The Alpha Article
by Spencer McGowan, CIMA President
McGowan Group Asset Management
Imagine the enormous ballroom of the Chicago Hilton lined with long rectangle white tablecloths in classroom style seating. Two giant black screens sit at opposite ends of a polished wooden center stage as 1,200 analysts begin slowly walking through the ballroom doors towards their seats. Large notebooks filled with 3 days worth of speeches are being opened from one end of the room the other. The ballroom speakers occupy the time with Frank Sinatra’s voice while everyone finds their place.
This was how the 2007 Fall Investment Management Analysts conference began. The single unifying purpose of this gathering was to advance the net profits of the tens of thousands of investors represented by these analysts, who invested their own money to fly to the windy city.
There is actually a measure of superior performance. That measure is called ALPHA.
α =ALPHA = Investment Performance Above a Benchmark
ALPHA, therefore, is the definition of superior performance. Regulators and ethics are very clear that ALPHA is not to be assured because it is so often elusive. How many star money managers of the late 1990’s were put to shame by losing money during the bear cycle of 2000-2002? This is the hard debate that began the analysts conference in Chicago.
The entire mutual fund, hedge fund, and equity management businesses are built on bright people pursuing ALPHA, measurably superior performance. Strategic Insight Mutual Fund and Research Company estimated the following for 2007: $5 Trillion in fee based managed money, $12 Trillion in funds, $2 Trillion in hedge funds and private equity all of which are dedicated to producing ALPHA or at least hitting a benchmark performance.
Investors often ask for education and are often rewarded with material that rapidly induces sleep even among professional investors. The complexity of investments has led to use of the Greek alphabet to define and measure important concepts.
One of the Wharton MBA professors has more than once jokingly reminded his audience that the use of Greek letters increases the willingness of investors to pay more to consultants. However, that same professor spent an entire afternoon using GAMMA and THETA to demonstrate the most profitable and sophisticated bond strategies in use today. Cynicism aside, investors who depend on results to earn a living, better be able to define those results.
β= BETA = Volatility of an Investment Relative to the Overall Market
This original measure was used for individual stocks. A beta of 2 meant a stock was twice as volatile as the market. Lower BETA is generally a smoother ride.
The question for an entire session with Merrill Lynch focused on WHICH market investors should be using and how other sources of positive volatility, capital gains from extra BETA, should be included.
According to State Street Global Advisors, exchange traded funds are almost $500 Billion with a 30% estimated growth rate in deposits. Total estimated exchange traded funds? How many different sources of different BETA? The total number of sector and index funds on the exchange is just under 600 as of October 2007! Each investor in exchange traded funds is seeking some type of positive volatility or capital gain.
Institutions have been the biggest buyers of ETF’s. State Street’s research showed that over 1,000 large institutions were using ETF’s because of the ability to efficiently get exposure to a basket of stocks like the Dow Jones Industrial 30, or Brazil, Russia, China, and India. This defines pursuit of positive BETA.
Γ = GAMMA = Bond Convexity,
The Advantage Created by a Discounted Price
When a bond falls below maturity value due to rising rates, the risk of future price declines is lower because of the discount. Potential for capital gains is actually higher because of the discount.
θ = THETA = The Advantage Created by the Passage of Time
THETA is, like GAMMA, originally a bond term.
When an investor gains additional benefits from the passage of TIME, the benefit is called THETA. As a bond approaches maturity value from a discount, a capital gain results. Large discounts, over time, produce large capital gains.
A portfolio with positive cash flow benefits from the passage of time, or THETA.
Negative Cash Flow = Negative THETA
A portfolio with negative cash flow or fees that exceed the cash flow income actually loses a little each day with the passage of time. The irony is that a large portion of investors own investments where the fees exceed their cash flow. This is negative THETA and it compounds the dangers of down market cycles.
Positive THETA = Discounts and Positive Cash Flow
∆= DELTA = Rate of Change, or Change in Price
The biggest rate of change discussion at our conference came from a pessimistic University of Chicago professor who featured 2 hours on the decline of the United States.
The question that exemplifies the fear that investors always live with: is the slowing of growth in the US going to result in a contraction of the economy, ultimately leading us into a recession? That fear is defined as the likelihood of the rate of change in the economy turning from positive growth to a negative growth. A recession is defined as two consecutive quarters of negative growth.
For the housing market in 2007 and the technology market in 2000, negative DELTA presented huge risks.
According to our University of Chicago professor, the decline of the United States, the dollar, and the growth in our economy is underscored by growth in the unfunded liabilities of social security and Medicare. Since 2000 these unfunded future liabilities have grown from $20 Trillion to over $50 Trillion as of July 2007 and, he added, under a Republican administration.
ρ =RHO = Correlation Of Total return between different investments
The holy grail of modern portfolio theory is combining investments in a portfolio that increase reliability because they behave differently.
Optimized combinations led consultants off the bear market cliff of 2000-2002 like lemmings. Using historic data for expected return and correlation was a mistake because at 30x earnings (2000), stocks will perform differently than from 10x earnings (1982). The lesson for investors is that expected return must be calculated by dissecting each asset class. Yale actually has a category of investments called “Absolute Return.” The implication is that selection of investments must make a reasonable forecast of returns through analysis.
Hedge funds generally behave differently than the equity markets by definition and this fact has led to an institutional shift. This is also the reason that so much money was given to sub prime mortgage lenders during 2003-2006. Borrowing money at 5% and buying mortgage paper at 8% would leave 3% that a fund keeps as a nice spread. Leverage 10x and make 30%–smart business as long as the value of the paper stays at par.
The debt crisis of 2007 climaxed on August 16, 2007, 45 days after the end of Q2, June 30th, 2007. The hypothesis is that the 45 day reporting deadline forced funds to mark to market bad mortgage debts. Seeing those losses, investors demanded their money back, and the Federal Reserve was forced to end the panic selling by emergency intervention.
σ =SIGMA = Variance from an Expected Return, RISK The Standard Deviation of Returns
SIGMA helps measure volatility and, therefore, helps estimate risk of loss. For example, emerging markets fluctuate, historically, about three times as much as the US or Western Europe.
The debate over how to define future risk has climaxed with the recent book, THE BLACK SWAN. Use of statistical models to define risk fails to take into account unexpected new events. THE BLACK SWAN drops a handful of warm moist controversy on the exclusive use of SIGMA to measure investor risk of loss. New measures are needed.
Even the endowments of Harvard and Yale whose alpha generating portfolios are discussed and worshiped at great length, still require basic income to pay the light bill.
Surprisingly, there was no breakout session in Chicago Hilton’s basement on the subject of Cash Flow. Turning the corner where Harrison Ford dodged the Chicago Police in the movie FUGITIVE, AllianceBernstein had set up a breakout session featuring a Monte Carlo simulation* for an affluent family. The goal was to increase the certainty of not running out of money through allocation between stocks and bonds.
*Returns and probabilities generated by a Monte Carlo Simulation are based on historical and hypothetical information; there is no guarantee that actual future results will perform in accordance with the probability assessment.
However, the study totally left out the subject of net portfolio cash flow. Remember, the WC Fields quote: “Earn 20 spend 19, Happiness! Earn 20 spend 21, Misery!”
During working years, investors are taught to spend under 70% of net after tax earnings. Earnings defined as real cash flow that hits the checking account. If over-endowed Harvard and Yale still have to pay the light bill, how should investors address the cash flow subject during retirement? If the actual goal for the bulk of US investor wealth is to generate well over $10,000 per month the pay the bills, investment professionals appear to be at least one Greek letter shy of a full alphabet.
According to Vanguard IRA balances stood at about $4.5 Trillion in 2007. Retirement plans balances totaled about $10 Trillion. Approximately 1⁄2 of those balances, $5 Trillion was expected to roll into large IRA’s as the often-discussed Baby Boom generation seeks to retire.
The demographically defined change to the investment markets has already become the most important change on the investment landscape because it will impact the structure and purpose of investment portfolios globally.
The Greek alphabet skips the letter C. However, NET PORTFOLIO CASH FLOW deserves its own label. KAPPA, at this writing remains unassigned and I have hereby defined:
Κ = KAPPA = NET PORTFOLIO CASH FLOW
The retiring age wave is in the process of investing both KAPPA, to pay the bills, and ALPHA to outpace inflation.
Welcome to The CASHFLOW Revolution!
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IMPORTANT INFORMATION ABOUT INVESTMENT RISKS
Past performance is not an assurance of similar results in the future.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
The value of fixed income securities will fluctuate with changes in interest rates, prepayment payment rates, exercise of call provisions, changes in the issuer’s credit ratings, market conditions, and other variables such that they may be worth more or less that original cost if sold prior to maturity. There is also a risk that the issuer will be unable to make principal and/or interest payments.
The return and principal value of a mutual fund or ETF investment will fluctuate with changes in market conditions such that shares may be worth more or less than original cost when sold or redeemed. Mutual funds and ETFs are sold by a prospectus. Please carefully consider the investment objectives, risks, charges, and expenses prior to investing. The prospectus, which contains this and other information, can be obtained by calling your financial advisor. Read it carefully before you invest.
Global and emerging market investing involves risks not typically associated with U.S. investing; including currency fluctuations, political instability, uncertain economic condition, different accounting standards, and other risks not associated with domestic investments.
Hedge funds and private equity funds carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. They are complex investment vehicles which generally have high costs and substantial risks. They tend to be more volatile than other types of investments and present an increased risk of investment loss. There may also be a lack of transparency as to the underlying assets. These funds are subject to fewer regulatory requirements than mutual funds and other registered investment company products and thus may offer investors fewer legal protections that they would have with more traditional investments. Additionally, there may be no secondary market and transferability may be limited or even prohibited. Other risks may apply as well, depending on the specific fund. Please carefully review the Private Placement Memorandum or other offering documents for complete information regarding terms, including all applicable fees, as well as risks and other factors you should consider before investing.
Except where noted this publication should not be construed as representing the position of Spire Securities, LLC or its affiliates. Neither the information nor any opinion expressed herein constitutes an offer to buy or sell any security. This material is not a complete description of the securities, markets or trading strategies discussed. Additional information is available upon request. All expressions of opinion reflect the judgment of the author at the time of writing and are subject to change without notice. Information contained herein is derived from sources believed to be reliable. However, complete accuracy, especially with data marked as estimates, cannot be assured. McGowan Group Asset Management, Inc. is a Federally Registered Investment Advisory Firm utilizing Pershing LLC, a BNY Mellon Company for asset custody.
All Rights Reserved Copyright 2007, Spencer McGowan