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 416.913.3924/cguthrie@hillsdaleinv.com
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
The Public Battle of Fundamentals vs. Quants Fundamental Managers Quantitative Managers
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
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
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% 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
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% 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
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% 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
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
Recent History of Quant vs. Fundamental
A Winner? When? Source: Normura Securities International Inc, S&P, Russell, Bloomberg.
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
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
Just as Much Crowding Among Fundamental Managers 14,000 160,000 12,000 140,000 10,000 8,000 6,000 4,000 120,000 100,000 80,000 60,000 40,000 2,000 20,000 0 0 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 CFA Level 3 Annual Grads CFA Level 3 Cumulative Grads CFA Level 3 Annual Grads CFA Level 3 Cumulative Grads
There are 140 CFAs to Practice Fundamental Analysis on Each Company in the Russell GMI (10,159): What Will They Find? 1 160 1 140 120 1 100 1 80 0 60 40 0 20 0 0 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 CFAs Covering Each Company* *Assumes 10 Companies per CFA
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 $- 0 20 40 60 80 100 120 140 160 Number of Strategies Source: evestment, June 2011.
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
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
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
The Effect of A Changing Market
Current and Foreseeable Market Environment?
Turnover Has Increased 35% Total Monthly Dollar Trading Volume as % of Market Cap Russell 2000 Index, March 1980 Feb 2011 30% 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
Potential Volatility is Here to Stay S&P 500 30 Day Rolling Volatility Jan 1928 Jun 30, 2011 100% 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% % 1928 1930 1932 1934 1936 1938 1940 1942 1944 1946 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Recession Periods Source: S&P Index Services
1.0 0.8 0.6 0.4 0.2 0.0-0.2-0.4-0.6-0.8-1.0 2006 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2007 2008 2009 2010 2011 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
Passive Funds Are In Ascendance Source: Normura Securities International Inc, EPFR.
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 2006-2012 Source: Axioma AXCA Canada.
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
How to Work with a Good Manager
Negotiate Fees. Insist on Performance Fees. Source: Don Raymond, PhD, CFA, CPPIB
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.
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.
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