CIF Xpert Speak - Richard Hoe

Probability of future returns v. historical statistics

Q. How do you calculate the probability of future returns? Do you use the probabilities to generate expected returns, standard deviations and correlation coefficients for use in portfolio optimizer or do you use historical data as compiled by Ibbotson.

A. This is a combination of art and science, isn’t it? In 1968, we thought that a balanced portfolio was 50% bonds and 50% stocks, or 50% growth fund and 50% income (bond) fund. That seems silly now, although it was what passed for allocation in the 1960s and 1970s. Even though Dr. Harry Markowitz’s seminal papers were published in 1952 and 1959, few, if any, of us in the new, raw profession of financial planning read them. Of course Markowitz did not get his Nobel until 1990; and I would argue that he was not especially famous outside of educational circles until then. Ditto Doctors Sharpe and Miller—in this case, though, Markowitz’s chicken came first and the Sharpe and Miller eggs later.

While the “driving forward by looking in the rearview mirror” argument has minor validity, practically, it’s quite important to study historical fund and stock returns in order to get a feel for management and its reactions and performance numbers in various economic and investment cycles. One of the key questions, particularly important for mutual fund investment management, is this: In bad times, does management rattle, or does it stick to its guns? Data from March, 2000 to March, 2003 presents a golden opportunity to study strengths and weaknesses.

Tools like Morningstar’s Principia Pro provide ready access to historical data Other programs provide helps to professionals in understanding possible future outcomes through CAPM and the efficient frontier, but are of marginal value in client presentations. Regardless of the value of the model, most customers’ eyes tend to glaze-over when they are presented with pages of software-generated images. An alternative is to allow them to watch an excellent 20-minute video offered by BetaVest, a Georgia company that has done a great job of explaining sequences of deposits and withdrawals v. return sequences in an interesting and informative manner. (As to Ibbotson, it is now owned by Morningstar and its efficient frontier software has been modified and is being offered in March of 2007 to Principia subscribers. While the Ibbotson-to-Morningstar software is standalone, it will act as a companion, taking the portfolio developed in Principia and running it through the efficient frontier chopper-shredder to produce more number-crunching and chart data.)

If running the numbers is the science—even though it’s approximate, not exact, and, in a sense built out of historical data—then the art is in the combining of things—funds, stocks and bond funds and thinking about the parts and the investment managers of each one. I once gave a talk to planners, money managers and wholesalers in Kansas City and demonstrated how a 2% shift, adding or subtracting one stock, could create a 10% difference in outcomes. The perception, that if a portfolio shifts by 100 bps that it’s no big deal, actually is a big deal. A person might say, “No worry, it’s 11% instead of 10 percent, only a 1% difference.” That’s a result of the human condition—humans don’t think about numbers well1. Actually, the difference between 11% and 10% over 10 years is a huge difference. Go ahead, run the numbers. And that 1% difference is not 1% at all; it’s 10% of the portfolio result.

The bottom line is that I use historical data and fund management’s style as an indicator of future discipline. I’m more interested in style and adherence to principles than in performance, although past performance is certainly a piece of the puzzle. My style seems radically different than most portfolio managers; the way I combine things, allowed me to carry customer portfolios through the March, 2000 to March 2003 downturn relatively unscathed. I have used SunGard’s AllocationMaster, and found it only marginal useful in customer presentation work (the eyes glazing-over problem, again!). As a planner and third-party advisor, I work in a narrow and singular area—I try to produce an 8 to 12% average annual appreciation over six to 10 years, and design and tweak portfolios also to hopefully avoid big market downturns. In other words, in baseball metaphor, I don’t try to knock one over the fence, and am only interested in singles and doubles. While I would advocate BetaVest’s online video as an outstanding, customer-oriented approach to explaining outcomes (BetaVest’s software is excellent, too), in my own practice, I am able to verbalize the problem and possible solutions easily; even so, I recommend the BetaVest video and software. Another excellent resource is Conserving Client Portfolios During Retirement by William P. Bengen, CFP (FPA Press, 2006). Bill has been writing on this subject since the early 1990s.


Informational value of yield curves

Q. Since the yield curve is currently inverted, are we going to face a recession in the next few quarters? Do you study yield curves to help make investment decisions for your clients?

A. Not so long as there are gobs and gobs of corporate liquidity out there. Companies are buying back stock, and merging like mad. Insiders are buying. Everyone wants to invest. These are not recessionary signals. Corporations are typically smart money investors.

Having written that, let me ask a question: Is it the duty of a financial planner to predict the future behavior of the capital markets and macro-economics? The planner must pay attention, of course, but consider that it may not be his or her role to expound on eco-futures. This is a subject for discussion. Unfortunately, many, perhaps most, customers ask planners for economic outlooks. Customers are insecure about finances, financial planning and economics.

In a Zen sense, an inverted yield curve is an inverted yield curve. It is what it is. Since I mostly use bond funds of short or intermediate duration, it is not something I worry about much. However, an engineer customer e-mailed me three weeks ago, suggesting that I move a bond fund sub-account out of one of his variable annuity portfolios “…since the bond fund was not performing well.” I responded by writing that it was there for a purpose, and I thought of Colonel Jessup’s line in A Few Good Men, approximately: “Deep down, in places you don’t talk about at parties, you want me on that wall, you need me on that wall.” That bond fund was “on the wall.” After the e-mails back and forth got a bit heated, I finally said, “Look, I’m not going to get out of that fund. If you want out, you’ll need to get another manager.” The next day, I woke up thinking this: engineer; he’s an engineer. I wrote again, asking him to imagine a beautiful office building built to withstand winds of 150 mph. Nearby, there was another building that was built to withstand 200 mph winds, but it had an ugly support column on the outside, where everyone could see it. It was clear that, in this land, a wind close to 200 mph would happen every six to 10 years. There were a number of days when winds hit close to 150 mph each year. People flocked to the offices in the beautiful building and only marginally occupied the ugly building. One night, a 190 mph wind came along and destroyed the beautiful building. People were forced to move into the ugly building. Soon, other ugly buildings sprouted-up, and were quickly occupied. My point to the engineer was that the bond fund in the portfolio was the ugly column; it allowed the structure to survive in a storm. (The story continued, and I wrote that, after five years or so, people began to forget about the 190 mph wind, and they began to opt for beautiful buildings again, happily trading status and appearance for higher risk [how easy it is to forget bad happenings, over time], a common problem. It may be true in buildings and for investments, that beauty is only skin-deep and that strength is what’s important. By the way, if the investment wind hits 250 mph, all bets are off, and we are selling apples in the street, circa 1929.)


Market efficiency

Q. What are your views on market efficiency?

A. Mr. Market is a discounter. If I learn something, it’s too late to take advantage of it in the short-term—Mr. Market has already factored-in the information to the share price. That is generally true, and I do not market-time investments in any way shape or form. I use mostly static portfolios, which I tweak from to time to time. While I take care of about 75% of the assets I have under management, I farm out about 20-25%, which allows me to watch other managers manage, and provides bases for comparison. If I do better, I feel good, and vice-versa.


Bond funds vs. individual bonds

Q. When would you put a client into a bond fund as opposed to individual bonds? When would you invest with individual bonds instead of bond funds?

A. I prefer bond funds and “mixed” funds that contain bonds and stocks. I might ladder individual bonds for a wealthy individual with $10MM or more to invest; otherwise I would rather have him or her in a pool of hundreds or thousands of bonds. While I had good results with inflation-protected bond funds and total-return bond funds in 2003 and 2004, at some point in 2005, I reduced exposure in to pure bond fund and bond ETF plays in advisory accounts when I decided that I wanted to have fund managers make day-to-day decisions about whether or not to add bonds or add equities, dependent on market conditions. I still use the “pure” bond funds, but in lesser percentages. My portfolios contain fairly high percentages of fixed-income, which, incidentally, is how I once observed incorrect allocation percentages in one software program. I confirmed the error by running a balanced fund alone and then in a mix of other funds; then I phoned the software company. Happily, the problem now seems to be repaired; it’s important, though, not to take things for granted.

 

Read more about Richard Hoe on his bio.