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Wise Words

Investing                The Industry               Mutual Funds               Financial/Investment Advisors               Insights

INVESTING

Money is a lot like soap, the more you play with it the less you have.

The point of investing is to grow assets within reasonable limits of risk.

 

You employ diversification to reduce risk, not as a tactic to improve performance.

 

Mindless diversification is not a substitute for intelligent thought.

 

Value is a function of the future not the past.

 

The ability to look up price often leads to short term action but has nothing to with the intrinsic value of the company.

 

“Fair Value” is simply a point that stocks careen past on their way to being either cheap or expensive.

 

High prices attract buyers, low prices attract sellers.

 

You can’t expect consistent results if you wish to seek higher returns. Even the most skilled asset managers will underperform for periods of time.

 

Only with full market volatility will you get full market upside. 

 

What effects stock returns; Short-term – Psychology, Mid-term – the Economy, Long-term – Valuation

 There are generally two reasons for a given investment strategy to “work” over time:

  • You earn a premium by accepting more risk.

  • You take advantage of the behavior of other market participants.

Fear is the most critical functioning cog in the investment machine. Equity investors get paid for facing these fears because, so many others will not face them.

Concentrated investing implies less risk of permanent loss as long as you maintain superior knowledge about the companies you own.

 With good active management, safety lies in careful security selection based on in-depth research, not in random or broad-based diversification, which an investor can get from passive management at a fraction of the cost.

You want managers who have the intellectual and emotional gifts to stray from the crowd. 

 

Managing risk is not the same thing as eliminating risk. To eliminate risk is to limit returns. It is the difference between being risk aware as opposed to being risk adverse.

 “Market Timing” - the problem with market timing is that for it to work you have to be right twice and for it not to work you only have to be wrong once The top The top 100 companies in S&P 500 have a total value that is about equal to the value of all the other listed U.S. companies combined.

 

In the diversified portion of a portfolio, it’s smart to rely on passive management to capture the market’s long-term returns as opposed to active management. Let the markets do what they have done for the last 100 years.

The greatest edge an individual investor can have is a long-term orientation.

Manager Identification

Relationship Network – The NS Capital Investment Committee (NSCIC) has a large network of industry contacts that it utilizes to “discover” talented asset managers before they become well known. This network includes money managers that the committee members have come to know over their careers, referrals from industry peers and suggestions from other investment management organizations. These referrals often allow us to find managers that may not yet have found their way into the industry mainstream.

Conference Circuit – Participating as both speakers and attendees in most of the industry’s leading investment conferences broadens NSCIC’s exposure to money managers who meet NS Capital’s criteria and embrace our philosophy of investment management.

 

Manager Selection

  • Step 1: Request quantitative data. An NSCIC member contacts the manager to introduce NS Capital and educate the firm about our investment philosophy and platform, and to determine the manager’s interest in participating. If the response is positive, NSCIC makes the following document requests: • The firm’s due diligence questionnaire • The firm’s complete form ADV • Performance history of the applicable investment strategy • Performance disclosures by the firm’s auditors • All regulatory documents including state and federal audits • The firm’s institutional marketing presentation • The firm’s recent newsletters and portfolio commentaries
     

  • Step 2: Search the Internet for third-party information on the firm and its key employees. NSCIC also searches the Security & Exchange Commission’s website for any available data.
     

  • Step 3: A review of all the relevant information and data by NSCIC to determine if the firm meets the quantitative bar before continuing the due diligence process.
     

  • Step 4: Conduct a formal due diligence call to begin the process of obtaining qualitative information. The critical topics covered during the call include the firm’s: evolution, organizational structure, hiring practices, growth strategy, research approach and capabilities, portfolio methodology, and compliance issues. NSCIC will then review the information to make the determination as to whether or not the firm remains a viable candidate and to identify any “red flags” that need further clarification prior to the on-site due diligence meeting.
     

  • Step 5: Send the NSCIC analyst team to the investment manager’s headquarters to conduct an extensive on-site due diligence visit. The analyst team will meet face-to-face with the Principals, Chief Investment Officer, Portfolio Manager, Research Analysts and other key employees to review the following: • Firm overview • Portfolio management philosophy, process and skill-set • Buy and sell disciplines • Portfolio construction and risk management • Trading and operations • Information technology infrastructure • Business continuity issues • Regulatory issues
     

  • Step 6: Make the final decision. The analysts will prepare a formal recommendation to the Investment Committee specifying whether or not the investment manager’s strategy should be offered a position in the Alpha Ring.
     

  • Step 7: Conduct a meeting at the investment manager’s headquarters between the firm’s principals and NS Capital’s Senior Managing Partner to define the business relationship and expectations and to determine the appropriate fee for the money management services to be provided.

 

Monitoring

The monitoring of NS Capital’s managers by the NSCIC is a critical component of the long-term success of the NS Capital Portfolios. The goal is not just to evaluate past performance, but also to continually monitor all the key factors that determine the probability of the manager’s future success. It is through this monitoring process that NSCIC is able to make the ongoing decisions that call for manager retention or, if warranted, replacement. Like most industries, the investment management business is dynamic, with portfolio managers changing jobs, firms merging and new investment ideas developing. The NSCIC continually monitors changes in manager strategy, process, resources and results. At the same time, we recognize and accept the important realities of successful long-term investing; that even investment managers with strong skills can experience periods of weak performance due to market or economic cycles that favor other strategies. The reality of manager diversification is that not all investment strategies and managers will perform alike at the same time, but over time, if the managers are evaluated thoughtfully and thoroughly, the strengths of a well-constructed portfolio will be apparent.

  • Step 1: Five-Factor Review • Strategy - Review each manager’s investment strategy from numerous perspectives to assess the likelihood of continued superior investment returns and • to ensure that changes in the strategy do not affect the manager’s role within the context of the total portfolio • Process - Review the process each manager utilizes to ensure implementation remains consistent, cohesive and efficient • Resources - Evaluate each manager’s organizational structure for depth and stability • Performance - Review the record of each manager for both relative and absolute total returns • Operating Costs - Regularly examine all costs involved in implementing an investment strategy, including fees and trading costs, because the surest way to improve returns is to control costs
     

  • Step 2: Ongoing Evaluation The NSCIC conducts a systematic review of the investment managers, which includes periodic conference calls, quarterly evaluations of investment performance and fund structure, annual on-site meetings and comprehensive three-year evaluations.
     

  • Step 3: Utilize a “Watch Status” “Watch Status” is an intermediate state of heightened oversight, triggered by any change that could jeopardize an investment manager’s ability to fulfill an assigned role. The NSCIC will put a manager on “Watch Status” if they produce disappointing performance results, change investment strategy or process without warning or experience significant personnel departures.

THE INDUSTRY

 

In financial services a brand is not a surrogate for value.

The financial services industry has created a system that prioritizes profits rather than investor well-being.

Financial services is an industry where opinion often drowns out reason.

The industry consists of two very different players, on the one hand is the profession of investing, where the goal is the intelligent management of an investment portfolio for superior long-term returns. On the other hand, is the business of investing where the goal is to gather as many assets as possible for the fees they produce which lead to profits for the investment firm.

The greater number of parties there are to a financial transaction the worse it is for the investor.

There is a constant striving by the Street to satiate investor demand by creating products that supposedly address the fear or greed that exists in the market.

The financial services industry loves to state the obvious with the thrill of discovery.

The financial services industry has been particularly adept at thwarting transparency with respect to its products and processes, keeping customers uniformed or misinformed about the products they sell and the services they provide.

 A large part of innovation activity at financial firms is devoted to making the large fees they collect from clients as hard to understand as possible.

The billions of dollars paid in fines shed light on the widespread problem in the world of finance. When the sale is being made, the banks, brokerage and insurance companies want customers to view the salesman as a trusted advisor. If the investment goes bad, the customer suddenly becomes a counterparty to whom the companies owe no obligation at all.

The pursuit of profit in the financial services industry overwhelms fiduciary responsibility toward investors.

When you hear the words “without admitting or denying wrongdoing”  you can be pretty sure some client got screwed.

Bottom Line:  the tyranny of career risk rules! Most professional investors know that it is better to be wrong with the crowd than wrong by yourself. That’s a rational response to the prospect of being fired, either by your investors or your  supervisor. That’s why they prefer choices that they can’t be blamed for. It’s much more important to be “not wrong” than to be “right”.

Individual investors are spending over $100 billion a year in fees and costs trying to beat the market in ways that don’t work.

 

Doing business with a public financial services company.

As Reported by RIABiz, “ there was a telling exchange during a recent brokerage company’s earnings call. An analyst grilled the CEO about whether the company was damaging shareholder interests in an overzealous regard for the welfare of investors.”

 

“The law requires corporate directors and managers to pursue long-term sustainable shareholder wealth maximization in preference to the interests of other stakeholders or society at large” . (A Duty to Shareholder Value, New York Times, 04/16/2015)

 

4 ways to make money:

  1. Risk Free Rate – Cash

  2. Credit Risk – Bonds

  3. Equity Risk – Stocks

  4. Illiquidity Risk – Private Equity/Real Estate

And one way too be sure not to make money - structured financial products created by a brokerage firm or a variable annuity from an insurance company.

A healthy dose is warranted when it comes to prepackaged investment products. The investment asset management industry has a history of creating and marketing these products to investors as solutions, does anyone remember “130/30”, “absolute return”, “global TAA” and “portable alpha”, none of which worked.

 Brokerage firms & insurance companies are conflicted because of the multiple levels of profitability the drive at the client’s expense.

 

The overwhelming goal among banks, brokerage and mutual fund companies is to increase asset size, simply because piling on assets results in piled on fees.

We can count on Congress to legislate the headlines, the SEC to be too weak to enforce the good laws and the Wall Street lobby to be strong enough to keep the bad laws on the books.

If you see the words trust or integrity in sales literature – beware.

 

Backtesting of Financial Products

If you torture the data hard enough it will confess to anything.

I never saw a backtest I didn’t like.

The worst 10-year period of any investment backtest is the next 10 years.

MUTUAL FUNDS

Actively managed mutual funds are dying from its own disease – GREED

To say the active mutual funds have fallen out of favor in academic finance is like saying that leeches have fallen out of favor in medicine.

The majority of mutual fund managers do not invest in the funds they manage.

Investors benefit from low fees, low taxes (related to low portfolio turnover), and fair transparent arrangements. Mutual Funds benefit from high fees, high portfolio turnover and inequitable, opaque arrangements.

The average fund turns over its portfolio more than 100% per year which increase costs by over 1%.

Poor performing mutual funds are routinely closed or merged erasing their bad performance from the historical record forever. This “survivorship bias” makes the statistic better than they really are.  

No amount of regulation can counter the fact that mutual fund assets generate brokerage commissions and brokerage firm distribute mutual fund products.

For most mutual fund companies, the client is the financial advisor – not the investor.

The overwhelming goal among banks, brokerage and mutual fund companies is to increase asset size, simply because piling on assets results in piled on fees.

Mutual Fund Share Classes – A,B,C,I,R,Y,Z same portfolio different prices. (you want the "I")

Asset Managers vs Asset Gatherers

Often Asset Managers Work Hard and Do a Good Job. which creates a choice;

  • Asset Managers close their funds to limit their growth in order to maintain the quality of what they have created.

  • Asset Gatherers cash in by riding the performance as long as they can to gather as many assets as possible even though they know performance will suffer.

(Asset manager professionals should pursue excellence as opposed to assets.)

Investment opportunities are exhausted by size. Bloated pools of assets under management provide handsome streams of fees to mutual fund management companies and create insurmountable obstacles to returns for investors.

You can’t diversify with large mutual funds in the same asset class.

 

 “Closet Indexers” tend to destroy value

“Closet Indexing”- Equity asset managers that charge active management fees for large stock mutual funds whose performance over time generally mirrors or underperforms the S&P 500 Index.

“Nothing fails like success”

As assets grow, managers have an increasingly tougher time sustaining good performance. Asset growth can lead to a more narrow opportunity set due to illiquidity constraints that prevent managers from allocating to their best ideas, they then add more liquid benchmark holdings which leads to “closet indexing”.

The giant bloated mutual funds with 10’s of billions of assets are just trying to be good enough so you don’t sell. The funds are being managed to hug the index they are benchmarked to. (This is what “closet indexing” is all about).

A “closet indexer” keeps a fund’s largest holdings within a few basis points of the index weighting to be sure to stay close to the index – then they churn around that core in an effort to beat the index by a few points. The investor winds up paying active-management fees for mostly passive management.

The large company US environment (S&P 500) is dominated by funds with managers whose skills are insufficient to overcome the powerful forces of market efficiency.

At a certain size, mutual funds try to be just good enough so you don’t sell them.

Benchmarks

Funds are rated by their benchmark (i.e. the S&P 500 index is the benchmark for large company fund managers) deviation not by whether they made or lost money.

Multiple benchmarks have been created solely to make every fund look better. Morningstar has over 75 benchmarks to help funds find a place from which NOT to deviate.

Interviews with Asset Managers who run successful, conventional equity funds: 50 to 100 and a portfolio sensitive to some benchmark index. 

 

Each was asked, how would you invest if it was only your money and you never had to report to outside shareholders, but you need to protect and grow this capital at an attractive rate for the long-term. Would you use the same approach, 50 to 100 stocks tied to a benchmark? They all said the same thing, “Absolutely not! I’d only invest in my 10 to 20 best ideas!".

The first was concerning Jeffrey Gundlach’s departure from TCW and starting Doubleline Capital. Commenting on his ability to be more selective now, Gundlach said, “It's fun to manage $5 billion. If you manage $70 billion you'rr going to have to say 'yes' to marginal securities”.

Next was Dale Harvey who left Capital Group (American Funds) to found Poplar Capital. Harvey said he felt frustrated because managing a large amount meant he had to "invest in 81 or more stocks and that is too many to track to do the quality job that is necessary". By running a boutique operation, he said he can now concentrate on about 30 stocks and give full attention to a fundamental stock picking process.

David Snowball (Mutual Fund Observer) on Active Management

“Find yourself asset managers that are relatively small and independent, with a clearly articulated philosophy and strategy. Look to see, that they are actually doing what they say they are doing and their interests are aligned with yours. Then look at their active share, the extent to which the holdings do not mimic the benchmark index”.

Market-beating mangers express their insights with portfolios that differ dramatically from their benchmark.

 

 

FINANCIAL/INVESTMENT ADVISORS

Advice should be genuine and not incidental to another agenda.

An advisor's job is to manage a client’s relationship to the capital markets. There are no one time decisions, nothing is static, all decisions must be constantly re-evaluated.

Fiduciary Duty/Registered Investment Advisor  vs Suitability Standard/ Registered Representative

 

“Advisors” at brokerage, banks and insurance companies legal title is Registered Representatives because they are agents of the firms they work for.  Registered Representatives have a primary obligation to their employer rather than their clients – salespeople vs advisors regardless of their title.

The suitability doctrine required of banks brokerage and insurance companies lessens the duty of care which protects them from lawsuits

A Registered Investment Advisor (RIA) provides specific advice for a fee, are paid only by their clients, and have an ongoing fiduciary duty which is a legal pledge that requires them to act on behalf of and in the best interest of their clients. 

You want to work with fiduciary advisors that are representatives of the client, not representatives of the manufacturer/distributor.

Transparency is the thing that tells you what side you are on because Ill-disclosed compensation arrangements between brokerage firms and mutual fund companies cause investors to receive “tainted” advice.

 

                                                                                                                       Yes, RIAs %       Yes, Large Fin Firms %

Convicted or pled guilty (nolo contendere) to a felony                    0                                     56

In the past ten years, been charged with a felony                              0                                     56

 SEC / CFTC ever found you involved in a violation                           1                                     89

 SEC / CFTC ever imposed a civil money violation                             1                                     89

 Ever found you to have Made a false statement, omission,          1                                      89

 or been dishonest …                             

                                              

Source: “What Investors Can Learn About an Advisors Conflicts in Form ADV”

 

 

INSIGHTS

Put a good person in a bad system and the bad system wins, no contest.  ~William Edwards Deming

Volatility is a long-term investors best friend.  ~Warren Buffett

 

Simplicity has a way of improving performance through enabling us to better understand what we are doing. ~Charlie Munger 

Not everything that matters can be measured and not everything that can be measured matters.  ~Albert Einstein

Truth doesn’t need to be promoted, it just needs to be revealed.  ~Unknown

It is amazing how difficult it is for a man to understand something if he is paid a small fortune to not understand it.  ~Upton Sinclair

Investment advice should be genuine and not incidental to another agenda.  ~Bob Veres

If you are comfortable with everything you own, you are not properly diversified.  ~Peter Bernstein

There are two kinds of forecasters – those that don’t know and those that don’t know they don’t know. ~John Kenneth Galbreith

Economic research shows many things, but it proves precious few.  ~James Grant

Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.  ~John Templeton

The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. ~John Kenneth Galbreith

The four most expensive words in investing are: This time it is different.   ~John Templeton

To be a reasonably successful investor doesn’t take a high IQ. It takes temperament.  ~Warren Buffett

Buy and hold investing is the worst kind except for all the others.  ~Ben Carlson

Sources

The Little Book of Common Sense Investing, Common Sense on Mutual Funds, and Enough, John Bogle

 

The Investor’s Dilemma, Louis Lowenstein & Neil Barsky

 

Pioneering Portfolio Management and Unconventional Success, David F. Swensen, Chief Investment Officer, Yale University

 

The Tao of Warren Buffett and Buffettology, Mary Buffett & David Clark

 

Fooled By Randomness, Nassim Taleb

 

Wall Street versus America, Gary Weiss

 

How Active is Your Fund Manager?, International Center for Finance, Yale

 

The Cost of Active Management, Kenneth R French