treasuries was so powerful that investors
were willing to accept essentially a zero
return for the safety of their principal.
| Equities | 2008 Performance |
| US | -37 % |
| Developed Markets (excl. US) | -43 % |
| Emerging Markets | -53 % |
| Bonds | |
| US Govt. Bonds – Intermediate | 11 % |
| Investment Grade Bonds – Intermediate | -3 % |
| High Yield Bonds | -26 % |
| “Alternatives” | |
| Commodities | -36 % |
| US REITs | -39 % |
Another Great Depression?
Commentators have drawn parallels with the Great Depression. For example, during the three months ending in November of 1929 the S&P 500 was down 33.1% vs. a decline of 29.6% for the three months ending November 2008. The demise, or near failure, of major financial firms (Bear Stearns, Lehman, AIG, Fannie Mae, Freddie Mac to name a few) reminded some of the failures of financial firms during the late 1920’s and early 1930’s. Very high volatility in these two periods was another similarity as was the temporary dysfunctions of the credit markets making credit prohibitively expensive to many individuals and businesses.
Despite some similarities, there are also major differences between these two periods. While the Federal Reserve was created in 1913, prior to the Great Depression, it lacked many tools. For example it wasn’t until a series of bank panics that the Banking Act of 1933 was passed creating the FDIC that provided insurance on investor’s deposits. It is also hoped that some of the mistakes during the early days of the Fed have been learned and won’t be repeated. For example, many economists believe that the Fed made a significant error by twice raising interest rates during the Great Depression, causing a 30% contraction in the money supply, creating a deflationary environment. Likewise, protectionist measures like the Smoot-Hawley Tariff Act of 1930 caused a series of import tariffs to be enacted across the globe causing trade to fall by 60%. Many observers believe this too contributed to the severity of the decline.
By contrast, today the US Government is taking a more constructive approach to addressing the credit crisis. The Fed has not only dropped interest rates to historic lows but has launched a panoply of programs designed to inject liquidity into the capital markets. This is likely to be quickly followed by a massive fiscal stimulus package in the coming weeks. Coupled with the US Government’s actions, foreign central banks have also been cutting interest rates while foreign governments have passed their own stimulus packages.
We certainly appear to be in the worst recession of our lifetime. Nonetheless it should be clear that we are a very long way from the depths that the world faced in the late 1920’s and early 1930’s. Governments around the globe are viewing this as a crisis and are responding aggressively.
The Best of Times
The deleveraging of financial institutions has contributed to the decline in the equity markets. Banks and hedge funds were forced to sell liquid assets, such as stocks, since the illiquid assets at the heart of the problem couldn’t be sold. (I would be happy to provide a more detailed explanation of the root causes of this crisis.) This forced sale of assets has pushed down prices of virtually all assets.
Valuations on a global basis are very
low reflecting investors’ risk
aversion. It is during times such as
these, when everyone is running away
from risk, that investors get
compensated for taking risk. Nothing
has changed the fundamental relationship
between risk and return. A
well-balanced and diversified asset
allocation combined with a disciplined
investment program provides the
opportunity to take advantage of this
current dislocation. By remaining
committed to your asset allocation plan,
your portfolio is structured for the
inevitable recovery. In other words
your portfolio has already absorbed the
risk, it seems sensible to stick around
for the return.
That was the title of a December Wall St. Journal article on the legendary Bill Miller. WSJ Article. Each year, from 1991 to 2005, Mr. Miller’s Legg Mason Value Trust mutual fund beat the S&P 500, a winning streak far more consistent than any other mutual fund manager. According to Legg Mason’s website his accolades included being ranked among the top 30 most influential people in investing by SmartMoney, “The Greatest Money Manager of the 1990’s” by Money magazine, Fund Manager of the Decade by Morningstar.com and the All-Century Investment Team by Barron’s.
Journalists reported that the odds of someone being able to outperform the S&P 500 by chance alone was one in 372,529, thus “proving” that active managers can add value over passive managers. That may have been a modest exaggeration. According to Leonard Mlodinow, a Professor of Physics at the California Institute of Technology, and author of The Drunkard’s Walk – How Randomness Rules our Lives NYT Book Review the odds are actually quite different. Instead of it being highly unlikely that Bill Miller’s record was by sheer chance, the correct odds of any one manager beating the S&P 500 by chance alone for any 15-year period is actually 75%. Whether Bill Miller ever had any talent or was merely lucky for 15 years, his luck has clearly run out in the most recent period.
After loading up on shares such as Bear Stearns, Merrill Lynch, Washington Mutual, Freddie Mac and AIG, this fund is no longer a star. In fact the fund’s 15 years of outperformance of the S&P 500 has been eliminated, wiping out the gains going back to 1991. An early investor would be no better off than had they simply placed their assets in a low-cost index fund like the Vanguard S&P 500 Fund.
But the story for the investor in actively-managed strategies like Mr. Miller’s is even worse for at least three reasons. First, throughout this 15-year period, taxable investors would have been realizing gains that were in excess of what they would have had to pay had they simply bought and held the index fund equivalent. Like many active funds, taxable gains would have been realized as the fund sold investments in favor of new ones. In contrast, a passive or indexed approach is much more tax efficient.
Even worse, most investors didn’t invest in 1991 but only after the fund gained prominence from its temporary outperformance. Investors who snapped up shares of this fund in more recent periods, perhaps after reading about its outstanding streak of outperformance, would have significantly underperformed. Buying the shares of a “hot” manager makes sense if there is a reason to expect the outperformance is due to skill rather than luck. Unfortunately, most investors tend to invest just in time for a fund’s “regression to the mean.” So, for example, for the five and ten years ending 12/31/08, the S&P 500 was down 2.19% and 1.38% respectively vs. the Legg Mason Value Trust which was down 11.26% and 3.25%. It is a common tendency of amateur investors to chase performance, which has long-term negative consequences.
Finally, investors who had limited themselves to a fund attempting to beat the S&P 500 were missing global diversification benefits by focusing merely on US large cap stocks.
The moral of the story: Look very critically at any claim of outperformance. While it is rarely fraud, and may not even be due to unseen risks (liquidity, leverage, credit) in comparison to the benchmark; it may just be due to sheer chance.
By now many of us are too depressed to read much more about Bernard Madoff. But the collapse of his scheme contains several lessons. First, some background. The existence of Ponzi schemes (somewhat different from pyramid schemes) may go back before recorded history. As many of you have read, a Ponzi scheme (named after Charles Ponzi) is when a fraudulent firm or individual pays an investor a return using the assets of a subsequent investor. This type of scheme can last quite awhile, as long as new investors keep joining and initial investors remain content to keep most of their assets with the firm. This particular scandal, however, was more shocking due to the incredible size and duration. Furthermore, the victims were not small investors looking to make huge gains. Rather, they were affluent investors looking for a steady return. Many of these investors were guided by “professionals” including banks and Fund of Fund companies, who were often paid handsomely for their ability to get their client’s money into the Madoff funds. These so-called professionals were supposed to be doing their due diligence. For an interesting perspective on how such a fraud could be perpetrated despite obvious red flags, I recommend reading Jason Zweig’s recent column in The Wall Street Journal. WSJ Article
Speaking of red flags, there were many in this particular situation. The first red flag was the fact that Madoff acted not only as an investment manager but also as his own custodian and broker dealer. A custodian’s main responsibility is the safekeeping of client’s assets. The lack of an independent custodian should have been a source of concern, as it meant that there was no independent party attesting to the existence of the assets. This conflict-of-interest alone should have set off alarm bells. Another red flag was the steadiness of the firm’s returns, given the claimed investment strategy.
By contrast, clients of Red Lighthouse Investment Management have their assets custodied by an independent, unaffiliated custodian (Schwab Institutional.) You have daily direct access to your account, independent of Red Lighthouse. Schwab sends monthly account statements reflecting your assets custodied with them. Red Lighthouse only has a limited power-of-attorney to execute transactions in your account. All trades are reported both as they occur and on the Schwab monthly statements. There should be no mystery as to the strategy being employed. We strive for full transparency in our operations and have structured out business to avoid any conflicts of interest.
No doubt
this very unfortunate incident will have
repercussions for the industry, perhaps
leading to greater oversight of alternative
investments. Appropriate disclosure and
greater transparency will be among those
issues that are examined.
Mark Sladkus, Founder and President of Red Lighthouse Investment Management received the William F. Sharpe Lifetime Achievement Award. Past recipients include Nobel Laureate’s Paul Samuelson, Harry Markowitz and William F. Sharpe. Other recipients include John Bogle, founder of Vanguard and Burton Malkiel, author of the classic, A Random Walk Down Wall St.
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Mark
Sladkus Founder and President, Red Lighthouse Investment, LLC, Formerly of MSCI Mark Sladkus is Founder and President of Red Lighthouse Investment Management. His more than twenty years experience with creating and maintaining indices provided the inspiration and foundation for Red Lighthouse. As head of Morgan Stanley Capital International (MSCI),Mark served as chair of the index committee, the group responsible for selecting which securities enter and exit the MSCI family of indices including the well-known EAFE, EM and ACWI Indices. Mark over saw the creation of the world’s first investable emerging market index and the world’s first global value and growth family of indices. Mark also headed up the effort to design a global small cap family of indices. He has presented to thousands of senior executives in dozens of countries including many of the largest pension plans, foundations, and endowments. Mark is a recognized speaker at investment conferences around the world. Prior to heading up MSCI, Mark was an internal consultant for Morgan Stanley. Mark has also held positions at Smith Barney and J.P. Morgan. Mark has a Masters of Business Administration (MBA) in Finance from the University of Chicago Booth School of Business and a B.A. in Economics from Cornell University. |
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