The Case For and Against Active Investment Management

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1 The Case For and Against Active Investment Management By Dr. Robert C. Smithson Anava Capital Management LLC Cupertino, CA Please Note: Individual companies shown or discussed in this presentation have been used as examples only and are not intended as recommendations of any kind by Anava Capital Management LLC or any of its representatives. The theme of this year s seminar is whether or not individual investors can improve their returns by actively selecting the best investments to make and the best times to make them. In other words, can an investor beat the market. We have four excellent speakers who will talk about four different approaches to investing: Don Stewart will make the argument that the market is efficient that is that all securities are always traded at the correct price. This is said to happen because there are thousands of well-financed companies, funds and other financial organizations that are constantly analyzing every available investment opportunity with powerful computers run by armies of Ph. D. level analysts. Hank Pruden will discuss the ideas in his new book, The Three Skills of Top Trading. This describes the view of those that use technical analysis and its extension behavioral finance. Those who follow this approach believe that while the market may be a random walk on average, at certain times it is possible to forecast price movements, including their magnitude, direction and timing. The idea is that because of normal human psychology the behavior of at least part of the market can be predicted successfully, and that using that fact can result in returns that are better than the market s 9% per year average Lynn Gillette will defend fundamental analysis, probably the oldest form of portfolio management. It is based on the idea that if you examine the quality of the companies underlying stock investments, and buy only the stocks of those companies that are the best businesses, you will outperform the market. Al Zmyslowski will discuss his methods of quantitative investing. Quant investing can include fundamental analysis, technical analysis, or both, but it is characterized by the automation of the investment selection and market timing. Instead of analyzing available data and then personally making buy and sell decisions, quant investors quantify their selection criteria and then program a computer to periodically re-evaluate the portfolio and make the decisions automatically. 1

2 SOME APPROPRIATE QUOTES If the market were efficient I d be a bum on the street with a tin cup. Warren Buffett An intelligent investor investing part-time and doing almost anything reasonable can beat the market by 3%. An intelligent investor investing full time and doing almost anything reasonable can beat the market by 9%. Anything more is luck. Warren Buffet efficient financial markets do not allow investors to earn above-average returns without accepting aboveaverage risks. Burton G. Malkiel, author of A Random Walk Down Wall Street The Market is long-term efficient and short-term inefficient. Bob Smithson (In the interest of full disclosure.) These quotes are believed to accurate in spirit, if not exact. The first two are from a book about Warren Buffett I read a few years ago. It is worth remembering that Buffett is no trader. He is a buy-and-hold value investor who determines the value of a company by becoming personal friends with the management! 2

3 THE EFFICIENT MARKET HYPOTHESIS WEAK FORM - The current price of a security already takes into account all historical price and volume information. - Therefore, technical analysis doesn t work. SEMI-STRONG FORM - The current price of a security already takes into account all relevant publicly available information. - Therefore, fundamental analysis doesn t work either. STRONG FORM - The current price of a security already takes into account all relevant information, public and nonpublic. - Therefore, no form of analysis, including the use of insider information, works. The efficient market hypothesis has a great deal of evidence supporting it in general. For example, taken as a group, stock price movements in the past have been shown to have no statistically valid correlation with future price movements. There is also strong evidence against the efficient market hypothesis. For example, it has been convincingly shown that investors consistently over-react to both good and bad news. One compelling reason to believe that the efficient market hypothesis is at least oversimplified if not completely wrong is the fact that a lot of people spend a lot of time and money collecting and analyzing information on the various available investments. This effort is absolutely essential for the market to be efficient. If information is not known, the market can t take it into account. The people doing all this analysis are doing so in the belief that they can gain a significant additional profit by acting on new information before the market does. Therefore the efficient market hypothesis will only be true if it is disbelieved by the very people who are making it true. Finally, an important question for an investor to ask is this: Just what is the correct price for a given security? If the correct price is different for different people, then if the price set by the market is correct for one investor, it must necessarily be incorrect for others. So a market that is efficient for large funds might be inefficient for a small investor. The rest of this introduction will explore that possibility. 3

4 Value of $1 Invested $6 $5 $4 $3 $2 $1 $0 T-BILLS THE SIMPLEST OF ALL INVESTMENTS 13-Week T-Bills Returns At Various Marginal Tax Rates Assumed Constant Throughout The Period (No Fees or Inflation, Interest Reinvested) Jan-78 Jan-83 Jan-88 Jan-93 Jan-98 RISK-FREE TREASURIES ARE THE STANDARD TO WHICH ALL OTHER INVESTMENTS ARE COMPARED. ALTHOUGH INTEREST RATES VARY, PRINCIPAL IS NEVER LOST. THEY ARE TAXED AT THE FEDERAL LEVEL ONLY. Yahoo Finance Historical Quotes, Symbol ^IRX ( Jan-03 Jan-08 10% Tax 15% Tax 25% Tax 28% Tax 33% Tax 35% Tax T-bills are short-term (up to 1 year) fixed-income securities issued by the U.S. Treasury. They guarantee that at a specific date in the future, the treasury will pay the holder a specific sum of money (in multiples of $1,000 in U.S. currency). They are sold at auction for a price that is less that the face value by an amount that is known as the discount, usually specified as a percentage of the face value This difference between the price paid and the the face value is the interest that is earned. Academic researchers as well as the general public regard the bonds, notes and bills issued by the United States Treasury to be the closest thing to a truly risk-free investment possible. Backed by the full faith and credit of the United States government, nobody has ever lost a dime investing in treasuries if they are held to maturity. Because of this, the interest rate paid by treasuries (currently around 4% per year for T-Bills) is considered the minimum rate any acceptable investment should provide. All other investments should pay more, because all other investments have risk, and it is not reasonable to accept less in a risky investment because you can get the treasury rate absolutely without risk. This chart shows the total return that would have been obtained between Jan. 1, 1978 and Sept. 30, 2007 by someone who bought T-Bills once every 13 weeks, held them to maturity, then immediately re-invested the resulting after-tax amount. (Tax rates are assumed constant throughout the period ) Treasuries can be bought at no fee from the US Treasury Department by setting up an account with Treasury Direct ( so this performance is actually achievable. As the chart shows, the after-tax returns varied between 200% and 400% over the thirty years, depending on the investor s tax bracket. 4

5 TREASURIES ADJUSTED FOR INFLATION $1.60 $ Week T-Bills Purchased Through Treasury Direct Returns Adjusted for CPI, No Fees, Interest Reinvested Value of $1 Invested $1.40 $1.30 $1.20 $1.10 $1.00 $0.90 $0.80 Jan-78 Jan-83 Jan-88 Jan-93 Jan-98 Jan-03 Jan-08 10% Tax 15% Tax 25% Tax 28% Tax 33% Tax 35% Tax CPI Data: Bureau of Labor Statistics, Series Id: CUUR0000AA0 ( While it is true that nobody has ever lost a dime investing in treasuries, as measured in U. S. dollars, it is not only possible but common to lose purchasing power. This chart shows the purchasing power in January, 1978 dollars of one dollar invested in 13-week T-Bills as described in the previous slide. Not only was it possible to lose purchasing power, particularly in the stagflation era around 1980, but investors in the highest tax bracket were in the red for the entire period except for a short time between 1998 and This would not have been true if the investment had been made at the low point on the graph around January, Nevertheless, for the highest current tax brackets the returns in real dollars are essentially flat for the long term. (The highest personal tax rate has been roughly constant since 1987.) Purchasing power is maintained, but no profit can be counted on. The behavior seen here is not unreasonable. After all, why should someone who is taking no risk be rewarded with an increase in purchasing power? This chart is also a good illustration that the value of an investment can be very different to different investors depending on their individual circumstances. Investors in the lowest tax bracket saw their purchasing power increase over the same period by around 45%. This means that T-Bills, often thought of by the general public as refuges for the rich, are actually more suitable for people in lower tax brackets who can t take risks with their spare money, and who might need to use it quickly. This also holds true for tax-free organizations such as pension funds and government agencies. 5

6 BUYING T-BILLS THROUGH A BROKER - THE EFFECT OF FEES - $ Week T-Bills Purchased Through Scottrade Returns Adjusted for CPI, 0.5% Fee, Interest Reinvested $1.00 Value of $1 Invested $0.90 $0.80 $0.70 $0.60 Jan-78 Jan-83 Jan-88 Jan-93 Jan-98 Jan-03 Jan-08 10% Tax 15% Tax 25% Tax 28% Tax 33% Tax 35% Tax Fee data from Scottrade website: Here s what would have happened if the T-Bills had been bought through Scottrade, a well-regarded discount broker. They currently charge a markup of about 0.5% on the purchase price of a T-Bill which, done four times a year, subtracts about 2% annually from the interest received. This is the result. If you buy short-term treasuries, you should set up a Treasury Direct account. Brokers fees can substantially affect returns. The good news for small investors is that Treasury Direct allows individuals to easily buy treasuries at zero or no fee, so you don t have to do this. 6

7 BUYING AND SELLING T-BILLS BEFORE MATURITY Any number of t-bills with the same CUSIP number may be sold at one time on Treasury Direct for a fixed $45 fee. They are sold at auction by the Federal Reserve Bank of Chicago. The amount received is the face value minus the discount offered by the highest bidder(s) at the auction. This adds risk, but not much. With our example 13-week t-bills at a 4% annualized yield, in the unlikely event that interest rates doubled the next day, and you were forced to sell, you would lose 1.01% plus $45. That s not a lot of downside risk, and it s a rather extreme scenario. The main point here is that buying and selling t-bills before maturity adds both fees and the risk of losing principal. The idea that t-bills are risk-free depends on buying them and holding them until maturity. 7

8 WHAT IS A FAIR PRICE FOR A T-BILL? 35% + 9.3% bracket Californian wants 30 day access to cash between stock purchases. Avoid mortgage-backed securities. - Schwab Investor Money Fund 4.65% yield (real after tax 1.03%) - Treasury Direct 28-day t-bills 4.049% yield (real after tax 0.99%) - Schwab s fund yields a little less and offers less safety. - t-bill fair price: -1.1% r. a. t. or 3.88% yield, price $99.70 per $100 - Actual auction price: $ , yield 4.049% - Fairly Priced 25% bracket Nevadan wants 30 day access to cash between stock purchases. Avoid mortgage-backed securities. - Schwab Investor Money Fund 4.65% (real after tax 0.17%) - Treasury Direct 28-day t-bills 4.049% (real after tax 0.99%) - Schwab s fund yields a little less and offers less safety. - t-bill fair price : -0.27% r. a. t. or 4.51% yield, price $99.66 per $100 - Actual auction price: $ , yield 4.049% - Overpriced The Nevadan should sell these treasuries to the Californian for a win-win transaction! The Californian is in a higher federal tax bracket (35%) and pays 9.3% state tax as well. The Nevadan is in a lower federal tax bracket (25%) and pays no state tax. Both are willing to accept 0.1% per year less yield to obtain the greater security of treasuries as compared to a Schwab money market fund. Changes in any of these criteria will affect the relative fair price difference between these two individuals. For illustration purposes, the calculation has been done for two different factors. One, the tax situation of the investors, is real and quantifiable. The other, nervousness about the possible existence of a risk of loss caused by money-market fund investments in mortgage-backed securities is based on a real concern, but is hard to quantify. It s possible to see if the fund invests directly in such things, but not easy to tell how important they might actually be. The reason for this is first that investments in the securities of any company could be affected if that company invested in mortgage-backed securities, and second that not all mortgage-backed securities are equally risky. It is impossible for an individual to quantify these things, so both our example investors have decided to invest directly in treasuries if it doesn t cost them too much. In this simplest of investments, there is no one single fair price. The market price, whatever it is, will be a sell signal to some and a buy signal to others. The fact that objective or subjective characteristics of investments and investors creates a different correct price for an investment for each investment-investor combination means that there can be an overall efficient market, but the market must necessarily be inefficient for all individual investors. 8

9 OTHER CONSIDERATIONS FOR T-BILLS ECONOMIC AND POLITICAL STABILITY EXCHANGE RATES LIQUIDITY ALTERNATIVES AVAILABLE - INSURED SAVINGS - MONEY MARKET ACCOUNTS CONVENIENCE TIME HORIZON ETC. One reason that treasuries are considered risk-free is that the United States has the modern world s best record for longterm economic and political stability. Because of this, large amounts of U.S. debt are bought by the central banks of foreign nations. A negative for foreign investors is that t-bills are in American dollars. This means that if the value of the dollar drops relative to foreign currencies investors can lose money. They can also make money if the dollar s value rises, but in either case they are more volatile for foreign investors and so more risky. There is a ready secondary market for treasuries. They can easily be sold at any time for a fair price. There are low risk alternatives available, so treasuries must have competitive rates compared to these. Brokerage sweep accounts are convenient to use. The investor doesn t incur any fees and doesn t have to take any action, and the money is instantly available for trading. Treasury Direct accounts can be free of fees, but it s a nuisance to move the money around, and the fees get large if you can t wait until maturity. Different time horizons for the use of the money affects rates and prices. 9

10 THE AAII S EXPERIENCE 56 Stock Investor Pro Screens Tracked Since Jan Average total return: 522.7% - S&P 500 total return: 57.3% - Screens below S&P: 5 - Screens above S&P: 51 - Screens with negative total return: 1 - Lowest screen return: -34.1% - Highest screen return: % These portfolios are rebalanced once a month No fees or dividends are included Some have worked better in the past, others in the present The chapter has an Active Stock Investor Pro users group run by Andy Prophet. See our chapter website for more information and meeting schedules. The website can be found at These screening results are from the AAII website at 10

11 THE AAII S EXPERIENCE CONTINUED Real 9.75-Year Returns Vs Std. Dev. of Monthly Returns Std. Dev Year Return Percentage Frequency of Real Returns Number of Screens Bin Real 9.75-Year Return Percentage The scatter plot shows a general confirmation of the conventional wisdom that higher returns go with higher volatility. However the effect is certainly not linear. Most returns near zero show a monthly standard deviation between 4 and 6, while a return of almost 2500% is at about 8.5. In addition, there are a significant number of low-return screens that show very high standard deviations, including the only screen with a significant loss at about 15. The histogram shows the screens clustering around real returns of about 200% over the 9.75-year period. Anything above 1000% is probably a fat tail outlier. However, are these high performers just chance. The highest is a new screen, the O Shaughnessy Tiny Titans, and the second highest is the Zweig screen. The newer screens were backtested in a way that should eliminate most survivorship bias. (If you test screens on earlier data on presently existing companies only, you eliminate those that no longer exist from consideration. However, the AAII has old data available in SI Pro, and therefore can, and presumably did, test on the actual data that was available at the earlier date) Nevertheless, recently developed screens were done by people who know what worked in the past, and tend to give unrealistically good results when back-tested. The Tiny Titans is a recently added screen, so the performance is suspect. Many of the screens in this data date back to, or near to, 1998, the earliest year used here. They have mostly been tested in real time, after the screen was developed. The second-best screen, the Zweig screen, is one of these. It has never had a negative year. Is this just chance or is there something valid here? 11

12 RULES FOR SUCCESSFUL INVESTING Keep fees low. Don t trade too often. Live below your means and invest a significant part of your income regularly. You ll be surprised how fast your means increases. Pay attention to real, inflation-adjusted income. This will tend to keep you out of safe investments that lose money. Find a method of investing that you can follow and then follow it. Be flexible, but DON T make seat-of-the-pants decisions. If necessary change your system and follow the new one in your future investing. Be realistic. You won t be right all the time. Don t agonize over your losers if your portfolio is doing well. Here are some rules I ve found useful. If you follow the first three, you ll do very well even if you just make the market s historic 9% per year (about 3% inflation-adjusted). If you follow the rest, it s possible to do better than that. See Warren Buffett on the subject at the start of this introduction. The last two are the hardest. Look at all the data on the AAII screens and if you are seeing downturns of the same magnitude don t worry, and if you re matching the average screen you re doing OK. Don t expect to match the best results in the future that screen probably won t match them in the future either. 12

Using Computers to Adapt to Changing Markets

Using Computers to Adapt to Changing Markets By Dr. Robert C. Smithson Anava Capital Management LLC Cupertino, CA 408-918-9333 Please Note: Individual companies shown or discussed in this presentation