Product and Strategy Notes: Challenges Facing Investors in Venture Capital Funds; Improving Warning of Future Financial Crises; A New View on the Fundamental Drivers of Equity Market Returns; and The Long-Term Impact of the 2007-2008 Crisis on Financial Advisers' Compensation

Another View of the Challenges Facing Investors in Venture Capital Funds

Following our recent article on problems in the world of buyouts and venture capital, a reader sent us an excellent research piece from Landmark Partners. In "Venture Capital: Hope is Not a Strategy", they make a number of good points:

• Venture capital returns have been closely related to returns on the NASDAQ Composite.
• Venture capital in the aggregate is therefore not a good portfolio diversifier; "in fact, it is a systematically risk-concentrating position relative to the broad equity market. That means the only good reason to invest in venture deals is if you're convinced you can find some alpha - some expected return that's due to manager skill and not to the market in general. And if the aggregate net alpha of venture capital is negative, as it appears, that means that most venture limited partners are probably overoptimistic about their own prospects for identifying and accessing alpha-generating managers."
• One way that LPs try to identify alpha generating managers is to focus on those who have had first quartile funds [in the past]. It is widely said that top performing funds tend to repeat, and to some extent that's true. But there's also a lot of evidence that simply relying on quartile rankings is not a good investment strategy. Recent evidence has shown that the successor fund following a top-quartile fund has about a 65% likelihood of being in the top half...The problem is that when an investor is considering a new fund (call it fund N), he doesn't actually know the results of the previous fund (N-1) that has only just finished up its investment period. Instead, the investor only has a pretty good idea of the performance of fund N-2 or N-3. If your information is about fund N-2, [the joint probability] of fund N being in the top half fall to about 55%. If your information is from fund N-3, the odds in your favor fall to about 52%. This is better than random, but not by much."

Improving Warning of Future Financial Crises

In the wake of the shocking events of 2007 - 2008, there has been a great deal of new interest in early warning models to improve regulators' and investors' foresight about developing problems in financial markets. The IMF's October 2009 World Economic Outlook devotes an entire chapter to this research (although, somewhat surprisingly, it does not mention the very large body of work from the intelligence community on the subject of warning and surprise). After reviewing the recent research, the IMF concludes that credit growth, the share of investment in GDP, rising house and equity prices, and growing current account deficits are the most informative warning indicators of future crises. Yet the IMF still concludes that "nonetheless, even the best indicator failed to raise an alarm one to three years ahead for roughly one half of all busts since 1985. Thus, asset price busts are difficult to predict."

In our view, however, the IMF analysis is far from complete, and not just because it ignores the body of findings from the intelligence community. It also ignores an impressive and growing body of work from complex adaptive systems theory about the underlying causes of phase transitions, when systems pass from a zone of stable operations into one that is highly unstable. An important part of this work is the search for variables that control these phase transitions. Last month, we reviewed a paper on one of these, "Leverage Causes Fat Tails and Clustered Volatility" by Thurner, Farmer and Geanakoplos. This is along the lines of the credit growth indicator identified by the IMF. Yet we also noted the equally important impact of rising uncertainty and the changing connectedness and strength of social networks that influence investor decision making (see, for example, "Asset Pricing in Large Information Networks" by Ozsoylev and Walden, or "Dragon Kings, Black Swans, and the Prediction of Crises" by Didier Sornette). As a practical matter, the challenge for investors has been to identify variables or statistics that can be used to identify the strengthening of networks that is often associated with phase transitions. It was with this in mind that we recently read an excellent paper by Lisa Borland, of the asset management firm Evnine and Associates in San Francisco ("Statistical Signatures in Times of Panic: Markets as a Self Organizing System"). Using the phase transition approach, Borland searches for statistical signatures of market panics, and proposes a new order parameter that is easy to calculate and appears to capture the changing dynamics of asset return correlations and the underlying social network phenomena that give rise to them. The parameter equals the number of financial markets or assets that have positive returns over a given interval, less the number that have negative returns, divided by the total number of financial markets or asset classes evaluated. If the value is zero, the markets are in a disordered state and far from the potential phase change point. However, as the parameter value approaches one or negative one, the markets are in an increasingly ordered state. In this state, networks are more extensive, and presumably social influences have a greater impact on investor decisions. Under these circumstances, a market is close to or at a phase change point, and therefore subject to a sudden, and potentially violent, shift in its previous trend. In our market value update section, starting this month we will calculate this order parameter for the 38 financial markets (excluding foreign exchange) we evaluate each month. Here are the results so far for 2009:

As you can see, in 2009 global financial markets appear to have swung from a relatively ordered and negatively oriented state early in the year, through a period of disorganization during the spring and early summer, into a period of stronger positive orientation by August that has begun to break down in September. Congratulations to Ms. Borland on an excellent and very useful piece of work.

A New View on the Fundamental Drivers of Equity Market Returns

Another fascinating paper that we read last month is "What Happened to the U.S. Stock Market? Accounting for the Last 50 Years" by Boldrin and Peralta - Alva of the Federal Reserve Bank of St. Louis. The authors begin by noting, "the extreme volatility of stock market values has been the subject of a large body of literature. Previous research focused on the short run because of a widespread belief that, in the long run, the market reverts to well understood fundamentals. Our work suggests this belief should be questioned as well." They conclude that changes in "actual dividends cannot account for the secular trends in stock market values...[However], a more comprehensive measure of capital income [which reflects both the changing share of corporate profits in national income, and the changing division of those profits between labor, taxes, and capital owners] fluctuates much more than dividends paid, and roughly coincides with changes in stock market trends." The authors show how between 1982 and 2007, both corporate profits and the share of them going to capital providers experienced a dramatic increase, which drove above average equity market returns over this period. The authors note, "the issue of what the market can and cannot forecast correctly is at the root of the problem we are addressing." For example, they observe that "it is only after the middle 1980s, when the...capital share of corporate income share of corporate income has started to rise steadily, that the market [valuation] ratio also picks up and starts reflecting either current successes, or, maybe, forecasting future ones." They stress that "a similar point can be made for pretty much every single major swing of the data we are considering: oscillations in equity market valuations are anticipated by oscillations in the share of capital income in corporate income instead of predicting them...The problem, obviously, is how reasonable is it to assume that people extrapolate trends that cannot be sustained forever."

The authors then show that by assuming that forecasts of corporate profit growth and corporate profit shares are inescapably imperfect, traditional asset pricing theory (which assumes perfect foresight about dividend growth rates and future discount rates) can be reconciled with the actual gyrations we observe in equity market valuations over time. However, this analysis applies to the long term more than to shorter periods. Over three year time horizons, the authors show that forecasts of future market values are likely driven more by forecasts of discount rates and investor behavior than by forecasts of changes in capital providers' after-tax share of corporate income. Still, as Jeremy Grantham has often noted, unsustainably high shares of corporate profits in GDP, and capital providers' share of corporate profits remain very useful valuation indicators, as trends than can't go forever on eventually must reverse.

The Long-Term Impact of the 2007-2008 Crisis on Financial Advisers' Compensation

Regular readers know that we are strong believers in the value that a first class financial adviser can add to a client's life. In particular, we strongly support fee based advisers who are subject to fiduciary standards, such as those that govern the behavior of Registered Investment Advisers in the Untied States. However, our commitment to financial advisers does not mean that we shy away from reporting on research that is critical of their performance, as we believe that it points the way to improvements that will benefit both them and their clients.

In the wake of the substantial losses suffered by many investors during the 2007 - 2008 financial crisis, a growing amount of research has been directed at the strengths and shortcomings of financial advisers. In 2007, Fischer and Gerhardt wrote an excellent paper on how individual investor decisions often deviate from what is theoretically optimal, and how financial advisers can add substantial value by reducing these mistakes ("Investment Mistakes of Individual Investors and the Impact of Financial Advice"). Unfortunately, there is also substantial research that suggest that many who hold themselves out as financial advisers fail to deliver these potential benefits to their customers and clients. For example, in "Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry", Bergstresser, Chalmers and Tufano found that "relative to direct-sold funds, broker-sold funds deliver lower risk-adjusted returns, even before subtracting distribution costs." One theory is that this reflects inherent conflicts of interest between brokers and their clients, since, unlike Registered Investment Advisers, who have a fiduciary duty to put their client's interest above their own, brokers are held to the much less stringent standard that the products they sell must only be "suitable" to their customer's needs. Indeed, there is growing evidence that more customers' recognize this trend, and have been voting with their feet (see, for example, "Wary Investors Are Seeking Out Objective Voices", Wall Street Journal, 29 July 2009). Eliminating this conflict lies at the heart of the current battle between regulators and brokers around the world over whether the latter should also be held to fiduciary standards.

Another theory about the underlying cause of the poor performance of broker sold funds focuses on whether brokers' skills are adequate in the face of the complicated nature of today's financial markets and customers' financial needs. In this regard, another recent article was illuminating. In the 1 August 2009 New York Times, Paul Sullivan reviewed a recent Price WaterhouseCoopers survey of 238 private banks and wealth management firms ("In Search of Competent (and Honest) Advisers"). The survey questioned advisers working with clients who have between $500,000 and $20 million in investable assets. As Sullivan notes, "of that sample, only 7 percent said they felt strongly they had received adequate training to complete their job to the highest standard. A little more than half said they had received some training. What is shocking is the rest -- some 36 percent of wealth managers surveyed --- said they believed they were not fully qualified to do their jobs." Sullivan asks, "Why haven't firms addressed this issue? The leading suspect is the industry's focus on advisers who can bring in clients with lots of assets, as opposed to advisers who can actually counsel clients."

A paper published this summer provides further fuel for this debate. In "Financial Advisors: A Case of Babysitters?", Hackenthal, Haliassos, and Jappelli "track the accounts of 32,751 randomly selected individual customers over 66 months, and allow direct comparison of performance across self-managed accounts and accounts run by, or in consultation with, independent financial advisers" in Gemany. They conclude, "in contrast with the picture painted by performance records, econometric analysis that corrects for the endogeneity of the choice of having a financial adviser (e.g., IFAs tend to be matched with richer, older investors) suggests that advisors are associated with lower total and excess account returns, higher portfolio risk and probabilities of losses, and higher trading frequency and portfolio turnover relative to what account owners of given characteristics tend to achieve on their own...Our findings imply that financial advisers end up collecting more in fees and commissions than any monetary value they add to the investment account." We also note that it is important to put this paper into its regional context, in that on the continent, the performance of the system for distributing investment products has been criticized by many parties (e.g., see Pauline Skypala's column, "Is It Time to Act On Distribution? In the 4 Oct 09 Financial Times). Of course, another hypothesis is that these excess fees compensate the adviser for other services -- for example, another paper ("Do Contracts Impact Comprehensive Financial Advice?" by Finke, Huston, and Waller) found that clients "who rely primarily on financial planners are more likely to have adequate life insurance holdings, while being a customer of a broker is not related to adequate coverage levels." Indeed, the economic value of these additional services can be substantial (of course, so too is the value of avoiding investment mistakes). This leads to the current controversy over the elimination of adviser commissions in favor of explicit fees, as has been proposed in Australia and the United Kingdom. Explicit fees not only reduce conflict of interest problems between advisers and product providers, but also make it easier to calculate the true economic value added of advisers' integrated service offering to their clients. However, we are still a long way from this approach becoming the norm.

Instead, as Gillian Tett and Kate Burgess recently noted in their 27 Sep 09 Financial Times column, "the financial storm that has raged for the past two years...has posed fundamental questions about 21st century investing and the nature of the industry that conducts that activity on behalf of hundreds of millions of citizens across the developed world...Unease is widespread about the very structure of the industry." ("Costly Cogs, Misfiring Machine"). Indeed, some of the asset management industry's leading lights are becoming increasingly vocal about their agreement with Ms. Tett's and similar criticisms. For example, consider what PIMCO's Bill Gross wrote in his August 2009 Investment Outlook: "My point is that those who sell [actively managed] investment 'potions' must wrap their product with an extra large ribbon because history is not on their side. Common sense would dictate that the industry as a whole cannot outperform the market because they are the market, and long-term statistics revealing negative alpha for the class of active managers confirms it. Yet, what a price investors are willing to pay! A recent Barron's article pointed out that stock funds extract an average 99 basis points or virtually 1% a year in fees from an investor's portfolio. Bond managers are more benevolent (or less pretentious) at 75 basis points, and many money market funds manage to subsist at a miserly 38. Still, those 38 basis points are as deceptive as the pea that disappears beneath the shell of a street-side con game. Since money market funds barely earn 38 basis points these days, much of the return winds up in the hands of investment managers. A mighty expensive potion indeed. While some index and ETF proponents avoid this extreme absurdity with lower fees, roughly 90% of the $1.5 trillion in 401(k) and other defined contribution assets in mutual funds are in actively managed offerings with expenses close to 1%. Paying for those potions during an era of asset appreciation with double-digit returns may have been tolerable, but if investment returns gravitate close to 6% as envisaged in PIMCO's "new normal," then 15% of your income will be extracted" -- before taxes.

It is for this reason that we believe the days are ultimately numbered for traditional long-only actively managed funds that deliver a mix of beta and alpha returns at an excessively high price. Under both market and regulatory pressure (e.g., a re-examination of prudent man standards for plan trustees in light of the great accumulation of evidence against the reasonable likelihood of long term active management success), we expect the best of these long-only active funds to evolve into uncorrelated alpha strategies that can deliver positive returns without the benefit of rising overall markets. As evolutionary pressure increases, the rest should gradually disappear, as more portfolios become composed of broad, low cost asset class index products and higher cost uncorrelated alpha strategies. We can already see evidence that this change is underway, both in the rising value of investments in ETF and other index products, and the growing number of uncorrelated alpha-type products that are being made available to retail investors around the world. On the other hand, these developments will also put rising pressure on advisers to become more adept at asset allocation and portfolio risk management.

As Tett and Burgess note, "two years after the crisis started, the task of fixing the social contract between the suppliers of capital and those charged with allocating it remains as great as ever. Indeed, it is arguably one of the biggest problems bedevilling the developed world today."

| Table: Market Implied Regime Expectations and Three Year Return Forecast | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns | Table: One Year Asset Class Valuation Conclusions and Recent Momentum | Market Phase Change Risk Analysis | October 2009 Issue: Key Points | October 2009 Economic Update | Product and Strategy Notes: Challenges Facing Investors in Venture Capital Funds; Improving Warning of Future Financial Crises; A New View on the Fundamental Drivers of Equity Market Returns; and The Long-Term Impact of the 2007-2008 Crisis on Financial Advisers' Compensation | Feature Article: Equal Risk Weighted Portfolios in 2007 and 2008 | Global Asset Class Valuation Updates Detail | This Month's Letters to the Editor: Oil and Gas Partnerships - Do they fit in your portfolio?; What's the best Asset Allocation Today; Is it Possible to Over-diversify a Portfolio?; PIMCO Heavy Weighting for Emerging Markets, II's thoughts?; Timber Followup |