Inside the black box

Hey there, time traveller!
This article was published 19/07/2009 (5987 days ago), so information in it may no longer be current.

There’s been a lot of talk about black boxes lately — much of it to do with tragic aviation accidents. One black box tragedy, however, has nothing to do with airplanes, but everything to do with a crash. The stock market crash, that is.

After the stock market blew up last fall, investors in the Bernard Madoff Investment Fund came looking to cash out some of those great returns they had come to rely on thanks to Madoff’s proprietary investment strategy. But the money wasn’t there because he had been running a multibillion-dollar Ponzi scheme, in which any prior payouts came from money from new investors.

In the end, the black box was a black hole. Maybe it was because Madoff was the former chairman of the Nasdaq, or maybe people were blinded by the fund’s impressive returns, but he managed to dupe investors out of billions of dollars in savings. While sensational, it is unfortunately not the only recent story of unwary investors being ripped off by thieves in ties and slacks promising financial paradise.

More recently, Quebec investment adviser Earl Jones came under investigation for allegedly running a multimillion-dollar Ponzi scheme, defrauding more than 150 investors.

While the stories make for intriguing headlines, particularly the Madoff case, the scandals drive home the importance of understanding how our investments make money.

Of course, most of us do not have the personal wealth to invest in hedge funds, which are part of the exempt market, but many of us consult portfolio advisers, or at the very least invest monthly in mutual funds and, as a result, trust the fund managers to know what they’re doing.

Mutual funds may come in all shapes and sizes — foreign markets, small companies, bonds and commodities, to name a few. But the majority of investors at least hold an equity mutual fund (a pool of stocks) so for the sake of time and space, we’ll focus on those.

Typically, these funds use one of three buy-and-hold strategies, sometimes referred to as long strategies. In other words, a fund buys stocks with the expectation they will increase in price over the long term.

But each strategy goes about reaching this goal somewhat differently.

The first strategy is value investing, a strategy created by two Columbia University professors, Benjamin Graham and David Dodd, in the 1930s.

"Value strategy is where you are looking for companies that are out of favour and undervalued," says Neal Brandon, an analyst with Morningstar Canada.

Fund managers will analyze stock and determine whether its current market price reflects its intrinsic value. A company might have had lower earnings than expected, which might drive investors away, but a value investor would try to dig beyond the earnings to determine whether the stock price accurately reflects the company’s real value.

Warren Buffett, the world’s most revered equity investor, employs a value strategy. In fact, he studied under Graham in the 1950s.

The RBC O’Shaughnessy U.S. Value Fund is an example of this type of strategy.

While a value investor tries to find stocks with prices lower than they should be, or selling at a bargain, a growth investor looks for companies displaying strong capital growth. A company’s stock can be expensive and widely held, but it can still be a good buy because the company is expected to have continued earnings growth, or increase its market share by using profits to reinvest in the company or to buy out competitors.

Typically, a growth fund would invest in companies that do not pay large dividends because the profits are going back into expansion.

Yet, when looking at an example of such a fund, AGF Canadian Growth Equity Fund, you’ll find it holds companies like natural gas producer EnCana, which pays a dividend — albeit one that has grown over the past few years.

 

Because the growth strategy tends to chase stocks that are popular because of their strong earnings, growth funds tend to do very well in bull markets and generally worse than value funds in bear markets. In fact, two subsets of the growth strategy — aggressive and momentum — strive for even higher returns in bull markets by investing in highly leveraged, riskier companies that can produce higher double-digit-percentage growth in good times, but equally as bad losses in bad conditions. The third strategy brings growth and value together and is called GARP (growth at a reasonable price).

"GARP tries to take the best of both worlds where you still have the earnings growth and you try to find a reason why it’s less than its intrinsic value," Brandon says.

Some small-cap investors use this strategy to find companies with strong financial numbers — little or no debt, good cash flow and earnings growth potential — with the expectation those will eventually be reflected in the stock price.

"You can find those values in the small-cap area of the market because some people just sell indiscriminately and people aren’t watching the sector as much," says Ryan Irvine, an analyst and president of Keystocks.com, an online small-cap research publication that uses GARP.

"You don’t have that type of opportunity to find that value with the larger and mid-cap companies."

Like a value strategy, GARP looks for good companies that are undervalued, but like a growth strategy, it looks for companies that will grow their earnings — as long as the stock price is… reasonable.

"If there’s something currently out of favour that still has relatively good earnings growth, GARP investors will pick that up," Brandon says. An example of a GARP fund would be the Mawer Canadian Equity Fund, which invests in mid- and large-cap companies.

Although each strategy has its advantage — higher potential returns for growth, steadier returns for value and a mix of the two for GARP — Edwards Jones chartered financial analyst Kate Warne says long-term investors shouldn’t worry so much about which strategy the fund uses. Instead, they should be concerned about whether the fund’s management is consistent.

"What always bothers us is when you have a fund manager that strays from the strategy," she says. "We figure they’ve put all their expertise in selecting one particular type of stocks and if they aren’t finding anything that’s good value there, it doesn’t make sense to us if they add stocks that don’t fit with their overall strategy."

Warne adds that investors with large enough portfolios could invest in all three types of funds, which would further diversify their overall holdings. But if she had to choose between the three, Warne suggests investors pick funds that buy stock in companies that pay to hold them regardless of the market conditions.

"Certainly, we like strategies that focus more on companies that pay dividends and increase the dividends, but you can get that both through growth at a reasonable price and value strategies."

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Bottom-up

Some fund managers use a bottom-up strategy as an overlay to their value, growth or GARP methods for picking stocks. These managers choose companies based on their financial strength alone, regardless of how the specific industry in which they operate performs. The thinking is that a solid company will outperform its peers even when that sector is facing significant challenges that affect profits.

Top-down

The opposite of the bottom-up is top-down, which looks at the broader industry conditions and economic trends. Many managers use this strategy to find a desirable geographical area or industrial sector to invest and then, look for stronger companies within that sector to purchase.

 

— Investopedia.com

 

Other approaches

 

Besides strategies for picking stocks, fund managers also use benchmark approaches for structuring a fund portfolio. The three major styles are indexed, active quantitative and fundamental.

Indexed funds

The manager tries to create a fund that mirrors the benchmark index in risk and return. Also called a passive fund, it does not try to beat the market. Exchange-traded funds would be an example of this kind of fund. Indexed funds should have lower management expense ratios (MER).

An active quantitative fund

The manager uses statistical risk models to sift through hundreds, if not thousands, of stocks to find companies that offer the best return while ensuring the risk is not extreme. These funds try to beat their underlying benchmark index, and they have higher MERs than indexed funds.

Fundamental investing

 

This is the old school of fund management. Managers must use old-fashioned stock analysis to find quality investments. Typically, growth, value and GARP managers will fall under this umbrella because they are looking for good investments based on the financial statements of companies and how they fit into the overall market.

 

— Teachers Insurance and Annuity Association-College Retirement Equities Fund

Hedge funds

 

These are not as risky as you might think. Contrary to the impression left by the Madoff scandal, hedge funds are often conservative investments that protect the primary holdings of an investor’s portfolio against a down market, says Rob Hall, a partner with Winnipeg-based hedge fund company Rival Capital Management. "Hedge funds vary significantly in their investing approach and have a wide range of strategies from ultra-conservative to high risk," Hall says. Part of the exempt market, these funds have greater latitude in strategies they can employ, including derivatives, to protect a portfolio against market volatility, though some can be used to increase profits and risk — as opposed to reducing risk and preserving profits, Hall says.

The Madoff black box

 

The black box strategy isn’t really all that novel for a hedge fund. Many funds try to keep some of their strategies secret, but most astute analysts can figure out how the fund makes its money. The black box often refers to the mathematical algorithm used to determine when to sell and buy derivatives like put and call options. The problem with Madoff’s fund is no one could understand how it posted consistently good returns. Many experts were skeptical of the year-over-year returns. After all, even Warren Buffett has bad years.

At first, some analysts thought Madoff’s fund used a strategy called collaring, involving purchasing both call and put options. This strategy would do two things — limit the upside and the downside. It would post returns, but the returns should have been conservative. When other traders and analysts tried to replicate the higher returns Madoff’s fund had been claiming, they were unable to do so. At this point, Madoff pointed to the proprietary black box that had a secret algorithm allowing the fund to out-perform.

 

— Risknews.net