The Reality of Investing Today Plus: Thoughts on How to Work With Good Managers

Transcription

1 The Reality of Investing Today Plus: Thoughts on How to Work With Good Managers Hillsdale Investment Management Inc. Chris Guthrie, CFA President, CEO and Senior Portfolio Manager

2 Agenda The Reality of Investment Management Practices Today Recent History of Quant vs. Fundamental The Effect of a Changing Market How to Work with a Good Investment Manager

3 The Public Battle of Fundamentals vs. Quants Fundamental Managers Quantitative Managers

4 What Does a Fundamental Manager Say Today? We seek companies that are global leaders in industries which exhibit reliable growth of at least 13% to 15% per annum in earnings. The key selection criteria are: 1. Industry Attractiveness 2. Competitive Position 3. Quality and Ethics of Management 4. Financial Strength 5. Valuation Analysis Source: evestment, A description of a prominent fundamental manager in Canada

5 What Does a Quantitative Manager Say Today? We seek companies that are global leaders in industries which exhibit reliable growth of at least 13% to 15% per annum in earnings. The key selection criteria are: 1. Sector Return on Invested Capital and Long Term Growth in EPS 2. Return on Equity, Patents per share 3. Audit Integrity, Environmental/Social/Governance Ranking, Earnings Variability, CEO Resume 4. Debt to Equity, Debt to Cash Flow 5. EPS/EBIT/CF/FCF+Div Yield, Price to Book

6 All Fundamentals Are Subject to Changing Investor Preferences Debt to Equity Top 30 Stocks Bottom 30 Stocks, 6 Months Rolling 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% -60%

7 All Fundamentals Are Subject to Changing Investor Preferences Dividend Yield Top 30 Stocks Bottom 30 Stocks, 6 Months Rolling 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50%

8 All Fundamentals Are Subject to Changing Investor Preferences Price to Earnings (Est.) Top 30 Stocks Bottom 30 Stocks, 6 Months Rolling 50% 40% 30% 20% 10% 0% -10% -20% -30% -40%

9 The Reality of Active Management Practices Today All Active Managers Use Quantitative Methods Quantitative Methods are Tools to Assist in Learning & Doing Improve Information Access Empirical Testing of Hypotheses Improve Decision Making Process Build Institutional Memory

10 Recent History of Quant vs. Fundamental

11 A Winner? When? Source: Normura Securities International Inc, S&P, Russell, Bloomberg.

12 Take Crowding : A Result of Deviation from Research and Lazy Quants Returns Correlation, Quantitative Managers vs. Index, 5 Year Rolling 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Q1/2000 Q1/2001 Q1/2002 Q1/2003 Q1/2004 Q1/2005 Q1/2006 Q1/2007 Q1/2008

13 The Generic Crowded Paradigm of Quantitative Investing 1. Alpha signals dominated by valuation forecasts, momentum and estimate revisions 2. Risk measured using a variant of APT which assumes the risk of a stock can be disaggregated into various exposures 3. Portfolios constructed using some form of mean-variance optimization usually provided by a third party 4. Single frequency, generally monthly A successful quantitative manager must consciously seek to avoid the elements above. * * Tony Foley, CIO, D. E. Shaw, Nov 2010

14 Just as Much Crowding Among Fundamental Managers 14, ,000 12, ,000 10,000 8,000 6,000 4, , ,000 80,000 60,000 40,000 2,000 20, CFA Level 3 Annual Grads CFA Level 3 Cumulative Grads CFA Level 3 Annual Grads CFA Level 3 Cumulative Grads

15 There are 140 CFAs to Practice Fundamental Analysis on Each Company in the Russell GMI (10,159): What Will They Find? CFAs Covering Each Company* *Assumes 10 Companies per CFA

16 Which is the Bigger Crowd? Market Share by Approach (US Large Cap) $6,000 $5,000 Average AUM per Manager $4,000 $3,000 $2,000 $1,000 AUM Size of Segment Fundamental Combined Quant $ Number of Strategies Source: evestment, June 2011.

17 Diminishing Returns to Research on Valuation When any manager has a large existing exposure to a given source of alpha, areas related to that alpha source often figure prominently in that manager's research agenda. This can result in a substantial misallocation of resources if the core implications of that factor do not differ materially from marginal modifications made to it. The diminishing returns to research on valuation are evident in research conducted by Hillsdale. We find that there are limits on the rewards to complexity and that even before considering the additional degrees of freedom, simplicity wins. Simple cash flow multiples with a few basic adjustments have similar IC s to the more sophisticated alternatives. Fundamental as a doctrine can be very dangerous too

18 Be Aware of the Quant or Fundamental Doctrine When Fundamental Becomes a Doctrine Use fundamental as a selling feature Consumed by human errors No testing of beliefs or hypotheses or effort to improve When Quantitative Becomes a Doctrine Use quantitative as a selling feature Cut back on research of true drivers of returns Resort to pure mathematics

19 Towards a Sensible Perspective and Critical Learning Recent History is a Reminder to All Managers. Not All Quantitative Managers are Created Equal. Many Emphasize Fundamental Research as much as the Use of Quantitative Methods. The Fundamental Space is Just as Crowded and Undifferentiated. Both Quant and Fundamental Managers are Facing a Drastically Changing Market. Look for Quality Managers, Quant or Fundamental

20 The Effect of A Changing Market

21 Current and Foreseeable Market Environment?

22 Turnover Has Increased 35% Total Monthly Dollar Trading Volume as % of Market Cap Russell 2000 Index, March 1980 Feb % 25% 20% 15% 10% 5% 0% Mar-80 Jul-81 Nov-82 Mar-84 Jul-85 Nov-86 Mar-88 Jul-89 Nov-90 Mar-92 Jul-93 Nov-94 Mar-96 Jul-97 Nov-98 Mar-00 Jul-01 Nov-02 Mar-04 Jul-05 Nov-06 Mar-08 Jul-09 Nov-10 Source: See Footnote 1 *Data prior to 1987 is quarterly and is monthly afterwards *Total monthly dollar trading volume data is index-weighted

23 Potential Volatility is Here to Stay S&P Day Rolling Volatility Jan 1928 Jun 30, % Great Depression 1987 Crash Credit Crisis 80% 60% Statistics Mean 15.43% Median 12.56% StDev 10.20% High 91.12% Low 2.99% 40% 20% % Recession Periods Source: S&P Index Services

24 Diversification is More Difficult 25 Week Correlation S&P 500 vs. Asset Classes MSCI Harvest USD/CAD CRB ML HY Source: See Footnote 1. Data as of September 30, 2011

25 Passive Funds Are In Ascendance Source: Normura Securities International Inc, EPFR.

26 Market Cap, Beta and Volatility Are Now Major Differentiators of Manager Returns in the Canadian Market, More so Than Fundamental. Equity Factor Risk Model: Factors Frequency of Statistical Significance Source: Axioma AXCA Canada.

27 The More Extensive and Better Use of Quantitative Methods May be Inevitable Among All Managers A New Market Reality Increasing Numbers of Influential Players and Drivers in the Market Capturing Profitable Opportunities Often Requires Exceptional Information Processing and Execution Capabilities

28 How to Work with a Good Manager

29 Negotiate Fees. Insist on Performance Fees. Source: Don Raymond, PhD, CFA, CPPIB

30 Summary The popular debate of quant vs. fundamental does not reflect the reality. Quantitative methods are tools that all managers use today. They are tools for improving learning, decision making and execution. When a method becomes a doctrine, it becomes dangerous. Both quant and fundamental active managers are facing the crowding effect. Both should learn from the past and understand the new market reality. All managers are facing a more complex and dynamic market. Quantitative tools are important capabilities to have in this new normal. Investors should focus on working with good managers who are innovative, research-oriented and motivated by learning and continuous improvement. Interests should be aligned with performance-based fees.

31 Footnotes and References Footnote 1 Source of Data All data presented is from Hillsdale s proprietary database unless indicated otherwise. This database consolidates information from over 30 vendors to support Hillsdale s research, portfolio management and reporting activities. Footnote 2 Simulation Performance and other data in this presentation are shown for illustration purposes only and are not based on actual results. The hypothetical returns are based on a simulation where stocks are selected based on a multi-factor ranking system. The drivers of the simulation are based on specified investment objectives covering both return and risk metrics as outlined in the Investment Objectives page of this presentation. The hypothetical returns are shown gross of fees and are calculated in Canadian dollars. No representations are being made that the investment process will achieve similar returns on a going forward basis. Investors should not take this example or the data included in the presentation as an indication, assurance, estimate or forecast of future results. The actual performance returns may differ materially from the returns shown for reasons including, but not limited to, investment restrictions and guidelines, fees and other expenses, cash holdings, timing of trade execution and fluctuations in the market.

32 Bibliography 1. Acadian Asset Management, Quantitative Equity Strategies A History of Rebounds from Performance Lags, March Chan, Ngai Hang and Genovese C R, A Comparison of Linear and Non-Linear Statistical Techniques in Performance Attribution, IEEE Transactions on Neural Networks, July Foley, Tony, Programmed Obsolescence: The Generic Paradigm in Quantitative Equity Investing and Why It s in Trouble, DE Shaw, November Hsu, Jason C., Chow, Tzee-man, Kalesnik, Vitali and Little, Bryce, A Survey of Alternative Equity Index Strategies, Financial Analysts Journal, October Israelov, Roni and Katz, Michael, To Trade or Not to Trade? Informed Trading with High- Frequency Signals for Long-Term Investors, Financial Analysts Journal, September Lakonishok, Josef and Swaminathan, Bhaskaran, Quantitative vs. Fundamental Institutional Money Managers: An Empirical Analysis, LSV Asset Management, May Mezrich, Joseph J. and Ishikawa, Yasushi, Active Management Headwinds: Correlation and Fund Flows, Quant vs. Fundamental, Normura Securities Inc., October 2011.