This is a guest article by Jim Stark. Jim Stark is a pseudonym for a practicing Canadian financial advisor. The article is written to financial advisors, but we both thought that readers of this blog would appreciate it.
Take it away Jim…
The thing about the ongoing ‘debate’ between active (markets are largely inefficient) and passive (markets are largely efficient) management is that no side has been able to score an incontrovertible ‘knock-out punch’. By the way, I use the term ‘debate’ loosely, as I’m unsure if you can call it that, given that few people in the active management camp seem willing to truly engage the logic and evidence that goes into a real debate. I digress…
The point that I make repeatedly is that the large majority of active managers lag their benchmarks and that the few that actually beat them are pretty much impossible to identify in advance (i.e. their performance does not ‘persist’). This is a compelling two-pronged argument, but many people have pointed out that one need only identify one (that’s right, one) person who can reliably be identified as a market-beater and victory for the active management side would be realized. Overwhelmingly, the one name that is thrust forward when it comes down to this is: Warren Buffett.
I have nothing but admiration for Mr. Buffett (who has encouraged most investors to use passive products more than once). By the way, “most” means at least 50% + 1. It means if 8,000 read this article, Buffet thinks at least 4,001 and one of them should use passive (assuming readers represent a representative sample of overall investors). With great respect, however, pointing to Buffett and saying “checkmate” rather misses the point.
What’s the use of going through the trouble of finding that one in a million person who can reliably beat the market if you don’t- you know- actually hire him to manage your money? It makes about as much sense as developing a foolproof way if picking winning lottery numbers- and then never buying a ticket! If a tree falls in the forest…
My impression is that MFDA registrants (Mutual Fund Dealers Association registrants – Financial advisors who can only sell mutual funds, GICs and Government savings bonds. They represent about 75% of all Canadian financial advisors- Preet) are somewhat more pro-Buffett than IIROC advisors (Investment Industry Regulatory Organization of Canada licensed advisors – they are allowed to also sell individual stocks and bonds and ETFs and other investments – Preet). It’s just my impression. The thing is this – MFDA registrants couldn’t hire Buffett to manage their clients’ assets if their lives depended on it. Berkshire Hathaway is a security and buying Berkshire Hathaway for clients requires a securities licence. Why people who are not licenced to sell securities extol the virtues of someone they cannot actually hire and an investment they are not licenced to sell makes no sense to me. If you’re an MFDA advisor who likes Buffett, please write to me to explain yourself. Don’t bother trying to convince me about how great the man is – I’ll only agree with you. What I want is for you to explain your behaviour to me.
(Technically, access to Berkshire Hathaway WAS available to MFDA advisors through single-security Principal Protected Notes – but the uptake was minimal and the PPN structure is all but dead for the time being anyway. Not taking away from Jim’s point, in fact it may even add to it. – Preet)
Let’s turn our attention to our Buffett-loving IIROC friends. What percentage of your client assets are managed by this icon of a man? My guess is that the number is an extremely small one. In fact, let’s open this up a little more. Who else is there with a great track record? My understanding is that it takes about a quarter century of data before performance histories can be considered statistically significant (i.e. to discern between luck and skill). How many managers (good, bad or otherwise) even have a 25-year track record? More to the point, what percentage of your asset base is managed by someone with a 25 year track record of clear market-beating performance? (Pauses for effect and to allow the reader to actually think about it). I see.
So let me get this straight: only a handful of managers outperform, but those outperformers remain largely unidentified in advance and the one person that has been reliably identified manages probably less than 1% of assets under management for the combined readership of this column? Again I ask you, if you could offer your clients a ‘bird in the hand’ instead of a ‘pig in a poke’, why wouldn’t you do it? And yet, most advisors don’t even tell their clients that passive options exist.
Thanks Jim! Look forward to your next guest article! :) – Preet
“And yet, most advisors don’t even tell their clients that passive options exist.”
Most (dare I say almost all?) advisors don’t tell their clients that options exist. Stock options. Puts and calls.
Both active and passive investors can benefit by hedging risk with options. Wouldn’t you love to tell clients that there is a guarantee they will never again incur a large loss? You can make that promise when you use options. And you will keep that promise. No lies, no gimmicks.
There is a downside (of course). With the guarantee that losses will be limited, comes the need to accept the fact that profits are also limited. But to many, that’s a great trade-off. The young have lots of time for growth and the people who already have wealth do not want to jeopardize it.
So where are the financial planners when it comes to recommending options strategies? Let me guess: You never mention options because you are not licensed to sell them.
So let me get this straight: Passive advisors take far more risk than necessary, just because they don’t know how to use options. If you could offer your clients a safety net, why wouldn’t you do it? Why don’t any advisors recommend the best risk-reducing investment tool on this planet? The stock option.
Great post :))
@Mark – I’m in total agreement with you. Advisors can make money well enough, and the educational standards are low enough that there has been no incentive to use options. Perhaps this market will open the eyes of advisors who are looking for better ways to manage money…
@Mark – Regarding to options in Canada, they are used quite a bit through Market Linked GICs and Principle Protected Notes. Market Linked GICs and Principle Protected Notes probably use a lot of OTC options and internally written options. Remember that commissions is what counts in Canada for most of financial advisors like what Preet said.
I find collars to be expensive to use with ETFs and stocks. Right now, I am learning on how to manage risk by using SMA200 as outlined in Mebane Faber’s Quantitative Approach to Tactical Asset Allocation, published in Journal of Wealth Management Spring 2007. Can you analyze the pros and cons of using collared positions vs SMA200 trendline analysis?
Henry,
The SMA analysis is based on an ‘asset allocation approach.’
I feel that asset allocation (aa) is no longer as useful as it was at one time. Too many people use aa, so in a panic, it’s more likely all assets will fall together than it used to be.
I’m not saying aa has no value, just limited value.
I did not read the whole article, but the methodology is based on technical analysis and market timing.
If you believe, then you believe. Some make lots of money using technical analysis, others believe it is of very limited value.
As to timing the markets – I see the advantages of being out of the market in a downtrend. But, it may take too long to get back in during an uptrend. Again, if timing the market feels right to you – there is no one who can tell you that’s it’s ‘wrong.’ Many argue against trying to time markets, but to each his own.
I prefer collars. I cannot really give you a comparison. If the SMA suits your comfort zone, then by all means go for it.
Yes, I have a bias towards options, but having a guaranteed floor on the value of a portfolio feels better to me than depending on market timing. Plus, market timing does you no good on a black swan opening.
If ETF collars are too costly, that’s a big problem. I don’t believe in paying cash for collars. It’s sufficient to give up the big upside, I’m going going to pay a debit also.
I don’t know how you choose the strikes for your collars. This is sort of a personal comfort zone question – I’m not looking for a reply. But, can you buy a cheaper put, or sell a lower strike call? Or both.
The bottom line is that no method is perfect. None is best all the time. You simply have to weigh the pros and cons and make a decision. If your portfolio is (or gets) large enough, you can adopt more than one method.
Thank you for your response.
I highly recommend reading the entire study. It should not take more than 15 minutes.
Regarding to “asset allocation”, the study’s theoretical portfolio has 5 asset classes instead of just one. Since the different asset classes move slightly different in the bull markets, one can benefit from the covariance. Using SMA200 to exit the market before the bear market crashes, one would not experience simultaneous correction of the multiple asset classes, where the covariance is 1. By combining asset allocation (multiple asset classes resulting in lower volatility of the entire portfolio) and trend-line analysis (do not long assets during severe bear markets), one can benefit the best from both worlds.
However, SMA200 may not be sensitive enough for reentry at times. Matt Stiles from futronomics.blogspot.com told me that I need to use SMA50 or SMA20 as entry points or stop loss if the SMA200 is very far away from the present price. This removes the concern that
SMA200 provides a slow re-entry point into an emerging bull market (cyclical or secular). Again, neither SMA50 or SMA200 is perfect and even combined, they cannot create a perfect system. I am trying to figure out how to use SMA50 and SMA200 together systematically.
Actually, I am not able to use collars at this point, because I am not allowed to sell covered calls. However, I have looked into collars seriously. I hold VWO. According to Yahoo Finance, DEC 09 37 Call has a bid of 1.45 and an ask of 1.75 and DEC 09 32 Put has a bid of 1.65 and an ask of 1.95. Assume that I can sell DEC 09 37 Call at 1.60 and buy DEC 09 32 Put at 1.80, I would pay .20 for insurance. In this scenario, it does not seem to be too bad at all and I would consider it if I am able to write covered calls.
Since I am not able to use covered calls, I am using SMA50 instead as a stop loss. SMA50 right now tells me that I need to sell @ 33.32 as a stop loss. That is what I am going to use. So most likely, I will be selling VWO @ 32 or 32.5 if VWO does reach to that point just like using DEC 09 32 Put. Using the SMA50 is great for me since I cannot write covered calls, I do not loose the upside after VWO reaching 37, and I do not need to pay .20 for insurance.
I have to admit using SMA50 and SMA200 can be stressful especially at the turning points and mastering behavior finance is required when using SMA50 and SMA200.
By using SMA50 and SMA200, I am trying to do what I call “Adjusted Buy and Hold”. I am long asset classes in a bull market and neutral or short asset classes in a bear market. A traditional buy and hold is long asset classes no matter what the situation. With “Adjusted Buy & Hold”, I think can bear the 10% to 20% correction in the portfolio vs the 50%+ corrections that traditional buy and hold strategy experiences. However, the strategy that I am using cannot deliver exceptional returns (15% to 20% annual returns) without leverage and other alpha creating strategies. In conclusion, I think using SMA50 and SMA200 with ETFs satisfies Ben Graham’s First Principle of Investing: Investing requires the protection of principle and adequate returns.
Your article on this blog is fantastic.
Well done! I’m a big fan of your blog and be sure to keep up the great work.
I plan on returning and linking to your site.
Sincerely,
Alan H.
http://www.alanhaft.com
Henry,
1) Sorry to say I had not seen your last response. But better late than never. I also published this reply on my blog.
2) For readers here: SMA = simple moving average.
3)Earler you had mentioned that ‘commissions are what counts’ in Canada. It seems to me that’s all that matters to far too many professionals here in The States also. If an investor has an advisor who thinks that way, he/she is already in trouble.
4) I have no problem with using SMA or any other technical analysis method to time the market. But, as you know, few – if any – professionals advocate that methodology. They would rather see clients invested at all times – and yes, in various asset classes. The academic stuies all tell us that trying to beat the market is a foolish, time-wasting endeavor. But that does not make it true. If you can do it, if you are taking the time to do research, learn and plan – then more power to you. I urge you to take advantage of those TA tools.
5) You and I agree that asset allocation works during bull markets. By ‘works’ I mean that the results are ok. But, I have come to believe – on anecdotal evidence, not a true academic study – that anything works during a bull market. Innocent investors, who trust their advisors, accept the returns because the are ‘good’ returns. Thye have no idea whether the returns are ‘good enough’ or whether their advisors charge fees for underperforming the markets.
My problem with asset allocation as the PRIMARY method for controlling risk is that I am NOT a believer that it works during bear markets in today’s world. My (unproven) belief is that too many undisciplined people now depend on asset allocation. If the stock market heads south – these investors will panic and sell all assets. If that is true (as I say, an opinion, and unproved) then all assets will fall and provide inadequate protection.
6) I don’t say that collars are perfect either. What I like about that option strategy is the guarantee that losses can be strictly limited to a predetermined level. And sacrificing the large upside is just too much for many to accept. But I can accept it.
7) The problem of not being able to write covered calls ought to be solvable. Can’t you find a broker in Canada who allows that (and who also has reasonable rates)? It’s considered to be a very elementary strategy here, and few are denied permission.
8) The data from the CBOE Collar Index (see first link in the blog post to which you commented) tells me that the specific collar chosen by the CBOE is just too costly for most investors. But, I firmly believe (without the data to back it up) that the CBOE S&P 500 95-100 Collar Index (which does not yet exist) would show that writing ATM calls (instead of 10% OTM calls) improves performance sufficiently to make it a viable alternative for many.
The bottom line is that if you can use TA to successfully time the market, you don’t have to worry too much about taking big losses. Your major worry would be that the SMA can get you in late and out late, and occasionally provide a whipsaw.
9) ‘Adequate’ returns is of course determined by the opinion of the invesstor. But if you can produce 15 to 20% on a consistent basis when not in a bear market, then you are going to do fine over the long term. That suggests to me that collars are not for you. But I cannot outperform the markets without using options. I cannot pick winning stocks. So I don’t try. Graham and Buffett notwithstanding.
You appear to have found a method that works for you.