Editor’s Letter

Writing this letter, I find myself fervently hoping that I am not pushed to the topic at hand by a mix of senility or excessive reverence for the past. Yet, it is hard not to note that the analysis of economic and investment developments typically distributed or published seems increasingly superficial and reliant on secondary work, as opposed to real, serious, primary efforts. Whether in the form of the almost mindless rehashing of press releases or views promoted by parties with an axe to grind, comments put out orally or in writing have become seemingly next to useless. Ostensibly, some of this may simply be caused by the virtually infinite devotion to the sound-bite god who does not tolerate any comment longer than a few seconds: As I discussed with younger clients in the recent past, the reader should find a topic which is really important to him or her and then try to justify his or her position in six seconds or less. It does not take unusual intelligence to realize that no rationale of any substance can be offered in such a minimal format.

Reality in today’s environment is framed by at least two new and crucial environmental variables. First, the amount of information available to anyone has grown so much that one can reasonably feel overwhelmed by it and unable to discern the important from the trivial. Second, the ubiquitous competition within the media world, which needs to capture one’s attention for ratings or circulation numbers, has led to a willingness to give up “some” accuracy in order to achieve greater speed to publish or a more attention-grabbing headline. Though one can certainly bemoan such developments, it is probably useless to spend too much time on them, as they are here to stay. As my late father used to say: “Deal with the world the way it is, not the way you would like it to be!”

Another important factor militating in favor of superficiality relates to the fact that not all markets have been moved solely by fundamentals over the last several years. When the history of the recent past is written, one can safely bet that a great deal of space will be given to the failed experiments carried out by most of the developed world’s central banks. Maintaining zero interest rate policies for so long and creating excess liquidity with the so-called “quantitative easing” has apparently failed to create either economic growth on par with prior recoveries or price levels consistent with these central banks’ stated targets. A recent article by St. Louis Fed Vice President Stephen Williamson is quite instructive, offering both theoretical and empirical logic as to why such a failure may well have been predictable. Yet, whether a success or not, the excessively liquid monetary environment thus created has predictably led to asset price inflation together with a misallocation of resources and a transfer of income from pensioners to traders. It is not surprising that in such circumstances ex post facto justification of recent price moves takes precedent over a cause and effect analysis of fundamental developments.

Looking ahead, this environment creates both a number of obvious challenges and selected opportunities for individual investors.

The first challenge deals with the need for individual investors and family offices to dedicate more effort to the analysis of fundamental developments. There was a time when the attentive reading of commentaries from a handful of well-respected analysts would provide a good-enough set of insights on which to develop one’s investment strategy. This is no longer the case, and primary analysis of data is crucial. Thus, families should create a framework within which they identify the areas that are most important and deserve the most cautious analysis together with an inventory of the principal data sources that they can readily access to evaluate any data point that seems to be crucial at one or another point in time. The plethora of information can be scary, but it is also a boon to the analyst who knows what he or she is seeking and is able to leave alone the marginal information. This may require a revision in the make-up and skills required from staff, but it would appear surely more important to perform primary analysis in areas that are not emphasized by others than to conduct the nth review of this or that manager.

A second challenge, which corresponds closely with the first, is to be clear in terms of what is predictable and what is not. I have seen many an investor want to predict or help predict a number of developments which empirically are totally outside of the range of reasonableness. Predicting where the price of oil will settle in the next several months is about as likely to succeed as calling the weather; by contrast, it is not impossible to identify the main determinants of the supply and demand for oil over some reasonable period of time and thus to identify those insights which can be predicted with some degree of accuracy and those which should be viewed as random. Here, it is worth remembering that the only forecasts that are likely to be quoted are those that are extreme enough to offer “shock value;” thus, the noise will come from and the attention will be directed at the extremes. Yet, the balance of probabilities suggests that these are the least likely to come to pass. It is interesting to note here that a recent analysis suggested that the likelihood of a scientific article to be modified or its findings revised at a later date was directly related to the “earth shattering” nature of its contents: the more dramatic, the more likely soon to be contradicted!

A third challenge is for each family to apply intellectual honesty and rigor in the execution of its investment process. Ostensibly, I favor investment policies developed using a goals-based process, but honesty forces me to make abstraction of this bias and to direct these comments to all investment policies. They must be developed in a way that recognizes that one of the most critical elements in their formulation must always be that investment policies be sustainable in times of greatest stress. Once they are in place though, it is equally important to respect the discipline they impose on the investment process. This discipline typically comprises three dimensions. First, one must have a clear decision-making process to justify moving away from a policy allocation. Second, any such move must lead to a position that remains within a preset deviation range. Third, manager selection within asset classes or strategies must remain honest and focused on managers whose performance can realistically be measured against the benchmark selected for each asset class or strategy.

While any one or all of these challenges can certainly appear daunting to families who have not adopted formal investment processes, collectively they present useful opportunities. In his classic book entitled Investment Policy, Charlie Ellis used to note that most professional tennis players won points while amateurs lost them. The insight he wished to communicate is that amateurs tend to overestimate their skills and attempt unrealistic maneuvers; professionals, by contrast, know their limits and can identify when they have an opportunity to win a point and when the task at hand revolves around sending the ball back to the other side of the net. This applies just as much in the world of investment management. Most of us are “price takers” rather than “price makers.” Thus, our focus should be on choosing carefully when an opportunity arises that can be highly profitable, most of the time preferring to protect capital; this latter idea being defined as staying close enough to policy allocation to maximize the chances of reaching our goals when they are due and with the minimum required urgency.

The Winter 2015 issue of The Journal of Wealth Management sets a new record in terms of the number of articles published, at least as far as my tabulations go, and is also about as diverse as has ever been the case. It dispenses, but only for a time, with our usual book reviews, simply because we ran out of space.

The first group of articles involves four pieces, each of which deals with one or another general aspect of wealth management. The first, by Ronald Janssen and Bert Kramer, deals with a very broad topic: the tailoring of risk management to the advisory process in private banking, concluding that an adequate implementation of a monitoring system is key to ensure that the suitability requirements are met on an ongoing and consistent basis for different service channels and client segments. The next, by Michael Crook and Matt Baredes, focuses on wealth optimization and starts with the observation that better technology would utilize liability relative optimization and a holistic balance sheet and incorporate behavioral finance considerations; it proposes a scalable, total wealth model for integrating liability-relative optimization into households’ portfolios. The third article, by Nicola Zanella, takes issue with some of the current literature dealing with the inclusion of human capital in total wealth allocation, presenting stylized facts on income and saving patterns over the life cycle and providing evidence that human wealth should be hump-shaped; younger workers, who do not have substantial wealth, have to implement a hierarchy of saving goals. The last article in this group is more technical and is by James Chong, William Jennings, and Michael Phillips, who explore the degree of homogeneity of investment performance of mutual funds within and among asset classes and conclude that the range of investment outcomes within a single asset class can vary considerably more than conventional wisdom would suggest.

Our next group comprises three articles that are more specifically focused on investment management issues. The first, by Tom Arnold, John Earl, and Cassandra Marshall, presents a simpler—though admittedly approximate—approach for computing bond duration and convexity. The next piece, by Levan Efremidze, Darrol Stanley, and Michael Kinsman, examines the effectiveness of entropy analytics for stock market timing, implementing, as an example, sample entropy analysis on the Dubai index series. The last piece, by Scott Seibert, is definitely meant for equity investors and examines the historical relationship between the S&P 500 operating earnings and the price of the S&P 500 index (SPX), suggesting that portfolios making buy/sell decisions using only operating earnings data are materially superior to an S&P 500 buy and hold portfolio.

Our next article stands on its own and is by frequent contributor John Haslem. The author uses his wisdom and experience of the mutual fund universe to review types of transparency and to suggest that the concept of “Normative Transparency of Disclosure” should be applied to a more complete and more empirically based mutual fund Total Cost Construct.

The next three articles may prove difficult for those of our readers who do not enjoy mathematics, but they cover topics which require sophisticated analysis and which we believe ought to be covered in The Journal of Wealth Management. The first, by Paul Bouchey, Vassilii Nemtchinov, and Ting-Kam Leonard Wong, focuses on volatility as both a risk management and a return enhancing dimension. The authors present a new way of thinking about the benchmark-relative risks involved with rebalancing: a formula that decomposes the excess returns of a portfolio strategy versus the market into three terms: a volatility return, a dispersion return, and a drift return. The second is by Anna Maria D’Arcangelis and Giuseppe Galloppo, who explore the relationship between portfolio concentration and the performance of mutual funds investing in emerging and developed markets, concluding that a fund selection process based only on the level of tracking error may contribute to disappointing results when not accompanied by information about the fund concentration in multiple market factors. The last article in this group is by Wai Mun Fong, who uses bootstrap simulations to quantify the effects of portfolio and time diversification in the context of global investing, concluding that a global portfolio is superior and thus arguing that long-term investors have much to gain by curbing the pervasive “home bias.”

Our final piece covers a topic we have never seen discussed in these columns: Douglas Wolford notes that auctions can be truly fun and satisfying, but can also be frustrating and costly for uninitiated and novice buyers, and offers essential points of etiquette, providing readers with first-hand knowledge and lessons learned about how one can truly “win” when buying art and collectibles at auction.

Jean L.P. Brunel

Editor

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