Disruptive Investing

Exchange traded funds (ETFs) are all the rage. They come large and small, long and short, ultra and supersized, and track just about any sector, geography, investing style or commodity you can think of. The great thing is they trade like stocks yet share some of the characteristics of mutual funds (without the massive overhead some mutual funds carry). ETFs are baskets of like stocks in a particular industry or region or index, and so, if you think for example high tech is going to take off, rather than study and research for which particular stocks to buy, jump on a high tech ETF and enjoy the benefits of spreading out your bet. You might not get as high a return as you could have with that one perfect stock pick, but then again, you have to be a really good stock picker while also bearing the risks of a less-diverse portfolio. Some say ETFs have lower overhead than mutual funds and perform just as well, because of the reduced fees. Some even say during down markets ETFs fair better t...

Figure 1 (click to enlarge) Now, we have defined mutual funds as digital assets that can be distributed thru a virtual network, from source where the value is created and managed, to the retail investors where payment of fees is made (plus information about self is granted) in exchange for that created / perceived value, via the wholesalers, distributors, financial advisors and institutional investing networks. But not all is simple, mutual fund managers must navigate a stormy sea of: • Redemptions (clients departing) • Performance (NAV decreasing, Cap gains & Dividends decreasing) • Risk (volatility increasing) • Asset Allocation (what’s the right mix?) • Modeling (efficient frontier “what ifs”) • Competition (perception of better & best) • Disintermediation / Transparency? • Reputation (least worst performing?) • Future? - How will they perform relative to their peers and other assets such as Hedge Funds and ETFs (Exchange Traded Funds)? – Independent scoring of “Diversificat...

Figure 1 (click to enlarge) The mutual fund industry consists of a complex web of connections, many to many relationships, wherein information is exchanged for value. Dissecting each class of member in this diagram, you can imagine what type of information trades for what types of value. Value is created at the source, where mutual funds are generated and managed. Better fund cosntruction results in better value. Skilled fund managers tend to attract more assets under management (AUM). Even unskilled fund managers can too, if they have really good marketing, and good distribution via the channels. Skilled and unskilled investors gain access to that value thru a variety of channels, and are willing to pay management fees for that value. Some call this value "alpha", that is, the amount of return gained above what the market would otherwise bear. We can't forget risk, so investors are also 'buying' a certain degree of mitigation of risk which is another form of v...

We usually think of assets as stocks, bonds, bank accounts, real estate, mutual funds, and other securitized instruments. Stocks are documents that grant rights to their owners, rights that relate to a particular company. • Companies are legal entities recognized by federated corporations (countries, states, municipalities, each other, persons, …) – Hard assets (equipment, factories, …) – Soft assets (processes, patents, secrets, …) – Operate in uncertain markets, thus have risk – Risk needs to be divided and shared, to reduce it • Companies thus sell financial instruments (virtual assets, ideas) – Stocks and Bonds, for “Cash” or “Credit” • Cash is a Promissory note to pay some form of value (capital) • Value is “created” by the signatures of the executors – Exchanged for either “shares” or “promise of coupon” – Shares pay dividends and / or have “growth” – Bonds pay interest and have “stability” – Promise of future performance determines market value of inst...

It’s not enough to say you’ve mitigated all your risk in the face of present economic change, but one must be able to quantify, measure and modify it often, in order to stay on the maximum potential return of a chosen portfolio strategy over time periods. Note the emphasis on the plural. The dilemma, to maintain a selection of quality assets on a portfolio's efficient frontier that add incrementally more return while not adding more risk. The problem is that flushing out risk can bring you closer to the market average. Risk-based portfolio optimization schemes, such as Mean-Variance Optimization (MVO) can suffer from unintentional mistakes (decisions made) because MVO tends to weight the historically higher returning assets more heavily, at the expense of ignoring potentially higher returning assets looking forward. In other words, there may be a greater chance that a great performer may no longer perform great, and alternative assets could add a higher return while decreasing the ...

Risk is difficult to measure and to manage. ETFs and indexes exist that provide performance averages. Mutual funds suffer from overhead and management costs, loads and redemption fees. When investors are paying fund managers to reduce risk, minimize volatility and maximize returns, and they realize an industry average, index (which has no management), or T-Bill has bettered their fund, they should be upset. They have experienced an opportunity loss while taking on excessive risk, and while paying people to manage that risk. We could use a backward looking lense to hopefully get a projection of what future performance or risk-adjusted returns might be. But, people cannot make informed decisions because they cannot truly know past risk, present risk, and more importantly future risk. As the economy changes and as individual assets within a portfolio change, daily, one must have a means of contemplating different asset allocations based on reality and make necessary adjustments to maximiz...

Risk is hard to define and even harder to measure. Because you can’t manage what you can’t measure, you cannot manage risk. You can only attempt to weed it out. Various selection processes and trading tactics can help reduce many types of risk. What is a useful definition of risk as applied to mutual funds? It is the probability of or chance of the loss of capital. It is this probability and its potential causes that create so much trouble. People disagree on what to measure and further can’t agree on how to measure it. Do we use standard deviation, semi-variance, maximum drawdown, value at risk, downside deviation or estimated tail loss? Do any of these truly explain risk or account for it completely? This places investors in jeopardy of loss of capital, because they’re placed into positions of risk they do not understand. Without understanding there's no plausible means of managing money effectively. This means there's always a chance of loss of capital, no matter how well co...

Making money today is not easy, and managing money successfully is even harder. With the global financial and economic crisis in full swing chief investment officers of mutal fund families, mutual fund managers, and their analysts must navigate an incredibly stormy sea. It is global and it is pervasive and is affecting every asset class. New regulations, reporting requirements, ethics, moral hazard and other non-core activities weigh on the ultimate time and focus available for optimizing mutual fund portfolios. Everyone is concerned with risk, volatility, diversification and the performance of their money relative to other potential investment choices. Mutual fund managers must retain existing clients, attract new clients, and avoid the "run-on" issues of mass redemptions that severely cripple the NAV of their fund(s). How to rebalance? What equities to buy? Which ones to sell? When? Which add to returns while also reducing risk? These questions and other problems can be ame...

EARN MORE! RISK LESS! Diversification weighting, is a product of diversification optimization (of a portfolio). Allocation weights can be determined by the extent to which an asset adds uniqueness to a portfolio. Some studies show that using diversification weighting, rather than risk-based weighting, or capitalization weighting, could improve relative performance while decreasing portfolio volatility.

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