Newsletter June 2014

By Nathan Erickson, CFA Chief Investment Officer

The first week of May I had the privilege of attending the CFA Conference in Seattle, which attracted 1,800 attendees from around the world to hear an esteemed lineup of speakers and network with peers.

The CFA Institute has been at the forefront of a movement they call the “Future of Finance”.  It is a global effort to shape a trustworthy, forward-thinking financial industry that better serves society.  Following the financial crisis and on the heels of the tech bubble and accounting scandals, the broad perspective on the financial industry is that it lacks in ethics; it is not working for the benefit of society; and it rewards only a small percentage of participants (the one percent).  CFA Institute, with its primary focus on education through the CFA designation, aims to change the perception of the financial industry from the inside out, encouraging all associated with the CFA to lead the industry in ethics and integrity.

That concept was clear at the conference as speakers addressed the challenges of the financial industry and how they’ve affected everyone from the average investor to global central banks.  Carl Richards, best known for his “Behavior Gap” sketches in the New York Times, encouraged us to promote transparency and a mindset to do the right thing for clients.  Sheila Bair, former chair of the FDIC, spoke about the efforts of regulators to bring safety to the banking system, and the challenges that still remain.  Possibly one of the most entertaining presentations came from Tomas Sedlacek, who spoke about the Economics of Good and Evil from a historical perspective and challenged us to think differently about traditional economic theory.  There were many other topics of discussion such as Emerging Markets, Behavioral Finance, Fixed Income investing, and Asset Valuation to name a few.

Perhaps my greatest takeaway from this experience is the idea that investment advice / wealth management and finance in general, can and should have a much broader impact.  As an SEC-registered investment advisor headquartered in Phoenix, Arizona, our firm’s impact on the global economy may be small, but our participation in and reflection of the “Future of Finance” initiative can have far-reaching impact.  As most of you know, Miller Russell Associates places ethics and integrity at the heart of everything we do.  We strive to be as transparent as possible and uphold standards of fiduciary excellence, reflected in our efforts to maintain the CEFEX certification and by our focus on fiduciary best practices.  If our objective was only to be a participant in the financial industry and earn a living, why would ethics, integrity, and fiduciary best practices matter?

We believe our firm’s impact becomes far reaching through you, our clients.  Whether you are one of our private clients or institutional clients, we believe most, if not all of you, have a desire to “leave your mark” on the world in which you live.  As a private client, that may be to leave a legacy for your family or to be present in the lives of your grandchildren scattered across the country.  It may mean leaving a charitable gift or endowment to an educational institution that influenced your own life.  For our institutional clients, it may be to further a mission to influence the local community, or provide your employees the opportunity to be better prepared for retirement.  No matter your objective, you count on us to be effective stewards of your resources.  We take that seriously and are proud to partner with you to achieve those objectives.

That is why ethics, integrity, and fiduciary best practices are at the heart of everything Miller Russell Associates does now, and will continue to be in the future.  In an era where the financial industry faces an identity crisis, we want to stand apart as a firm that puts our clients first.  We recognize that our legacy is your legacy, and our success is measured only by your success.

CFA Institute is a global association of investment professionals.  The organization offers the Chartered Financial Analyst (CFA) designation, the Certificate in Investment Performance Measurement (CIPM) designation, as well as the Claritas Investment Certificate. It provides continuing education conferences, seminars, webcasts and publications to allow members and other participants to stay current on developments in the investment industry.

By Eric Peterson, CFA, CAIA Senior Investment Analyst

One of the long-standing debates in the investment world has been over the pricing of assets.  In other words, what determines the prices of stocks?  Is it all fundamental information, like the earnings of a company and the growth rate of dividends, or are there other factors influencing pricing?

Since the 1960’s, the prevailing belief was that market prices of assets reflect all publicly available information and that prices instantly change to reflect new public information.  This is called the “Efficient Market Hypothesis”.  This concept traditionally refers to the stock market, but it could be applied to any market.  For instance, if the concept is true, then the price of an apple at the grocery store reflects all publicly available information, and the price is accurate.  All publicly available information would include the amount of apples in circulation, the most-up-to-date cost to transport, and even the amount of apple pies being baked this week (reflecting demand).

Why does this concept matter?  Simply put, if markets are efficient, there are no opportunities to do “better” than the market.  If the stock market accurately reflects the price of all stocks, all investors should just own the market.  However, this concept at face value does not appear to be true.  If it were, why do we experience market events where prices seem so disconnected from all available information?  For example, one could argue that the tech boom of the 1990’s, the real estate bubble of the late 2000’s, and the financial crisis in 2008, all reflected information beyond the fundamental earnings and growth rates of assets.

The reality of financial markets and the conflict with the rationality of the Efficient Market Hypothesis gave rise to the belief that there is more to asset pricing than “all available information”.  In the 1980’s Robert Shiller challenged the Efficient Market Hypothesis, concluding that investment decisions, and thus asset prices, are often driven by emotion instead of rational calculation.  This concept is part of a larger body of research called Behavioral Finance.

So, imagine the surprise in the investment community last October when the Royal Swedish Academy of Sciences awarded the Nobel Prize in Economics to both Eugene Fama, considered the father of the Efficient Market Hypothesis, and Robert Shiller.  Clearly, both have made significant contributions to economic thought; however, their beliefs could not be further apart with regard to how financial markets function.

The Nobel Prize has brought the discussion to the forefront, once again.  Perhaps what the Nobel committee did, however, is change the nature of the discussion.  The argument used to be “which one is right?” Maybe the real question should be “in light of these two theories, how should we invest?”

In general, the Efficient Market Hypothesis is fairly convincing.  However, as mentioned previously, history is riddled with events that pose some serious challenges to the theory.  As Yogi Berra noted, “In theory there’s no difference between theory and practice.  But in practice there is.”  Events such as the one-day drop in the Dow Jones Composite Index of over 22% in October of 1987, the tech stock bubble of the late 1990s, and the housing bubble of the mid-2000s are not very well explained under the theory of market efficiency.  Shiller has referred to such bubbles as periods of “irrational exuberance” as investors’ “animal spirits” drove them to chase these assets to absurd prices.

Yet, despite its shortcomings and some exceptional moments in time that present very real challenges to the Efficient Market Hypothesis in its purest form, the theory of market efficiency actually does provide a very respectable foundation on which to base one’s investment philosophy.  To simply dismiss Efficient Market Hypothesis altogether, due to examples of when it appears to have failed, could have reckless implications.  Be wary of thinking that just because Efficient Market Hypothesis doesn’t always hold up, it therefore must be fairly easy to beat the market.  Even some of the most successful active investors have noted the difficulty of being consistently better than average.  Charlie Munger (Warren Buffett’s investing co-pilot for decades at Berkshire Hathaway) has famously noted that beating the market is “not supposed to be easy.  Anyone who finds it easy is stupid.”

While awarding the Nobel Prize to two pioneers of opposing schools of thought may seem counter-intuitive, as you take a closer look at the core philosophies of each and compare their theories to the real world, it is clear there are elements of truth (and some flaws) in each.  Human beings do not always make rational decisions.  We are prone to psychological biases that hurt our ability to make optimal choices.  But this does not mean we are always wrong.  It is very difficult to consistently beat the market.  In fact, it may be best to assume we are normally reasonably correct in pricing investments, but to be cognizant of the fact that we tend to gyrate to extremes on the way up, and again on the way down.

How then does Miller Russell Associates answer the question “in light of these two theories, how should we invest?”  With regard to stock markets, we think they are relatively efficient.  It is difficult for an active manager to beat the market because information is so widely available and immediately incorporated into stock prices.  Our firm’s approach with stocks is to take advantage of academic research that identifies alternative ways to outperform the market by accessing specific risk exposures, such as small cap and value that over time produce predictable excess return.

In other asset classes, such as fixed income and multi-strategy, we think it is appropriate to take a more active approach.  Fixed income is historically a very inefficient asset class, where prices can be influenced by factors beyond fundamental data.  Managers who have size and scale to take advantage of mispricing can provide significant value.  In our global macro allocation, we utilize managers who have a track record of successfully allocating to mispriced asset classes.  To quote Warren Buffett, they are “fearful when others are greedy, and greedy when others are fearful”.

The asset pricing debate will continue for decades to come.  It is nearly impossible to capture human behavior in a model, and so while prices may be efficient most of the time, there will always be periods where they are inefficient.  Miller Russell Associates is thoughtful in our approach, and we use solutions that we think have the highest probability of success for our clients.