Product and Strategy Notes: Developing an Agile Mindset; Good News in the U.S. Financial Regulation Bill; Impact of High Frequency Trading; Common Sense and Value Investing; Two Excellent Papers on Risk Management

Developing an Agile Mindset

When someone asks us what our publications are about, our short answer is always the same: How to achieve long-term financial goals in the face of rapid change and uncertainty? When asked to get more specific, we say that the answer to this challenge can be thought of as a three legged stool. Part of the answer lies in improved forecasting (e.g., simple averaging of forecasts based on different methodologies), and part lies with improved portfolio construction and risk management techniques (e.g., focus on target real rates of return, rather than beating external benchmarks; models that integrate a wider range of decisions; us of simulation optimization and multi-regime methodologies, etc.). However, the most frequently overlooked leg of the stool is agility and adaptability. Clearly taking market valuation levels into account when making decisions is part of this. But so too is thinking clearly (e.g., avoiding over-optimism, overconfidence and the confirmation bias), recognizing the powerful impact our emotions can have, and developing what we like to call an "agile mindset." We have always found the latter hard to succinctly describe, though easy to identify when you encounter it, whether in the investment, corporate or military world. The good news is that we recently read an article that does an excellent job of describing this concept and defining its key components.

In "The Innovator's DNA", Dyer, Gregersen and Christensen report on the results of study of 3,500 recognized business innovators. They conclude that five "discovery skills" are critical to innovation success. The first is "Associating", or "the ability to successfully connect seemingly unrelated questions, problems or ideas from different fields." The authors note how this complements diversity: "the more diverse our experience and knowledge, the more connections the brain can make...The more frequently the people in our study attempted to understand, categorize, and store new knowledge, the more easily their brains could naturally and consistently make, store  and recombine associations." The second discovery skill, and the one the authors deem the most important to practice, is "Questioning -- innovators like to play devil's advocate and constantly ask questions that challenge common wisdom...To question effectively, innovators ask 'why?', 'why not?' and 'what if?'" The third discovery skill is "Observing -- innovators carefully, intentionally, and consistently look out for small behavioral details...particularly in the behavior of potential customers." The fourth discovery skill is "Experimenting -- trying out new ideas by creating prototypes and launching pilots." Interestingly, the authors found that "one of the most powerful experiments innovators can engage in is living and working overseas...The more countries a person has lived in, the more likely he or she is to leverage that experience to deliver innovations." The fifth discover skill is "Networking -- unlike most executives, who network to access resources, to sell themselves or their companies, or to boost their careers, innovators go out of their way to meet people with different kinds of ideas and perspectives to extend their own knowledge domains."

The authors conclude, "though innovative thinking may be innate in some, it can also be developed and strengthened through practice. We cannot emphasize enough the importance of rehearsing over and over the five behaviors described above, to the point that they become automatic."

Good News in the U.S. Financial Regulation Bill

Hidden among the pages of the recently passed U.S. financial services reform legislation (the Dodd-Frank Wall Street Reform and Consumer Protection Act) were two gems. The first calls for a study (by the Government Accounting Office) of mutual fund advertising that uses past-performance data, and recommendations for how regulations in this area should be changed to improve investor protection. Specifically, the bill includes this language: "The Comptroller General of the United States shall conduct a study on mutual fund advertising to identify -- (1) existing and proposed regulatory requirements for open-end investment company advertisements; (2) current marketing practices for the sale of open-end investment company shares, including the use of past performance data, funds that have merged, and incubator funds; (3) the impact of such advertising on consumers; and (4) recommendations to improve investor protections in mutual fund advertising and additional information necessary to ensure that investors can make informed financial decisions when purchasing shares."

The second gem gives the SEC authority to impose the same standards of fiduciary responsibility on brokers as now apply to Registered Investment Advisers. We have long advocated this change, and strongly believe that the current "suitability" standard for broker's recommendations is too loose. While we have no doubt that both of these gems will be fought by interest groups with the most to lose, we have high hopes that the studies called for in Dodd-Frank will result in long-overdue reforms.

The Impact of High Frequency Trading

We have noted out belief that the increased use of algorithmic trading programs, and the move to high frequency trading had to be affecting the nature of market prices. A recent research paper confirms this view. In "Is High Frequency Trading Inducing Changes in Market Microstructure and Dynamics?", Reginald Smith concludes that, in the case of fourteen heavily traded stocks that he studied, there has been "a shift toward more self-similar dynamics in recent years" that coincided with "declining average size of trades with smaller trades showing markedly higher degrees of self-similarity." Call it more micro-momentum, if you will. For better or worse, the daily "battle of the trading bots" is changing the nature of the price and returns series we observe each day.

Common Sense and Value Investing

We have long had a relatively simple view of the logic behind active investing: You buy an asset because you expect its price to increase, based on your analysis of the underlying business and/or your analysis of other investors. Over the years, lots of academic studies have blurred this basic concept, with endless arguments over the underlying source of the "momentum factor" and the "value premium." Occasionally, however, you come across a research study that thankfully brings the discussion back to basics. We recently enjoyed one of those all-too-rare experiences when we read "The Other Side of Value: Good Growth and the Gross Profitability Premium" by Robert Novy-Marx. The author starts with an examination of different measures of profitability and finds that gross profits "is the cleanest accounting measure of true economic profitability. The further down the income statement one goes, the more polluted profitability measures become, and the less related they are to true economic profitability." Despite this, "popular media is preoccupied with earnings, the variable on which Wall Street analysts' forecasts focus." Novy-Marx uses gross profits to construct a measure of firm productivity by dividing it by total assets. He finds that this measure has "roughly the same power to predict the cross-section of expected returns as the book to market ratio." Moreover, "more profitable firms earn significantly higher average returns than unprofitable firms, despite having, on average, lower book-to-market ratios, and higher market capitalizations. That is, profitable firms are high return 'good growth' stocks, while unprofitable firms are low return 'bad value’ stocks." These results contrast with Fama and French's view that "profitability, as measured by earnings, adds little or nothing in economic terms to the prediction of returns provided by size and book-to-market."

Two Excellent Papers on Risk Management

We highly recommend both of them: (1) "Tail Risk Hedging: A Roadmap for Asset Owners" by the Deutsche Bank Pension Strategies and Solutions Group, and (2) "Tomorrow's Risk Management" by BNY Mellon's Alternative Investment Services Group.

| This Month's Letters to the Editor: How can a UK Investor Access Volatility as an Asset Class? and II Uses Crystal Ball for some of its Monte Carlo Simulation and Calculations. Do you have a preference for CB over @Risk? | Table: Fundamental Asset Class Valuation and Recent Return Momentum | June 2010 Issue: Key Points | Product and Strategy Notes: Developing an Agile Mindset; Good News in the U.S. Financial Regulation Bill; Impact of High Frequency Trading; Common Sense and Value Investing; Two Excellent Papers on Risk Management | Investor Herding Risk Analysis | June 2010 Economic Update: The Joint Operating Environment | Global Asset Class Valuation Updates Detail through May 31, 2010 | Overview of Our Valuation Methodology | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns | Table: Market Implied Regime Expectations and Three Year Return Forecast | Feature Article: Understanding and Predicting Uncertainty Shocks, Part 1 |