Tuesday, December 21, 2010

How to Not Find the Right Investment Advisers - Reflections about Madoff and Deserts


It happens all the time, and it will happen again.

The end-of-year period around Xmas is a good one for a reflective note. This was the year of the big Bernie Madoff scam. Why do even intelligent people continue to fall for Pyramid scams? Answer: because the Investment Game is not a simple one. Performance analysis of good investments in either individual stocks or bonds or mutual fund strategies is a profession. But yet, and that is the sad thing for professionals in the financial industry: unlike in the medical profession, too many amateurs believe they can do it. Would you consider doing some complicated surgery yourself? Nope. Would you consider putting all your money in 'that fantastic investment strategy that brings you 30-40 percent per annum guaranteed?'. Too many people do the latter.

Even Bernie Madoff didn't get away with things. Sooner or later all Pyramids collapse.

But OK, this story has been told so often. And we won't go into details here. Pyramid games stand a chance because of a mixture of 2 things:

  1. Investors are still very sensitive to 'form' instead of 'content'. In our last entries to this blog we talked about that, quoting academic research that confirmed investors' sensitivity to form-related factors like Age of the Adviser, Power Dressing, Size of his/her Portfolio, Look and Feel of the Office etc.
  2. Performance analysis is a complicated thing. You need to look at Return, Risk (in several dimensions), compare things with the right peer group and analyze sensitivity to market factors.
It is definitely true that the bulk of investors reduce point 2 to an analysis of historical return graphs. So if someone made a relatively high return over the last couple of years, he has to be good!!

Sure? I don't think so. Our database of good, licensed investors contains some 1,000 providers with on average about 10 strategies each. That is 10,000 individual financial products that passed our first tests. Now let us assume that - like in so many fields - for every reasonable or good professional there are 10 crooks out there.

That would lead to a sample of 10,000 potential 'scam' or 'lousy' investment advisers. Of course: the bulk of them is just plain mediocre, but still....Quite a few of them will be professionals or amateurs that somehow have the charisma to have others follow them, even when performance is not of the highest quality after correction for risk.

If we assume that a dollar return of 10% per annum for stocks is 'average' over a longer period of time (looking into our database with information covering the last 100 or so years we see that this is not a bad assumption) and a volatility of standard deviation of 40% we know from Statistics that 2/3rds of all managers will score returns between -30% and plus 50%. This implies that 1/3rd is either totally lousy, bringing in returns of less than -30% per annum, or fantastic: scoring more than 50% per annum.

Result: the group with returns less than -30% will shut up. The group with returns above +50% per annum will make sure people know. They are the champs. Fantastic!

This means that after one year, there are 10,000/6 = 1667 (rounded) managers with more than 50% return. Now, obviously average returns are not 10% each year. But let's assume that on average it is a fair estimate to assume that the group of managers scoring fantastic returns of more than 50 percent per annum will be bigger in good years and less good in bad years. But OK, in the mixture of good and bad those with some buffer due to good performance in the (recent) past will get away with things in less good years, won't they? You can't win in every year.

Now, continuing the math assuming for simplicity sake that we can use the average return as our basis for all consecutive years, we can find out that after 5 years we are left with one manager who scored returns of more than 50 percent in every year !!! That is a cumulative total return equal to 1.50^5-1 = 659.4 percent (rounded). Far more than 5 x 50%, due to the compounded return effect.

We are not using any knowledge about expertise etc here. Just a simple characteristic of statistical data. And since we did not use knowledge about expertise but just statistics, it is equally well possible that our 'good' manager will be in the minus 30% group in year 6 as it is that he is in the positive group. So another 50% annual return is just as likely every year as a -30%. Random statistics is a neat game that in the end will reverse toward the mean.

If everyone were just investing with his/her own money and not in a situation in which he/she could impress others there is nothing wrong with this. But it is tricky in a situation in which investors follow gurus. A lot of those 'scam' guys will be considered stars simply because of their good historical returns in combination with charisma and non-investment-related 'form' factors.

Voila: that explains the opportunities out there for the Madoffs of this world. Not just the opportunity to attract investment money without solid strategy, but even worse: also the opportunity to rob the system by extracting amounts from the system that were never earned. Or: other possibility in Pyramid games, to trigger excitement further by using some of the new inflows of the growing group of followers to pay out some dividend to the smaller first group, so that you create 'disciples' who help spread the gospel ('They really did it! These guys are fantastic!').

But things get even more scary.

This morning the financial newspaper reported that the Dutch regulator did fine an investor for stock price orchestration. During a period of 1.5 years he did more than 500 transactions (buying one share on each occasion) in one relatively unknown and illiquid stock and almost 1,000 in another. His total costs of buying these 1,500 shares was marginal.

But the costs to society could be huge. Idea? Think of this. In a time in which people are already disappointed or dissatisfied with the behavior of the big, boring banks who always advise those same group of stocks that anyone can think of (large and mid caps, blue chips etc) this guy came up with two unknown shares!! ''Waw, he dug so deep to get all this unknown information!' You can almost hear people get enthusiastic.

So, at the beginning of his buy rounds (i.e. before buying one share) he - with at that time still not so much followers - reports that he bought those stocks for his strategy. In the reports on his website he will then start to follow the shares and the portfolio performance. What will happen? Remember that the stocks are unknown and illiquid.

A combination of two things:
  1. Even his small individual transactions on the buy side will sooner or later lead to upward share pressure.
  2. Sooner or later actions by 'followers' will start to appear, thereby increasing things further.
And that is the time when our friend reaches guru status. He will maybe get to a point where some followers want him to invest for them. Find new stars!

As you understand the reason why everyone, including the star manager, in this case are fooling themselves is quite simple. In an illiquid market you make your own price. So the positive return looks nice, but the moment you want to use it to get out, negative price pressure will make it very difficult to really benefit from the price increase. This was not a price increase 'carried' by positive firm news other than the increased trading which we created ourselves in the first place. It provides the manager and his followers of the first hour with an opportunity to exit. Simply make sure that gradually but slowly you become a bit more opaque. Tell them a bit less about what is going on, i.e. use part of the liquidity for your own exit from the desert.

I am not saying anything more. But do you now understand why there are so many unknown 'advisers' with fantastic Penny Stocks advises? Be careful, enjoy a well-deserved great Holiday Season and make sure that one way or another you get your performance analysis right! And let us make sure that regulators around the world get sufficient power to fight scams like this one. Powers in terms of fighting them ex-post, and powers in terms of demanding more transparency up-front.

Even a little bit of liquidity can become expensive in the desert. But after it dries up you probably still die a terrible death. Better not to go into the desert in the first place, unless you ensure yourself of sufficient REAL liquidity.

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