Media Gets it Wrong on Active Management… Again

In a recent “Your Money” column in the New York Times, John Wasik did a great job of delivering the status quo message about portfolio expenses. He reminds us that John C. Bogle, Founder of the Vanguard Group, and many others, have performed studies that demonstrated that active managers cannot beat a passive index because of the fees charged in actively managed funds. He reminds us that these consist not only of the well-known and often discussed fees in a fund’s expense ratio, but also include ‘hidden’ fees like the cost of managers who leave too much money in cash (which does not earn market returns), and fund transaction costs. The article goes on to mention a recent paper by William Sharpe, the Nobel Prize winner this year in Economics, who compared the expense ratio of Vanguard’s Total Stock Market Index Fund to a more expensive actively managed fund, and found that the costs of active management were $2,000 for a $10,000 investment over ten years.

The Shutdown is Over, So What Now?

With the end of the government shutdown and the lifting of the debt ceiling, it’s time to review how we’ve positioned Pinnacle’s portfolios. First, our stance has been that the political impasse was mostly noise — that’s why we didn’t pull volatility down over the past few weeks. Washington’s politicians waited until the last minute, hoping to force some policy concessions, but had to acknowledge the practical reality that making a deal was better than the alternative.

How to Make Money at Neutral Volatility

Lately I have participated in several discussions about how to make money at “neutral vol,” or when Pinnacle portfolios are positioned to have roughly the same volatility as our benchmark portfolios. A good starting point for the conversation is to analyze the total equity positions we own in the portfolio versus the neutral allocation to equity in our benchmark portfolios. In Investment-Speak, changing the overall portfolio risk posture by underweighting risk assets is called a “beta trade.” We are reducing the portfolio allocation to market risk.

A Turning Point in the Market?

Inflection Point: (N) – Mathematics – A point on a curve at which the curvature changes from convex to concave or vice versa.

In describing our current thinking, I have to resort to an investment writing cliché where the financial markets are described as being “at an inflection point.” While the mathematical definition for an inflection point is presented above, in the business of investing inflection points occur where there is a change in the long-term trend or momentum of the financial markets, economy, or price of an individual security. Inflection points are critically important because if you recognize one and if you understand the significance of the change, then you can make a lot of money.

The Quantitative Picture Gets Brighter

Back in June our proprietary quantitative model gave us a warning signal by dipping below the neutral bracket into what we consider mildly bearish territory (see the red line in the chart). The fact that the external models we follow were also behaving similarly had us somewhat concerned. However, that turned out to be a brief signal, as the model quickly reversed course and crossed the neutral bracket in just a few weeks, landing in mildly bullish territory last week. The message was again confirmed by the external models, which all turned up over the past couple of weeks.