What’s past is prologue, Shakespeare wrote, although the Bard never had to test his theory with an investment forecast. If he had, he would have discovered the hard way that history can mislead when it comes to searching the past for clues about the future of risk and return. Looking at, say, a simple average equity performance for the past 20 years is hopelessly naive for projecting what awaits in the next 20. Yet for all its flaws, the past is still a building block for modeling future performance of asset classes for the simple reason that history carries some information about the future. Nonetheless, an enlightened strategist recognizes yesteryear’s limits along with its insights, and adjusts his outlook accordingly.
Among the veterans who are paid to do just that is EnnisKnupp & Associates (EnnisKnupp.com), a Chicago institutional-investment consultancy that oversees $700-billion-plus in assets for the likes of pension funds and foundations. The 25-year-old firm is a respected force in the business of advising big money, and so it has learned much about making forecasts that are prudent yet practical for clients.
With the U.S. economy weakening and a variety of global trends buffeting confidence in the prediction game, we wondered how the big picture looked to a veteran consultant with lots of capital at stake when it comes to designing investment strategies. Our queries were answered by Armand Yambao, who heads up financial modeling at EnnisKnupp. In a recent interview with Wealth Manager, Yambao advised that the outlook for returns is relatively modest compared with the past, which means that the margin for error is shrinking when it comes to asset allocation. For details, read on.
Q: What is EnnisKnupp’s strategic outlook for equities?
A: As a long-term investment, U.S. equities will provide enough compensation for the risk underlying it. In one respect, the outlook for U.S. equities is based on faith in the U.S. economy and corporations in general. Basically, there are no red flags that the U.S. economy’s in big trouble. You can’t guarantee short-term performance, or that the economy won’t soften in the near term, of course. But as we see it, there are no fundamental changes for long-term investors.
Q: What’s your time horizon?
A: Usually, we’re looking at a 15-year time frame. That’s arbitrary, but looking at less than 10 years is too short in terms of having patience with different asset classes, and looking beyond 20 years is too uncertain. We’re surveying current economic measures when forecasting our assumptions, and somewhere between a 10- and 20-year time horizon is reasonable.
EnnisKnupp’s latest semi-annual outlook (see tables on page 70), published midway in 2006, has a forecast for compounded expected return for U.S. equities at 7.5 percent a year. How does that compare with history?
If you just look at historical equity returns, you’ll come up with something like a 10 percent to 11 percent annual return, and so our 7.5 percent forecast for U.S. equities is less than what backwardlooking expectations suggest.
Q: How do you model expected equity returns?
A: We use dividend income, nominal growth in corporate earnings, and changes in equity valuation levels. The dividend yield for stocks was recently 1.8 percent. The historic dividend yield is much higher, which partly explains why our 7.5 percent equity performance outlook is lower than history’s. We also consider inflation, and our expectation for inflation is only 2.5 percent. Depending on how you slice the past, inflation might be 3 percent over time. But we expect a somewhat modest 2.5 percent inflation, and that’s another reason for projecting a 7.5 percent equity return instead of 10 percent or 11 percent.
Q: What convinces you that inflation will be that low?
A: Recent economic indicators. The market’s implied outlook for inflation for the next 10 to 30 years was recently around 2.5 percent based on inflation-indexed Treasuries. Another data point comes from the Blue Chip Economic Indicators newsletter, which also had a forecast of 2.5 percent inflation.
Q: What’s your outlook for bonds?
A: We’re expecting a 5.6 percent compounded annual return for bonds over time. We came up with that by looking at the current yield for the broad bond market index. Midway in 2006, the current yield was about 5.8 percent [based on Lehman Brothers Aggregate Bond Index]. That’s consistent with our expectations. We develop our fixed-income return expectations based on the current yield, and then consider the outlook for yields going forward.
Q: Your expected return of 5.6 percent for bonds is a bit lower than the current yield of 5.8 percent when you ran the numbers. Why the difference?
A: One reason is volatility. If bond prices remained unchanged, the current yield of 5.8 percent would become the compounded return over time. But volatility, or uncertainty, will affect bond prices, and our expectations account for that by reducing the performance outlook down a bit to 5.6 percent. Overall, our outlook for bond volatility is average compared with history. We think that volatility for bonds will be a standard deviation of 6.6 percent, meaning that in two out of three years, bond returns could be plus or minus 6.6 percent of the average return number.
Q: What about foreign stocks?
A: For non-U.S. stocks, our long-term expectation is a compounded annual return of about 7.2 percent, or a bit lower than the 7.5 percent for U.S. equities. The reason for the slightly lower performance forecast is higher volatility. If you backtrack, the risk premium for non-U.S. equities is slightly higher than for U.S. equities. But non- U.S. equities are more volatile, and so they carry greater uncertainty. We compensate for that by projecting a 7.2 percent return. Nonetheless, we encourage clients to diversify internationally. One reason: There’s a diversification benefit with foreign stocks, even though the returns are expected to be less than for U.S. equities.
Q: How does the future for real estate look?
A: For a generic real estate investment, the outlook is in the range of 6.5 percent on a long-term basis. Our long-term return expectation for real estate is somewhere between U.S. bonds and U.S. equities, and that’s how we come up with a 6.5 percent compounded return that’s between those two asset classes. Basically, we look at the historical experience—how much market risk premium was rewarded for real estate relative to U.S. bonds and U.S. stocks. We find that real estate’s outlook is somewhere between the two. If you look at real estate returns, it’s a combination of income— to the extent there’s rent—and appreciation. The rent is a bond-like characteristic, while the appreciation is more equity-like in terms of uncertainty and fluctuation in relationship with the economy. That’s how we rationalize an outlook for real estate returns that’s between those of stocks and bonds.
Q: Based on your projections, U.S. bonds in the years ahead will post a much lower correlation with U.S. stocks than will real estate or foreign equities. If so, that means that bonds will continue to deliver substantial diversification benefits. Why do you think that low correlation between U.S. stocks and bonds will persist?
A: The main component of fixed-income return is yield. If yields go higher than expected, that will be an attractive investment for many investors. To the extent that investors buy more bonds, they tend to sell equities. So, in a tradeoff, equity returns might drop because of the selling. The inverse will be true, too. If the current yield or current return expectation for bonds is low, equities will be more attractive, and people will buy more stocks. In general, market equilibrium tends to keep correlations between stocks and bonds lower than with other asset classes.
Q: On the flip side, what do you think of the rising correlation between foreign and domestic stocks in recent years?
A: Some predict that the higher correlation will persist because of, say, an increasingly globalized economy. But history shows that rising correlations don’t necessarily persist. It’s a subject we’ve discussed internally. Our conclusion is that for a long-term investor, there’s still not enough compelling evidence for expecting a lower diversification benefit between foreign and U.S. equities. The markets are still different, and there’s a currency effect that might dampen the correlation. We’re skeptical that the higher correlation of late will persist for someone with a long-term outlook because higher correlations in the past eventually dipped.
Q: Some strategists say that history is a more reliable guide for predicting standard deviation and correlation than it is for forecasting returns.
A: Correct. That’s the reason why we rely more on history for developing our assumptions there. Nonetheless, U.S. equity standard deviations could be very different from our forecasts, which we estimate will be close to 17 percent [about two-and-a-half times as high as bonds]. Of course, if you focus on shorter time frames for, say, standard deviation, you have more volatility. But for a long horizon, it’s more stable.
Q: How far back do you look into history for your estimates generally?
The late 1970s. That’s how far back confidence extends for bond-market data, for instance. And in real estate, you have limited history.
Q: Do you use the straight histories for coming up with expectations for standard deviation and correlation?
A: We take the straight history from 1978. The only exception is the standard deviation for U.S. bonds. If you just take the standard deviation for U.S. bonds from 1978, it’ll be higher—roughly 7.5 percent versus the 6.6 percent we expect. The problem with blindly using the history from 1978 is that past volatility, especially during the late 1970s and early 1980s, might be overstated. The U.S. bond market is tamer now, and so the volatility of the 1970s and early 1980s is less likely to continue. That said, the 6.6 percent standard deviation for bonds that we come up with isn’t totally arbitrary. We ran a Monte Carlo simulation of interest rates over the next 15 years.
Q: Why is the past so risky for forecasting returns?
A: Historical returns aren’t a very good predictor of future returns. If you did a back test and relied only on history, you’d do a poor job. Let’s say that equity performance skyrockets in 2007. What happens in 2008 is that the straight history from the previous year makes your return assumption higher than it was before. But rationally, market expectations might say that if you just had a good year, you might want to temper expectations because equities could be overvalued at that point. Stocks, as a result, might be more prone to a correction. It’s sort of counterintuitive, but if you increase return assumptions, you’re probably doing so at the wrong time in the market cycle, given the cyclical nature of returns.
Q: Wouldn’t a recent jump in volatility lead you to temper expectations for standard deviation as well?
A: Not really. If you look at different slices in history, standard deviation is more stable. The cyclicality of the market returns isn’t really present in standard deviation.
Q: What about correlations?
A: It’s a similar kind of thing. Correlations basically mean that returns tend to move in the same direction. It’s not based on whether recent history was a down or up market.
Q: You expect a risk premium in U.S. equities of 190 basis points. How does that compare to history?
A: History gave you a higher risk premium. Our forecast is lower.
Q: What’s the bottom line?
A: Investors shouldn’t blindly rely on equities to satisfy investment goals. We’re not saying avoid equities; it’s more about understanding the risks.
October 2006
PRICING MATTERS
A new tool measures the true cost of active management.
The results are enlightening, but not necessarily pretty.
By James Picerno
The life of a middling manager isn’t getting any easier, especially if he charges a premium. An ever-growing assortment of software and analytical metrics enhance transparency in the money game, helping investors shine a light on the mediocre funds that aren’t shy about levying high fees. The latest addition to the clarity- boosting arsenal is the active expense ratio (AER), a quantitative gauge devised by Ross Miller, a professor of finance at the State University of New York at Albany and president of Miller Risk Advisors.
AER’s goal is simple enough: Measuring the portion of expenses directly tied to the active investment management. Think of AER as a refined version of the gross expense ratio that’s reported in every fund prospectus and otherwise dispensed by data vendors such as Morningstar. Refining is vital because the gross expense ratio is often misleading when it comes to measuring the true price of active management, Miller says.
The reason is that most actively managed mutual funds harbor some degree of influence from the market. Beta, in other words, is a familiar, and sometimes dominant companion in most actively managed mutual funds. But gross expense ratio puts a price on the entire portfolio, and so by that measure it’s unclear how much a fund charges for alpha delivered, if any.
No longer. In a paper Miller penned last year, he has come up with what he says is a practical solution for calculating the cost of alpha. Titled “Active Expense Ratios and Active Alphas” and available at MillerRisk.com, it outlines “a method for allocating fund expenses between active and passive management and constructs a simple formula for finding the cost of active management.”
In a recent interview with Wealth Manager, Miller summarized the central issue for fund pricing this way: “How much does the alpha cost? It’s not obvious from looking only at the gross expense ratio.”
Crunching the data for Miller’s AER is enlightening, but not necessarily encouraging. For example, at the end of 2004, the paper notes, the mean AER for large-cap equity mutual funds tracked by Morningstar was 7 percent—roughly six times higher than their published expense ratio of 1.15 percent.
The good news is that by outing the real costs of active management, the pressure is growing on funds to shave expenses. Exactly how far any newfound thrift extends remains to be seen, although Miller’s AER has received a fair amount of press over the past year. The publicity, he suggests, has convinced some fund companies to think twice about what they’re charging.
Because Miller’s paper is forthcoming in the Journal of Investment Management, a new round of publicity for AER may be in the offing. To learn more about his formula, we recently caught up with Miller.
Q: What does your active expense ratio measure?
A: It allocates the costs of money management between the passive and active components of a portfolio. You can think of an actively managed mutual fund as having two parts: One portion is comparable to an index fund; the other is an active part. When you buy a mutual fund, you’re buying a package deal—a package of beta and alpha. The active expense ratio measures the costs of the assets that are being actively managed.
Q: How does it work?
A: Let’s say you had a money manager, and all he did was put your money in a domestic stock market index fund, and for that privilege he charged 100 basis points. You’re paying 100 basis points for something you can get for 10 basis points on a retail index fund like Fidelity Spartan. So, our manager is charging something like a 90-basis-point overcharge.
That’s an extreme case. A subtler example is an active fund that closely tracks an index—not perfectly, but closely. Historically, funds that closely track an index have low management fees relative to other types of funds. Nonetheless, the question is, “How do you figure out how much of your money is going for active management and how much to passive management?” That’s a critical issue because money managers often try to reduce tracking error relative to an index. There’s nothing wrong with that, but investors need an accounting of the costs because managers aren’t always doing a lot of active management. A classic case is the PIMCO Stocks Plus Fund, which is basically an S&P 500 index fund with an overlay of Bill Gross’s bond picks. You’re not buying a lot of active management in the fund overall and you’re paying a fair bit for Bill Gross.
None of this, by the way, is an issue of judging the intentions of the portfolio managers running funds. Rather, it’s an issue of accounting for what’s actually happened. The managers could have the best of intentions, but if you find that over a period of time that you could do what the manager’s doing a lot less expensively, money’s going to flow out of his fund.
Q: How is your active expense ratio calculated?
A: The formula has three key variables: The R-squared of the fund you’re looking at against the relevant benchmark; the active fund’s expense ratio; and the expense ratio of the investable index fund that’s an appropriate alternative for capturing the beta portion of the active fund.
Let’s say you have a large-cap domestic equity fund that charges 100 basis points for expenses and is said to be actively managed, but in fact is a shadow index fund with an R-squared of 99 percent against the S&P 500. If you ran the math for dividing beta and alpha out, based on my paper, it turns out that roughly 91 percent of the assets are passively managed and the remaining 9 percent, actively managed. As a result, the active expense ratio is a steep 9 percent.
Q: How do you come up with 9 percent?
A: In my paper, there’s a formula for converting the R-squared, which tells you how much of the variance in the active fund is explained by the benchmark. I convert the R-squared into active and passive shares of the portfolio. You can think of it as separating alpha and beta. That’s the tricky intermediate step that converts the 99 percent R-squared into 91 percent beta and 9 percent alpha in the example I just gave you.
The next step is determining how to replicate what the fund’s doing. Based on the numbers generated by my paper’s formula, 91 percent of the money would go into an appropriate index fund, which you can get for 18 basis points in the Vanguard 500 Fund, for instance. If you put all of your money in this index fund, the total charge would be 18 basis points. But in this example of trying to replicate the active fund, you’re putting 91 percent of the money into the index fund. That works out to a charge of around 16 basis points. In other words, 91 percent of 18 basis points comes to a charge of 16 basis points.
What this means is that for the active fund that charges 100 basis points, you can reproduce the passive side for 16 basis points. That leaves 84 basis points, which is the price of the 9 percent of the fund that’s actively managed. That translates into an active expense ratio of more than 9 percent. So, in this example you’re paying quite a bit for the active management—much more than implied by the gross expense ratio of one percent.
You might also think of the calculation in absolute-dollar terms, which makes the formula easier to understand. Using the same fund example, a $10,000 investment in the active fund incurs total fees of $100—that is, a 1 percent expense ratio. Of that $100, you’re paying $16 for the roughly $9,100 that’s being passively managed. And you’re paying $84 for the $900 that’s being actively managed. It’s that $84 divided by the $900 that’s being actively managed that gives you the roughly 9 percent active expense ratio.
Q: Is your active expense ratio the first of its kind?
A: Yes, and that’s why it’s been so popular. I’ve been at conferences where I’ve had notable economists come up to me and say, “I’ve thought about something like that.” But there are a lot of wrong ways to do it. In the practitioner literature, for instance, people have thought about using the R-squared number, but that approach gives results that don’t make any sense, which is why I modified R-squared in my paper.
Q: What’s the range of active expense ratios for mutual funds?
A: From 1 percent to over 20 percent. The best-case scenario is found with the active funds from Vanguard, like the Wellington and Windsor funds which tend to have active expense ratios in the 1 to 2 percent range. In the next range up are the portfolios from American Funds, for instance, which tend to have a 3 to 4 percent active expense ratio. Above that are the low-fee shadow indexers, which are in the 5 to 8 percent range. For funds with the highest active expense ratios, the typical characteristics are portfolios with an R-squared of 98 or 99 percent and a gross expense ratio in excess of 2 percent.
Q: What’s your take on fees as related to active money management these days?
A: I think people are getting wise to the fee issue, and so it’s putting a lot of downward pressure on fees. There are still plenty of active managers, and there probably always will be. But many investors now see the portfolio process as one of capturing beta and sector exposure through passive investments, and getting alpha through targeted active investments.
Q: Does your active expense ratio work with hedge funds?
A: It’s more problematic if you’re trying to compare hedge funds [because there’s not always an obvious benchmark or because leverage employed can be relatively high.] On the other hand, for a pure hedge fund—one that’s uncorrelated with the markets—its overall fee is the active expense ratio. That’s because with a hedge fund that’s pure active management, what you pay is only for active management.
Q: What are the caveats to using your measure?
A: Within the current mutual fund world, the active expense ratio does just fine. But like any other measurement—alpha, Sharpe ratio, whatever—the simple form of my active expense ratio is something that a clever manager can game because a clever manager can game any performance measure.
Looking backward, however, the active expense ratio is a great tool because no one knew it existed. But the world is changing, and funds are being punished for being shadow indexers. If you look at the funds that are working on becoming more active, they’re not necessarily more active in absolute terms; they’re just more of a hybrid. As a result, Morningstar is going to have to start abandoning its single benchmark approach. Instead of asking what it costs for a single benchmark, the question’s becoming: What does it cost to reproduce the package of benchmarks? For a fund that engages in active asset allocation, my method fails; in fact, pretty much all of portfolio analysis method fails for that hybrid approach.
Q: Is that because there’s no obvious benchmark?
A: Right. I was sensitive to that from day one, because back when I worked in asset management, I was head of research for a family of products that involved sector rotation and country rotation. There was no fixed benchmark. If you performed style analysis on the portfolio, the results changed every month. But the number of funds like that currently is still tiny.
Q: Is it fair to say that the value of your active expense ratio is dependent on having a reliable investable benchmark?
A: Right. You need to have something that’s a passive alternative that consists of one or more investable indices.
Q: If mutual funds managers are targeting more than one benchmark, the challenge of coming up with a good investable index becomes tougher.
A: Yes, but the same is true for any performance analysis.
October 2006
A HIGHER STANDARD
A new mutual fund redefines hedge
fund investing for the masses
By James Picerno
Geronimo Financial is a small money manager with a big idea: Tear down the barriers for hedge fund investing. Not just a little, but all the way. A tall order, to be sure, but one that Geronimo claims it offers with a recently launched mutual fund, the Geronimo Multi-Strategy Fund (GeronimoFunds.com).
Bringing hedge funds to the masses is an idea that’s been around for a while. But the results have been mixed when it comes to delivering the hedge fund space writ large in one portfolio that’s both affordable and representative of the alternative funds world. Taking a fresh shot at the challenge is the four-yearold Geronimo Financial, which specializes in privately managed absolute-return investment strategies.
The Denver firm recently expanded into the world of mutual
funds, which is good news for investors who are looking for an
expansive definition of hedge funds in one package. Geronimo
Multi-Strategy is a noteworthy addition to the small but growing
niche of alternative investment mutual funds. Indeed, Geronimo
Multi-Strategy sets a new standard for advancing the concept of
democratizing hedge fund investments. The fund’s most impressive
feature is its diversification across eight broad hedge fund
strategies, each represented by dozens of existing hedge funds
chosen by HFR Inc. for its HFRX Equal Weighted Strategies Index,
an investable index-platform previously available only to institutional
investors. The fund also features:
* Low minimum investment of $1,000
* No net-worth accreditation hurdle for investors
* Daily liquidity and pricing
* Performance-based fee structure
* Daily monitoring and analysis by HFR of the managers in the index
It’s too soon to pass judgment on a fund with less than a year of history, but Geronimo Multi-Strategy is clearly an intriguing newcomer that could ultimately set a new standard for publicly traded alternative investments. Indeed, others have tried to make multi-strategy hedge fund investing more affordable and accessible, but the growing pains have been considerable. For one notable example of what has gone wrong, stir the ashes of the now-defunct products tied to the S&P Hedge Fund Index. In June, Standard & Poor’s stopped publishing the benchmark—a victim of the blowback from Refco, the derivatives broker that collapsed last year. As a result, products benchmarked to the S&P Hedge Fund Index have been forced into early retirement, including the Rydex Sphinx Fund, a publicly registered fund that succumbed.
Even among the new generation of hedge fund products that are currently available, there’s plenty of grumbling about portfolio design. In some cases, critics say that the manager choices are unimpressive, or that portfolios are relatively undiversified. In other funds, they find liquidity to be limited, or that investors must be relatively wealthy in order to buy shares.
Still, there are choices to consider, and they’re growing in number and sophistication. Rydex, for instance, rolled over the remaining Sphinx assets into the firm’s Absolute Return mutual fund, a new quantitatively managed portfolio that replicates a mix of hedge fund strategies with derivatives and various trading techniques. In fact, there’s a lengthening list of mutual funds focused on one or more hedge fund strategies, such as long/short and market- neutral. According to Morningstar, 39 long/short mutual funds were plying the investment waters at mid-point this year.
It would appear that Geronimo Multi-Strategy is just one more addition to an already established field. But while launching a “long/short” mutual fund is old hat these days, a closer look at the Geronimo portfolio suggests that it’s a bit different after all. While it remains to be seen if Geronimo satisfies as an investment in the long run, it is a new yardstick for bringing multiple hedge fund strategies to the masses in a single fund.
The fund’s architect is David Prokupek, CEO and CIO of Geronimo Financial, which he founded in 2002. Most of the $350 million under management at Geronimo Financial resides in privately managed accounts, but Prokupek embraced a wider audience in January when he launched three mutual funds: Geronimo Sector Opportunity, a long/short fund; Geronimo Option & Income, a market- neutral strategy; and Geronimo Multi-Strategy, which has the broadest scope of the three.
Geronimo Multi-Strategy is essentially an enhanced hedge fund index, with HFRX Equal Weighted Strategies Index (HFRX) serving as the index and Prokupek’s management delivering any enhancement. Prokupek, who was formerly president of the capital markets group at investment bank Tucker Anthony Sutro, recognizes the challenge of trying to second guess a broad-based multi-strategy hedge fund index like HFRX. In deference to the risk, Geronimo Multi-Strategy’s returns will be primarily driven by HFRX over time, he says. His attempts to enhance the benchmark’s returns will play a secondary role with manager and strategy selection. For example, Prokupek explains that he may overweight certain managers, or underweight a strategy, relative to the HFRX mix. Prokupek can also adjust the fund’s allocation to HFRX overall, depending on his outlook for hedge fund strategies.
The overall goal is producing so-called absolute returns by tapping into the broad landscape of hedge fund strategies and tracking or exceeding HRFX’s returns. Historically, the multi-hedge fund universe has produced returns of roughly LIBOR plus 300 to 500 basis points, he says.
With so much riding on HFRX, the first order of business for assessing Geronimo Multi-Strategy is reviewing its benchmark, which equally weights among eight HFRX sub-indices, each targeting a particular hedge fund strategy, such as convertible arbitrage, distressed securities and relative value (see hedgefundresearch.com for details). In all, some 80 managers are included in the HFRX index.
The ability to access HFRX’s manager lineup is a breakthrough for a mutual fund, says Prokupek. Although there are competing mutual funds that hold multiple hedge funds, Geronimo—courtesy of HFRX—distinguishes itself by exposing assets to the performance results born of dozens of managers. By contrast, Alpha Multi Strategies—a competing mutual fund—recently was using nine hedge fund managers as subadvisors. There’s nothing wrong with that, Prokupek says, but it’s a different, more narrowly focused approach, and shouldn’t be confused with Geronimo Multi- Strategy’s grander ambitions.
In addition to quantity, Prokupek emphasizes the quality of the hedge fund managers in the HFRX index. The Chicago-based HFR is really two companies: HFR Inc. is the database and research division; HFR Asset Management offers an investable hedge fund index platform to institutional investors. Geronimo’s partnership with HFR allows the Multi-Strategy Fund to tap into the returns streams from dozens of hedge funds in an investable-index platform designed for institutional investors.
Opening a portion of HFR’s platform to anyone, for a nominal sum, is a considerable achievement in the annals of hedge fund investing, says Bill Santos, senior managing director of business development for HFR Asset Management. “The fact that you now have the ability to access these 80 or so institutional-quality hedge fund managers in a mutual fund structure, with daily liquidity, with a $1,000 minimum, and no accreditation is big news,” he adds.
However, the transmission of HFRX’s hedge fund returns to Geronimo Multi-Strategy is a bit circuitous, coming by way of swaps, or privately negotiated derivatives contracts. Geronimo Multi-Strategy doesn’t invest in the HFRX funds directly. Ownership of so many hedge funds would be problematic for a mutual fund for a number of reasons, including liquidity constraints and calculation of net asset values on a daily basis.
Geronimo gets around the obstacles with an innovative backoffice strategy of tapping into HFR’s platform through the magic of financial engineering. The fund receives the associated performance of the index by way of total-return swaps. The bottom line: Several financial firms contract to deliver the related gains or losses to Geronimo’s fund. As of this past May 31, for example, 39 percent of Geronimo Multi-Strategy’s net assets were in swaps issued by investment banks IXIS Corporate & Investment and Barclays Capital.
By mutual fund standards, Geronimo Multi-Strategy doesn’t come cheap, with a gross expense ratio that can rise to as much as 3 percent for I class shares available to wealth managers. That looks pricey if you consider that most of the domestic stock funds in Morningstar’s database charge less than 2 percent. Then again, Geronimo’s expense ratio is slightly below the 3.24 percent average for Morningstar’s long/short fund category. And by hedge fund standards, where 2-and-20 pricing is common (2 percent of assets and 20 percent of any profits), Geronimo’s fees are a bargain.
Meanwhile, fans of incentive-based pricing will find reason to cheer Geronimo Multi-Strategy’s dynamic fee system, which is one of the more ambitious in the mutual fund world. The fund’s basic management fee is 1.25 percent, but that can fluctuate, based on whether the fund’s returns exceed the Merrill Lynch Three-Month Treasury Bill Index over the preceding 12 months. The management fee will stay at 1.25 percent as long as the fund’s performance is within a band of plus or minus 200 basis points of the Merrill Lynch T-Bill.
If performance rises above that 200-basis-point band, the fee increases; if performance drops below the band, the fee drops. Overall, the management fee can range from 0.25 percent to 2.25 percent, and so the gross expense ratio can vary from 1.0 percent to 3.0 percent for the I class of shares after adding the fixed 0.75 percent “other expenses” component.
For investors who are convinced that owning a wide sampling of hedge fund strategies is a worthwhile addition to an asset allocation strategy, Geronimo Multi-Strategy promises to be a favorite. The larger question is whether hedge funds will live up to the hype in the long run and materially improve the risk-reward profile of a traditional stock/bond/cash portfolio.
All the innovations in the world don’t change the fact that it’s too early to make definitive conclusions about hedge fund performance generally. The products have precious little performance history for making the kind of sweeping judgments about the past such as those dispensed in the name of equity and fixed-income indices. Financial engineering continues to impress, as Geronimo Multi-Strategy illustrates. But some questions about portfolio strategy can only be answered with time. Even though it’s becoming easier to own hedge funds, the jury is still out on the long-term merits of hedge funds in context with other asset classes.
September 2006
MINTING MONEY
Rare coins are a hobby, but are they a good investment? Yes, says
one investment strategist with the numbers to back up his claim.
By James Picerno
The quest for superior risk-adjusted portfolio returns knows no bounds in the 21st century. Investors routinely look beyond the traditional mix of stocks, bonds and cash. Commodities, hedge funds and private equity are among the more popular choices in the search for alternative asset classes. The amorphous category of art and collectibles is also gaining attention. Does that mean that rare coins are worthy of a spot in strategic asset allocation?
The question invariably leaps to mind after reading a recent study by Robert Brown, chief investment officer in the Encino, Calif. office of Genworth Financial. After crunching data on 62 years of price history through 2003, Brown concluded that rare coins are “a highly attractive complementary asset category that even with a small allocation provides good diversification for a well-diversified portfolio...,” according to his study, published in August 2005 on the Journal of Financial Planning’s Web site (“Rare Coins: A Distinct and Attractive Asset Class").
Recently, Brown updated the research, adding two additional years of performance data through last November. The long-term performance record still looks impressive. His proprietary index of rare coins posted a mean 9.8 percent return for the 64 years through the end of November 2005. That compares with 12.2 percent for the S&P 500 and 5.6 percent for long-term Treasury bonds, the study reports, although on a risk-adjusted basis, coins ranked higher than stocks as well as bonds.
His yet-to-be-published follow-up paper takes a step beyond its predecessor’s mandate by identifying the main variables driving rare coin prices, the author explained in a recent interview with Wealth Manager. Three factors stand out, says Brown, a CFA who earned a Ph.D. in finance from Northwestern. The leading driver is economic growth, followed by long-term Treasury bond returns, with silver prices in third place, he says.
Brown—a private coin collector himself—advises that the collectibles represent “a critical component of my wealth management solution.” As CIO of Genworth, however, he cannot recommend rare coins officially. The reason? The firm isn’t prepared to make collectibles recommendations—at least not yet.
But for advisors inclined to put a slice of client portfolios into the likes of an 1808 large U.S. cent (among Brown’s prized pieces), Genworth’s CIO offers ammunition to the case for using rare coins in asset allocation plans.
Q: Why did you revise your earlier study?
A: Two reasons: First, I updated the data, which adds two more years of numbers, with performance through November 2005. I also focused on causality from the standpoint of drawing conclusions about what drives rare coin prices, and under what conditions rare coin investments do well. The results are somewhat instructive [in that] there appears to be an explanatory connection between rare coin prices and three variables: How fast the economy’s growing, performance of long-dated bonds, and the inflation-adjusted behavior of precious metals, measured by silver.
Q: How did you determine that those three variables are so influential?
A: Simple statistical tests. Initially, I looked at about 25 explanatory variables. Most were asset categories, along with some economic variables like population and gross domestic product per capita.
The three that came out on top were the statistically strongest variables. And in my mind, they fit with intuition.
Rising GDP, for example, makes sense. The faster the economy’s growing, the more wealth there is for investing in collectibles. And vice versa. If a recession or depression hits, you’d expect a pullback in the wealth available for collectibles.
As for long Treasuries, if interest rates are relatively high, and bonds are doing well and posting solid returns, people are going to start viewing bonds as a practical alternative for their wealth. In turn, that pulls money away from collectibles.
The third component driving rare coin prices is precious metals, which I suppose is a proxy for people looking for physical assets instead of securities. And silver usually dominated gold in this respect.
Q: Why is that?
A: Perhaps gold reflects other phenomena, like fear factors, which is a confusing element [for analyzing rare coin prices] and so I didn’t use it.
Q: So silver is a superior predicator of rare coin prices over gold?
A: Yes, clearly so.
Q: What about equities? How do they fit in, if it all, to your model?
A: I was expecting that equities would appear with an inverse relationship to rare coin prices. That is, when equities did well, they’d take assets away from coins. But the data didn’t support that assumption. During an isolated time period, sure, there’s a seeming relationship. But it’s not there over the 64-year period I studied.
Q: What’s the worst-case environment for rare coin investing?
A: A period similar to 1980-1993, for example, when interest rates kept falling. Those years generated larger and larger profits for bonds because fixed-income securities prices appreciated as inflation kept surprising on the downside.
Q: Does that mean that rising inflation helps rare coin prices?
A: I looked at whether inflationary surprises on the upside do a better job of predicting, forecasting or directing rare coin prices. The answer is no. Bond returns did a much stronger job of directing rare coin prices.
Q: What’s the bottom line for rare coin investing?
A: First, you want a robust economy—rapidly growing, ideally. You also want rising interest rates because it undermines the opportunity cost because you’re probably losing money on bonds. And you’d like to see investors focus on physical goods. When you have those three things conspiring, historically that’s when rare coin prices have done their best.
Q: Are you surprised by your latest findings?
A: Before I saw any of the results, I was fairly neutral on the whole thing. Before running the statistics, I expected that inflation, inflation expectations, or inflationary surprises would be one of the leading variables, but they weren’t. There were other surprises, too. I was surprised by how high the returns were for rare coins versus other asset categories. Over the 64 years through last November, rare coins had a considerably higher return per unit of risk compared to about two-thirds of the other asset categories I studied.
Q: In your study, one-year Treasuries post the best return/risk ratio in your ranking of 18 investment categories. Your reaction?
A: Short-term Treasuries did so well because their risk level is so low. Those Treasury returns are higher than their standard deviation, and that’s why they look so good. That doesn’t mean you should build a portfolio only with one-year Treasuries, because if you do, you’ll end up giving up much on the return side.
That said, rare coins not only have a very favorable return per unit of risk; they also have a fairly high absolute historic return: 9.8 percent a year over time on a geometric basis. I was surprised at how high rare coins returns were.
Q: How did you build your index of rare coins?
A: I used prices published in the so-called ‘Blue’ and ‘Red’ books [The Official Bluebook Handbook of United States Coins and A Guide Book of United States Coins, respectively] as far back as they went, which is to 1941. For each year, I took a sample of 650 coins. The universe was equally weighted by coins, and it was redefined each year based on what was in the next book. I chose the highest grades of coins available in the books for each year. To oversimplify, my index is made up of the 650 non-gold coins that represent the highest quality coins across the various denominations. I excluded gold because I didn’t want any confusing element from gold pricing.
Q: Does the fact that your rare coin index performs impressively over time suggest that investors should own rare coins?
A: Yes, but with some qualifications. The first is that someone should ask the question, ‘Why on earth are rare coins generating these kinds of returns and with such consistency?’ I think it comes down to the fact that we’ve got robust economic growth, and as long as that continues—a reasonable presumption—then you can check that box. The other issue is that there’s a serious question regarding acquisition and storage costs, along with the information required to build a coin portfolio. Acquisition costs are significant.
Q: Define acquisition costs.
A: How much you have to pay for a coin over its fair-market wholesale value. And that mark-up can be fairly high. There’s nothing wrong with that, but it says something about your holding period; it has to be considerably long in order to justify the acquisition cost. In addition, there’s the information hurdle. One either has to have the knowledge base or work with people who have the knowledge base to go after the attractive opportunities.
Q: Then does all this suggest that investors should steer clear of rare coins?
A: Sometimes I hear the comment that the acquisition costs are so high, and the information so difficult to acquire, that it makes rare coin investing unpalatable. But I think the two are connected. One of the reasons that the acquisitions costs are relatively high is because if you’re doing this right, part of what you’re acquiring is the knowledge base. That means that you find the dealers with the knowledge, the connections, the ethics, the pricing, and so they’re the agents working on your behalf. Yes, there’s a search process involved, but I’m not sure it’s any different than building a portfolio of rental properties. You’d have to go out and get expertise and pay fairly for it. I’m not sure collectibles are any different.
Q: What’s your recommendation on holding periods for rare coins?
A: There are two issues. One is, what point in the cycle are we in? The other, what’s the time horizon? Rare coins had a rough time from 1980 to about 2003. That made for a marvelous entry point. Since then, there’s been a shift of attention toward physicals, as expressed by the rising prices of precious metals and real estate. But even if you buy at the right spot in the cycle, you probably still want to wait a dozen years or more before selling because of acquisition and disposal costs.
Q: As we speak, in the middle of 2006, is it still a good time to buy coins?
A: Yes, absolutely. If one asks, ‘Is the cycle with us or not?’ It certainly is neutral, and probably still favorable.
Q: How long have you been collecting coins and how did you get interested?
A: I’ve been collecting for about 25 years. Collectibles has always been an interesting area. And in my position as chief investment officer, I’m always asking the question, ‘What are the asset categories, how do they behave, and what are the alternatives?’ [Coins] started purely as a hobby for me, and now has progressed to being a critical component of my wealthmanagement solution. I see it as part of the retirement game.
Q: How big a share are coins in your overall investment portfolio?
A: About 9 percent.
Q: What’s one of your more prized coins?
A: It’s probably an 1808 large U.S. cent, in very nice condition.
Q: As chief investment officer of a financial planning firm, are you recommending that clients put money into coins?
A: No, because we haven’t structured ourselves to make that a product offering. Our business model is working with advisors, as opposed to the end clients. We provide turn-key, client-ready wrap accounts, investment solutions to our advisor clients, including broad asset allocations using mutual funds, ETFs, and individual stock selection through outside managers.