Professor Kenneth French started the DFA Investment Symposium this year with a talk on a group he has helped organize, called the Squam Lake Working Group (SLWG). By combining the intellect and experience of 15 highly credentialed academics, the goal of the Squam Lake Working Group is to influence the legislative and executive branches of government towards developing a better securities regulatory environment.

During Professor French’s presentation, he highlighted the importance of the financial system to the overall economy, as well as the backward logic of the “Too big to fail” concept. He argues that as institutions become larger, their importance to the broader economy can become significantly greater than the combined importance of many smaller institutions that aggregate to the same size - particularly in times of crisis.  As such, he believes that larger institutions should be subject to greater scrutiny and regulation. Part of Professor French’s logic is that there is systemic risk inherent within financial markets.

The working papers put together by the SLWG offer real recommendations and ideas rooted in today’s reality. Their notion of hybrid securities, for example, would be to have debt securities that are convertible to equity when banks violate the bond covenants during a crisis. The ultimate idea here is to reduce the debt overhang of a bank in crisis. If a troubled bank issues equity, then their bonds become less risky and ultimately worth more.  Thus, one way to avoid, or at least mitigate, a future bank crisis is to enable the conversion of debt to equity.  The details obviously need to be hammered out, but this is why the SLWG is making these recommendations to government legislators and executives.

The ideas coming out of the SLWG are extensive and, as expected, incredibly well-developed. This short blog cannot do it full justice. To learn more about what the Squam Lake Working Group is thinking and writing, please visit their website.

Dimensional Fund Advisor’s (DFA) Annual Investment Symposium took place in Austin, Texas last Thursday and Friday. The two-day event is a rigorous agenda of topics that runs the gamut from high-level economics and statistics to regulations and operational views of the inner-workings of their mutual fund offerings.

From the infamous Professor Eugene Fama (University of Chicago) to the equally renowned Professor Ken French (Dartmouth College), and including a litany of investment-oriented academics; this annual conference provides a constructive forum to learn and discuss all of the current and cutting edge high-finance topics of the day.

In the coming posts, we’ll be sharing the presentation high-points of the conference covered by the brilliant minds at Dimensional Fund Advisors.

In our previous blog, the Cost of Volatility, we conclude by saying that “Having a well-constructed portfolio means having a palatable portfolio that is naturally diversified, where the risk is just right, unforced errors are mitigated, and discipline requires little action.” Achieving a diversified portfolio is fairly easy, but removing unforced errors and establishing low-action discipline is a bit more difficult.

Robert Arnott and John West from IndexUniverse.com take a look at negative alpha, and in their article, they do a good job at uncovering what some of those unforced errors might be.

Negative alpha is defined as “the slippage investors unnecessarily incur in the execution of their investment strategies.” There are three main aspects of negative alpha, including equity concentration of a portfolio, failure to rebalance, and chasing winning funds with high returns. Ultimately, one’s risk tolerance needs to be properly assessed to deliver a palatable portfolio of equity and fixed income. Within that portfolio, we believe that equities should be globally diversified with a tilt to small-cap and value-style exposure. Once that’s achieved, rebalancing guidelines need to be established. As long as the rebalancing mandate is not too restrictive or too loose, then it becomes easy to avoid chasing top-performing asset classes as rebalancing will naturally sell high and buy low.

For more in-depth analysis, please visit “A Crisis Review of Negative Alpha” at IndexUniverse.com.

Poor forecasting begets more poor forecasting. An article by Carl Bialik, the Wall Street Journal’s “Numbers Guy,” looks at how economic forecasts “didn’t fully anticipate the recession,” which then caused “recent forecasts…[to miss their] mark.” It’s easy to understand that a forecast can be thrown off due to unanticipated external shocks (like surging commodity prices or deep recessions). But forecasts in general deserve much greater scrutiny.

The article dives into forecasts in the hotel-industry, airlines, gas prices, and communications. While the article cherry-picks inaccurate forecasts, it also takes a look behind the forecasts, and even at how forecasts are measured to display very high historic accuracy. While forecasters attempt to provide clear insight into the future, they manage to haze over and manipulate their methods and success metrics.

From an investment perspective, uncertainty is the underlying nature of capital markets. Investors are better served by diversifying away company-specific risk and capturing market risk. That is a sustainable method of investing that delivers greater long-term performance than forecasting - which effectively increases unnecessary risk.

Click here for the full article.

In an article by Dan Richards, “The True Cost of Volatility,” he explores what volatility means (and costs) in a practical sense. If one looks at the growth of a highly volatile asset class, one will see remarkable growth of wealth. There will be lots of ups and downs, but over the long-term, the asset class will show an overwhelmingly positive end result. One might then surmise that making that asset class a larger part of a portfolio is a smart move. Unfortunately, the volatile ups and downs are often overshadowed by that elusive ending value that displays a significant total return over a long time-period. The problem is that volatility is real, and tolerance to downward market swings is thin-skinned.

A study by Morningstar, looking at 10-year annualized returns (ending 2007), that accounts for cash flows in and out of funds, found some interesting numbers.

An investor that held a specific sector fund did worse than the actual fund. How’s that possible? It has to do with the investor not being able to stomach the volatility. In balanced funds, investors captured all of the actual performance of the fund. The reason for this is that the balanced fund produced smoother returns that investors could swallow more easily for the full time-period. With the balanced funds, investors tended not to flee when returns were sub-par. One can see that an annualized 1.13% was given up due to investors’ distaste for higher risk. For all intents and purposes, we could look at this as an explicit opportunity cost associated with investing in specific sector funds for the time period researched.

Morningstar then looked at funds based purely on standard deviation, as opposed to sector funds versus balanced funds. A similar pattern to the above table was uncovered.

A couple of valuable takeaways result from this article. First, discipline and diversification are critical to successful investing. Second, risk can be increased beyond a tolerable state; at which point, more harm than good is often the result. Having a well-constructed portfolio means having a palatable portfolio that is naturally diversified, where the risk is just right, unforced errors are mitigated, and discipline requires little action.

The full article is here.

Even though small-cap stocks broke their winning streak last week amid fears of a September, “calendar anomaly” pullback, the broad small-cap indexes still saw gains for the week. The Russell 2000 closed up 4.05% for the week, despite losses of .22% on Friday. For September, through 9/11/09, the Russell 2000 has returned 3.76%. Year-to-date, the Russell 2000 is up 17.34% (ending 9/11/09). That includes the -32.14% loss for the Russell 2000 from January 2, 2009 through March 9, 2009. Most impressive, however, is that from 2009’s current bottom (3/9/09) to present (9/11/09), the Russell 2000 has returned an astounding 72.92%. The small-cap indexes may have snapped their 6-day consecutive winning streak, but this is inconsequential in the bigger picture.

The above numbers illustrate several points. Perhaps most importantly, the numbers show the volatility that we’ve experienced in 2009. High volatility is closely, and correctly associated with negative returns, but high volatility also provides the opportunity for great positive returns. If one timed their exit and reentry into the Russell 2000, how much of the almost 73% would they have missed? On a total return basis, the best method of investing is also the disciplined method - despite it also being perhaps the most boring method.

Based on a WSJ article by Donna Kardos Yesalavich.

Self-preservation is universal across all organisms. In the face of danger or pain, it is just in the nature of life to stop the pain and avoid the danger. Some organisms are more effective than others, and thus some species have been able to evolve and flourish more readily. Humans take self-preservation to another level and apply the concept to more than just oneself. We apply it to our friends and family members, strangers, our pets, and of course, to our investments.

As fortune would have it, we naturally associate losses with danger and the instinct is to Sell, Sell, Sell! Then, when returns turn positive, we become euphoric and our gut tells us to Buy, Buy, Buy! The following chart shows equity mutual fund cash inflows (in blue) alongside bond fund cash inflows. An overwhelming number of investors sold at the bottom, missed the rebound, and bought back in at more expensive levels.

Timing the market may appear to be a primordial result of the desire to self-preserve. Successful investing requires resisting these urges that may be quite adaptive in other avenues of behavior.

The volatility experienced in 2008 has continued through 2009. With such across the board uncertainty in all market sectors, it seemed like active managers might fall upon their day in the sun. Volatility decays slowly and with high volatility comes the opportunity for high positive returns. With that in mind, active managers should have had stellar performance before, and certainly during the market rally.

In an article on Bloomberg.com, the authors found that investors that put $10,000 in the market using only Wall Street analyst forecasts “to buy companies in the highest-rated industries and bet on declines in the lowest since the advance began on March 9 lost everything and would owe as much as $6,000 to cover bearish trades…”

The companies with the worst earnings led the S&P 500 to 46% gains from March 9 through mid-August. On average, analysts led investors to drug and energy producers which trailed the MSCI World Index by -24%, for the same time period.

One person’s trash is another person’s treasure…

For the full article, please click here.