A Return to Long Horizons

02/01/2007

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The information revolution slashed transaction costs and transformed investment strategy.   “We do everything we can to get the best information.” It’s a common declaration of savvy money managers, and the information revolution has made this an extremely cost effective task for many. From strategic-minded business leaders to discerning consumers, the slogan ‘knowledge is power’ has become a self-evident precondition in financial success. But the real power of knowledge lies in how it’s applied, and that’s what separates winners from losers. By empowering high-churn money managers in the late nineties, broadband Internet revolutionized the financial markets and the business of investing. Rapid-fire trading produced eye-popping results and a new breed of Wall Street leadership. Market fortunes, however, once again favor the go-slow approach of Benjamin Graham, as pervasive information accessibility makes once scarce critical real-time information for one trader an easy achievement for thousands of his competitors. The benchmark is no longer the market index: It’s the performance of that newly minted billion-dollar fund downstairs on the fortieth floor, or the dozen in the building next door. As prospective shareholders begin to rank money managers more by peer performance and risk-return conditions continue shifting against portfolio churning, margin-of-safety will replace absolute return as the buzz-phrase of the next five years.   First introduced in Benjamin Graham’s and David Dodd’s seminal work Security Analysis (first published in 1934), margin-of-safety desribes the difference between a stock’s intrinsic worth and its market value. Seth Klarman borrowed the phrase for the title of his 1991 book, and added the notion of absolute return in addition to several wise observations on investing. Now out of print, Mr. Klarman’s book commands prices on Amazon.com of between $1,500 and $2,500 (speaking of good investments!). Rank and file value-investors dutifully covet both works, the majority of whom commit to multi-year time horizons. This article addresses transaction costs as a critical economic force. Whether software development or pharmacy claims adjudication (as discussed on these pages and in our various events), these costs have steadily declined, with significant benefit to the overall economy. Share trading provides one of the clearest examples of how this cost factor reflects an momentous period for the entire economy. Measuring in risk/return and time, we show a significant transition to more deliberate action.   ☆ ☆ ☆ Momentum behind trading-driven investing began accelerating in the late 1990s, with Wall Street’s (and Main Street’s) full embrace of the Internet and its capacity to deliver relevant, instantaneous information. Broker-dealers (“B/Ds”) quickly invested billions of dollars in online trading systems and information delivery.   Between 1995 and 2006, the total number of Internet users grew from 16 million to over one billion, and the number of Web sites with domain names and content from 18,000 to over 100 million. Latching onto the Web’s emergence, market centers such as alternative trading systems (“ATS”) or electronic communication networks (“ECNs”) became viable alternatives to traditional stock exchanges following the 1998 court decision against Nasdaq market-markers. They hastened price competition, and quickly gained market share (now over 60 percent of all over-the-counter stocks from just a few basis points in 1997). More recently, crossing networks have appeared. By sidestepping the process routing an order to an exchange or market center, these systems allow institutional investors to trade directly and anonymously, often across international markets. Liquidity, however, can be problematic depending on the security. Examples include Liquidnet, Posit and Pipeline Though a contributing factor too, expanding computer hardware and software capability has been much more anticipatory than the sudden surge in Internet-driven information. Computer systems, after all, are only as effective as the information available to analyze. The result: extreme compression in investment horizons, with increasing numbers of money managers trading for sixteenths (decimal points from 2001) over days or even minutes. The information revolution fundamentally altered the practice of money management, with commission reductions and the rise of absolute return investing becoming its consequences, rather than its drivers. Simultaneously connected, portfolio managers could better assess a data point’s validity, especially those who could act on its immediacy. Imagine a world without your Blackberry – now imagine it without any form of electronic communication. Better performance on better information attracted shareholder dollars. Greater buy-side power, whether under the guise of alpha or absolute return, then augmented market liquidity: sell-side transparency rose and transaction (or trading) costs declined. While the Internet unexpectedly advanced the quality and quantity of information, its success is now commoditizing information as access points proliferate and costs decline. Together with government regulation (fair disclosure and Sarbanes-Oxley), information’s evolutionary surge has turned to level the playing field – at least for those playing the trading game. Churn and burn Between 1995 and 2006, mutual fund turnover (the rate at which funds replace their portfolios, with 100 percent equaling a complete replacement over a twelve month period) slowed from 71 percent to 47 percent on an asset-weighted basis, while turnover on the New York Stock Exchange (“NYSE”) jumped from 59 percent to 102 percent, and over 110 percent in recent months.   Applying ownership levels and typical manager characteristics, we estimate an underlying turnover rate of 300 percent in today’s market. Mutual funds hold about 20 percent of corporate equity, according to the NYSE. Pension funds and insurance companies make up another 30 percent. Both represent longer holding periods than mutual funds, but we assume identical periods for this exercise. Households, bank personal trusts, foreign funds and alternative investment vehicles comprise the remainder. Assuming half of these match the mutual fund level and the NYSE turns over at its current 110 percent rate, 25 percent of market participants buys and sells its portfolio every four months. If we use the same framework for the 1995 market, this segment then bought and sold its portfolio only once every four years. The eleven-year period, therefore, witnessed an impressive twelve-fold increase in turnover. Of course, there are several moving parts to this analysis, and we do not pretend to be precise, but the trend is patently obvious. Trading costs A byproduct of the shifting balance between buy-side and sell-side trading desks, declining trading costs (down more than 25 percent from 1998, according to an Elkins/McSherry study) have contributed significantly to rising market activity. [Elkins/McSherry is a leading trading cost consultant, monitoring costs for many of the world's largest pension plans, investment managers and broker/dealers.]   The chart above breaks down global trading costs as commissions (broker fees), fees (exchange fees) and market impact (the price change between the broker’s receipt of an order and its execution of that order). Key factors include market transparency (price discovery) and liquidity (number of participants). Market impact as a percentage of total costs is down eight percent from 1998, 14 percent from the 2000 to 2002 period, and 20 percent from its 2000 peak – corresponding with a pronounced downshift in market volatility. NYSE and Nasdaq trading costs have fallen by more than 40 percent – due in large part to market impact (see volatility section). [The 2001 and 2006 cost levels for NYSE and Nasdaq were 29.2 and 37.9, and 17.51 and 20.66, respectively. A fairer comparison would be between similar volatility periods (in this case, low to low), but we do not have the data.] Elkins/McSherry described the shifting market relationship between the buy-side and sell-side in an August 2006 press release: “Brokers are slowly becoming technology and liquidity providers as buy-side desks are demonstrably adding greater value to the investment process. For the typical $10 billion dollar money manager with 100 percent turnover, a five basis point reduction in trading costs is equal to $5 million in increased returns to investors.” Although we don’t anticipate commission rates rising, the rate of deceleration could abate if performance mean reversion persists, and trading-driven investing dissipates as a market force. During a frenzy of mass poor-performance, we would, not doubt, an outcry for lower rates, but this would moderate as the worst performers shut down. For slow turnover money, cost is a less factor, and therefore less of a bargaining chip with the sell-side (assuming execution, not research, is the dominant reason for interaction).   Large low-turnover fund complexes with several hundred billions of dollars under management can exert their sheer size to force downward pressure on rates, although we expect this would vary depending on volume: A 60 percent turnover strategy, for example, would generate four times the commission volume of a 15 percent strategy on the same asset base – all things equal. The move toward unbundling (vendor cost transparency) has reinforced execution as a market force on commission rates. Prior to new soft dollar rules, investment firms could compensate B/Ds with commission dollars for a range of services beyond just trade execution – a practice now limited to research. The questions now become: What’s the value of research relative to execution? How much research value do executing (full-service) B/Ds generate? How much execution value do full-service B/Ds offer relative to execution-only services? Price discovery, of course, varies by stock exchange or market center, with developing countries typically more sensitive to liquidity balances than developed ones (the ratio of foreign to domestic investors). Liquidity affects market impact, and the overall cost of trading – why investors require vastly higher risk compensation in Colombia than Japan, for example. The table below illustrates how portfolio turnover affects investment performance, net of trading costs and management and performance fees typical for alternative investment strategies.   Mutual fund fees may or may not include a load charge at entry or exit. This can be as high as 5.75 percent. Management fees range between 70 and 150 basis points. Performance fees are rare. This analysis does not include the effect of leverage or taxes.   Trading costs vary not just by market, but also by broker-dealer, who negotiate rates based on several different factors including market-maker capability, order size, liquidity, and market information and communication (the relationship between broker and client). We assume an aggregate level of 20 basis points, including market impact and exchange fees – slightly higher than the current NYSE cost of 17.5. For the purpose of comparison, we also assume that each fund produces a similar dollar volume of commissions. Broker rates would otherwise vary, normally favoring the higher volume client. Risk-return payoff As described in past issues, risk compensation – the rate at which the market rewards risk taking – varies over time. Shareholders can adjust their fund exposure according to the holding period, depending on underlying conditions. Although the market has favored high turnover strategies in recent years, the chart below shows long-term investors performing best over the ten-year period.   The chart’s values equal the compounded return of the daily four-year, one-year, and three-month moving average of risk compensation between January 1994 and January 2007, with a beginning level of one. We define risk compensation as market return per unit of risk, and calculate it by dividing the daily level of the VIX index (closing prices) into the daily percentage change of the S&P 500. This metric captures market expectations of risk-return, and more accurately portrays market dynamics than either variable by itself. It also provides a means to anticipate shareholder money flows by estimating future performance, where those funds achieving higher risk compensation have a greater probability of outperforming. Using the S&P 500 allows us to assume a generic money manager that reliably beats 70 percent of its competition. It also captures about two-thirds of total stock market capitalization.   The majority of active managers underperform the blue chip benchmark on any given year, with even worse odds for mid- and small-cap investors. See Standard & Poor’s January 17, 2007 press release, “Year End Index Versus Active Scorecard.” In 2005, total US market capitalization was $17 trillion versus $11.2 trillion for the S&P 500 (sources: IMF, Standard & Poor’s). We assume too that turnover has a greater effect on performance than investment style (growth, value, GARP, etc.), which the dotcom mania proved arbitrary: Investment mandates can vary widely and be quite flexible. That said, people typically associate shorter holding periods with growth and momentum. Performance levels in 2006, in fact, show value (generally perceived as long-term) outperforming, according to the fund intelligence company Lipper. Large-cap growth funds and diversified funds advanced six percent and 12.9 percent, respectively, while value funds achieved a resounding 18.5 percent return – against 15.6 percent for the S&P including dividends. As we demonstrated in our January 2007 issue, the fourth quarter of 2006 finished with the third best risk compensation level in the last ten years. According to our analysis, the final quarter is normally the best performer, while the first is the worst. The cost of money Absolute return means not losing money, and the safest investment of all is cash, which we define as the 90-day Treasury bill. This serves as an investor’s basic hurdle. If you can’t beat cash, why bother? In the age of leverage, it also serves as the basic cost factor. The more expensive the cost of money, the higher an investor’s required risk-adjusted return. This next chart illustrates how the simultaneous hurdle and cost basis varies by investment horizon – assuming, of course, identical transaction costs, credit quality, and reinvestment risk. By borrowing less frequently, the long-term strategy lags its competitors in cost exposure – now an advantage with short-term rates having only gradually risen over the past two-and-half years.   We calculate each value as the four-year, one-year, and three-month moving average of the three-month Treasury bill (constant maturity). A history of volatility Our own commentary notwithstanding, many pundits have wondered at the low level of market volatility in recent years. Our view holds that global capital market evolution and capital flow directions since 1990 explain the current environment, which various malignancies such as war and asset price fluctuations have failed to alter. But how low in the cycle are we? Well, that depends on your time frame. The following chart dates back to 1950, and presents volatility as the annualized standard deviation of daily close-to-close percentage price changes for each month. Except for an extreme spike in 1987 (the October market crash), volatility remained largely subdued throughout most of the two-decade bull-market that began in 1981, and was clearly lower on average in the 1990s until 1997. As we’ve argued in past issues, generational socio-economic events around the globe prompted elevated levels during the 1997 to 2003 period, making it not just aberrational, but also a critical contributing factor to our present state of low volatility: The average level for this period was 14.83 percent, in contrast to 9.48 percent for the 56-year period – 5.97 percent for the month of December (2006). [“Market Calm: Parts I & II” Perspectives July & July 2005, volume 1, issues 2 & 3]     The Transaction Economy. A climate of voluminous liquidity and favorable risk compensation has swelled the coffers of both private and public market investors. Together with the added effect of low economic and market volatility, the quantity of market transactions, whether in terms of trading volume or company purchases, has exploded. In 2005, for example, the average daily volume of the NYSE reached 1.6 billion shares, more than three times the 1997 level, and in 2006 financial buyers made record-setting purchases: HCA and Equity Office Properties Trust for $33 billion and $36 billion each, for instance. “I can’t afford not to participate,” goes the parlance on the Street. Sensing a buyer always lining up, market participants have pushed for greater risk exposure – in many cases moving beyond core competencies in sectors and markets (what practitioners call style-drifting). Though indeed historically low, today’s volatility is by no means excessively low – and should be viewed in the evolution of capital market efficiency beginning in 1981. It has also facilitated strong investment performance, by curbing trading costs. Should volatility suddenly elevate, narrowing performance differentiation among trading-driven strategies could result in sharply lower returns – as one moves so they all move together. Going long At the end of summer 2006, we noted a turning point between risk compensation and the cost of money for a 100 percent turnover strategy – reiterated in January. Again, this does not constitute an index level forecast (we’ll leave that to the experts), rather it’s an estimation of the ability of different investment strategies to achieve excess return. The market itself may rise or fall.   We present again the 100 percent turnover strategy in this next chart as a baseline (see September 2006 and January 2007 newsletter issues). It shows the timeline of turning points (marked by circles). The green (jagged) line depicts risk compensation, and the blue (smooth) line the risk-free rate.   Stock selection will continue to separate the field over the short-term, but performance mean reversion will be more pronounced than previous periods, as risk compensation and risk-free rate converge and move in tandem. Although – for the short-term strategy (400 percent turnover) – the gap between risk compensation and the risk-free rate widened considerably in the fourth quarter 2006, the general trend of its closing holds, so long as risk compensation normalizes after its eight-year peak and short-term rates do not suddenly drop.   The picture, however, changes markedly for the long-term strategy (25 percent turnover). Currently, the hypothetical slow turn fund is best positioned, with risk compensation expanding relative to the cost of money. Though vulnerable to negative performance, this strategy never actually suffers negative risk compensation as with higher turnover strategies even during a prolonged downturn, due to the smoothing effect of continuous buying over an extended period. Conversely, it also means a slower recovery period.   The market’s tendency toward appreciation corresponds with the firmly entrenched adjustment capability of the broad economy, and should not falter, though whether it beats a cash return is another question. An aggressive, short-term trading strategy eying market contraction (chronic short-selling), therefore, seems precarious at best.   ☆ ☆ ☆ Transaction costs have declined across many industries, not just equity trading. This reflects in an increasingly flexible economy, which has engendered strong growth often surpassing consensus forecasts. These costs represent the economic effect of not only a revolution in information delivery and availability, but also the explosive dynamic of Web-based communities – large numbers of people collaborating on common goals – and, consequently, the efficiencies of process innovation. At what point, though, do risk/return profiles diminish? That depends on the size and scale of a particular business. More nimble players will adopt unforeseen technological breakthrough faster than those plagued by bureaucratic decision-making. In many cases this disrupts traditional business models. Over time, the playing field rebalances, as money flows alter – graph below.     The aftermath of the dotcom bust, however, instructs us that several traditional business practices hold fast, even strengthen. Has video-conferencing encouraged or discouraged the number of in-person meetings, for example? Record-high business air travel volumes would suggest more people spending more time in meetings than ever before. In respect to equity trading, wide-scale distribution and affordable access has blunted the informational edge gained in recent years. The information revolution roused market liquidity, which contributed to reduced trading costs. Having flocked by the billions of dollars, short-term investors now risk crowding out their own opportunity for excess return. Unless liquidity freezes, we would not expect trading costs to reflate, although broker-dealers may take advantage of firmer footing in client relationships. At their present course, market conditions are favoring long-term holding periods over rapid turnover. Declining transaction costs have likewise benefited the overall economy, by widely spreading wealth, especially among the capital-hungry entrepreneurial class. Whether or not this represents the low point in the cycle depends on the economy’s flexibility. We reckon it to be historically high; but, as always, this assessment remains at the mercy of gatekeepers (politicians, regulators, central bankers) and their continued wisdom.     © Lyceum Associates, Inc.  All rights reserved.

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