Why Does Anyone Think This Will Outperform Index Funds ?

New quantitative models to be used by hedge funds to outperform the markets...haven't we been there before...including Long Term Capital Markets (LTCM)?

WSJ:

How Computers Trawl a Sea of Data for Stock Picks

Funds managing billions hunt for investment clues in newswires, weather, Twitter

Two Sigma is part of a new frontier in computerized investing, in which scientists and engineers with little formal financial training are trying to funnel massive computing power into predicting securities prices by drawing from clues in news and data.

“The secret of the markets is they can be predicted,” says Alexander Migdal, a former Soviet physicist in Princeton, N.J., who writes algorithms to predict securities prices based on a broad set of data, such as news feeds. “Not 100%, of course, but just enough to make a difference, to make a profit.”.....

Mr. Migdal, the former Soviet physicist, after leaving academia started a high-frequency-trading firm using computers to zip in and out of markets, earning tiny profits on hundreds of thousands of transactions. But he believes the profit opportunity there is diminishing. His new company, Migdal Research LLC, is devoted to longer-term predictions based on a broader data set.

Mr. Migdal, 69, compares data to water drops before they form a river. “Many little movements of the drop may become a flow,” he says. “Not all the events in the financial world take the form of dramatic and obvious announcements. Quite often, they begin as small drops moving in the same direction in a way that isn’t immediately visible to the human observer.”

Still, says NYU’s Mr. Kolm, computers aren’t close to being omniscient: “For the majority of financial-prediction models, the degree of certainty is much, much weaker” than even weather forecasts.

Don't Blink, the Conventional Wisdom Just Changed

Not a good argument for market timing.

WSJ March 30

Morning MoneyBeat: Why Stocks Could Keep Rising as Recovery Matures

WSJ March 29

Stocks Revisit Last Spring’s Selloff — With a Difference

The latest pullback in technology and biotechnology stocks echoes a temporary selloff last spring. But this time around, some investors are warning that the broader market’s problems could run deeper.

Index Investor or Hedge Fund Investor...Who is Smarter ?

Seems a better simpler strategy is available tot the little guy is better than the complicated one available to big hitter "qualified investors" and their genius managers

Two headlines recently at the WSJ

Are Index-Fund Investors Smarter?

Hedge Funds: Don’t Call Us a Hedge Fund:

One of the keys to running a hedge fund is learning how to say you don’t.

Grappling with years of uneven performance, image problems and deep-pocketed clients who have publicly distanced themselves from the industry, hedge-fund managers are taking pains to avoid the moniker.

Asset Allocation in Two Minutes

I wrote in an earlier post how "Robo Advisors" come up short by not sufficiently getting to understand a clients circumstances before recommending an asset allocation.

Over at future advisor...they promise: asset allocation in two minutes. Plug in your age and retirement age and it triggers a detailed portfolio allocation.

Seems to prove my point.

Do You Think You Know How to Pick Actively Managed Mutual Funds ?,,,The "Experts" Don't

From the economist Buttonwood blog

Nobody knows anything

WHENEVER one writes about the failure of active managers to beat the index, someone is bound to pop up online and argue that people don't pick fund managers at random. Select the right fund managers and all will be well. But how? Relying on past performance does not seem to work. Logic would also suggest that it cannot be easy to identify the best performers in advance; if it were, then why would anyone give money to the underperformers?

Many pension funds and endowments hire investment consultants to help them choose fund managers (one estimate is that 82% of US pension plans use such services, and consultants advise on $25 trillion of assets). The consultants employ highly-educated workforces, have decades of experience and charge hefty fees. But an award (the 2015 Commonfund prize) has just been granted to an academic paper that concludes

we find no evidence that these (the consultants') recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless...

 , while one can be willing to accept that there are smart fund managers who can outperform the market, the trick is identifying such managers in advance. This process seems as difficult as identifying hit films in advance; in that business, as William Goldman wrote once "Nobody knows anything". 

The Economist also had a recent article specifically on large cap actively manged funds

BETTING on red gives the punter an 18-in-37 chance (in Europe) or 18-in-38 chance (in America) of success in roulette. Parcel out your money carefully and you might have a diverting 20 minutes or so until it's all gone, with a few wins along the way. If the odds were just one-in-four, then the whole game would be much more discouraging.

But those have been the chances, over the last 20 years, of largecap US mutual funds beating the market. It has happened in just five calendar years..... investors buy a US largecap fund to get exposure to largecaps, not the other stuff. To the extent that managers go off piste, that can only be justified if they reliably outperform. They clearly don't.

This explanation only makes the lesson clearer; if you want an exposure to US large caps, buy a US largecap index fund with low fees.

Of course, many people will ignore this advice. They see an index fund as a boring commodity product; they want the best in class, a manager that can outperform. And no active manager will admit that he (or she) is likely to underperform. But it is remarkable how few will put their money where their mouth is.

Do You Know What Your Mutual Fund Owns..And What it is Really Worth ?

The NYT reports on the growing number of mutual funds that own stakes in non public tech statrt ups. 

The retirement accounts of millions of Americans have long contained shares of stalwart companies like General Electric, Ford and Coca-Cola. Today, they are likely to include riskier private stocks from Silicon Valley start-ups like Uber, Airbnb and Pinterest.

Big money managers including Fidelity Investments, T. Rowe Price and BlackRock have all struck deals worth billions of dollars to acquire shares of these private companies that are then pooled into mutual funds that go into the 401(k)’s and individual retirement accounts of many Americans. With private tech companies growing faster than companies on the stock market, the money managers are aiming to get a piece of the action.

Fidelity’s Contrafund includes $204 million in Pinterest shares, $162 million in Uber shares, and $24 million in Airbnb shares. Over all, there were 29 deals last year in which a mutual fund bought into a private company, and they were worth a collective $4.7 billion, according to CB Insights. That was up from six such deals, worth a combined $296 million, in 2012. T. Rowe Price was the most active

These non public companies are illiquid, difficult to value and the investor can actually only realize profits when the company goes public. In other words, at least parts of major mutual funds have left the world of publicly traded stocks into the far different investment marketplace of venture capital. I doubt too many investors are aware of the difference.

 Since these start up companies are not public the requirements for publicly available financial disclosures don’t exist. And based on the type of measures used in the public equity markets the valuations are astronomical, This means any disappointments in performance of the business or surprises in any of the financial metrics could lead to a large rapid decline in value. And of course even those valuations are based only on the data voluntarily provided by the company. For example Uber owned by these funds has encountered regulatory issues and other controversies in various part of the world. 

As a group small cap growth publicly traded stocks(growth meaning high p/e or other valuation measure) are the worst performing category of the stocks.  They are often referred to as “lottery tickers”..since a few wind up generating high returns but many many more disappoint.

A strong case could be made that these non public small companies with high valuation are even riskier.

Barrons gives some more specific information about this trend  here   

 As of the Boston fund(Fidelity) giant’s latest filing, its $113 billion Fidelity Contrafund (ticker: FCNTX) alone owned $162 million worth of Uber and $142 million of file-hosting company Dropbox. T. Rowe Price Group (TROW) had about a dozen funds on the list, including the $46 billion T. Rowe Price Growth Stockfund (PRGFX), which recently had a $63 million stake in rental marketplace Airbnb and $74 million in Dropbox. Rounding out the list were funds from BlackRock (BLK), Franklin Resources (BEN), and Vanguard Group, among others.

I looked at the information on the Fidelity and T Rowe Price websites at information on the funds losted above. 

The following appears for the contrafund on the Fidelity website

Strategy

Investing in securities of companies whose value FMR believes is not fully recognized by the public. Investing in either 'growth' stocks or 'value' stocks or both. Normally investing primarily in common stocks.

The TROWE Price Growth Stock fund has the following on the TROWE website hard to see how Dropbox and Airbnb match this description::

This fund provides long-term capital appreciation potential by focusing on established growth companies with proven performance records. These companies are typically financially sound and represent a wide variety of industries. To enhance return potential, the fund also has the ability to invest in foreign companies.

Bottom line: 

Unless you check carefully your mutual fund may own types of securities you didn’t expect it to hold.

And since some of the securities you fund may own are not traded securities with open market prices you may not really know what your fund shares are worth.

Strong Dollar Winners and Losers

Although we have had a pause, the US dollar has strengthened over 20% against the Euro in the past 12 months

Who wins and who losses from the move ?

Losers: Large cap multinational coroporations

Worst hit from the strong US dollar are US multinational corporations. Their large sales overseas means large declines in the US dollar value of their earnings.

As the WSJ reports:

Strong Dollar Hammers Profits at U.S. Multinationals

Analysts have sharply reduced earnings estimates; smaller, domestically focused firms gain allure

Analysts, citing the dollar’s strength as a key factor, are predicting that profits at S&P 500 firms for the first quarter will show their biggest annual decline since the third quarter of 2009.

As a result, investors are keeping a continued bias toward U.S.-based stocks that do less business abroad, such as shares of small companies that tend to be more domestically focused, and on companies outside the U.S. that stand to benefit from a weakening of their home currency as the dollar strengthens, particularly European manufacturers

The speed of the move means that these corporations have been caught by surprise not implementing the currency hedges they often put in place.
. It is the large cap multinationals that take the biggest hit, Many of these are in the S+P 500 others in both the S+P 500 and large cap indices such as the Russell 1000.

Winners are European multinationals. They benefit in two ways: their foreign earnings in dollars are worth more in Euros and their prices are they charge for therio goods and services can be more competitive in selling to foreign markets as their goods are priced in Euros/their costs are in Euros. After a long period of underperformance European stocks have outperformed US stocks as the Euro has weakened. Year to date Eurozone stocks (ETF ticker FEZ) have outperformed the S+P 500 by 7.7% vs 2% the hedged European ETF (ticker HEDJ) is up 19.6%.

Large Cap vs Small Cap US Stocks. Small cap companies tend to be more domestically oriented and thus less affected by the lower Euro. After underperforming  with a return of 5% (etf vtwo) for small cap vs 13.1% for large cap (IWB) in 2014, the trend has reversed year to date with small cap at 5.2% year to date and large cap 2.6%.