Many people seem to be worried that the market is a little toppy. This is kind of strange because the market is basically flat and hasn’t done anything. But OK, the market was up 30% last year so if you include that (and the whole rally since the 2009 low) the market has come up quite a bit.
But still, smart folks like Howard Marks (who was just on CNBC yesterday) said that the market is not in bubble territory at all; maybe somewhat overvalued. The market is still in what Buffett called the “zone of reasonableness”.
Others say the market is in nosebleed territory and is due for a correction or at least subpar returns for a long time.
David Einhorn is short a basket of really expensive momentum stocks but he says that is only a small part of the market (mid-single-digit percentage of the market bubbled up compared to 30% of the stock market in a bubble back in 1999/2000).
I wrote about what to do in a market that has gone up a lot and you wonder what to do. You can see that post here: What to do in this Market
My thoughts haven’t really changed at all. I also wrote a series of posts on market timing (even including ‘pricing’ the market instead of ‘timing’ it). You can see my posts about Buffett the market timer here
In order for people to have earned 10%/year in the last 100 years, you had to own it through the depression, through war and peace, when p/e’s were 7x and when p/e’s were 30x. The point is that most people would not have been successful getting in and out of the market and doing better than 10%/year, even if you used market valuation levels (instead of economic forecasts). 10% returns were not earned by being fully invested at 7x p/e, 50% invested at 15x p/e and 0% invested at 25x p/e or anything like that.
Another way to illustrate this is if you look at something like Berkshire Hathaway. BRK has gone down 50% three times in the past (or maybe more). Once in the early 1970’s, once in 1999 and then again during the recent crisis. Of all the investors who owned BRK in 1970, how many have done better than the 20% or so return of the stock over the years by getting in and out of it in order to avoid the 50% drawdowns? There may be some who were able to improve on that buy and hold. But I doubt that there are too many people, even if they used very good valuation methods to time the sales and repurchases.
So that’s sort of the way to look at the market. As long as you have faith in the U.S. and the system at work here, you can look at the stock market in the same way. Most people who sound clever now telling us what the market is worth and getting in and out accordingly is probably not going to outperform the market over time. They will look good temporarily when the market goes down, though.
OK. So we all get that.
Having said all of that, it is still interesting to look at what’s out there in terms of alternatives for people who don’t like stock market exposure. I am really skeptical about those market-timing funds that change asset allocation according to market valuation, economic forecasts and things like that. A lot of that stuff is great for asset gatherers and marketing; everyone hates volatility and a lot of presentations by these tactical allocators just make a whole lot of sense. The problem is that I don’t think that they perform all that well over time.
So here’s the punch line:
As you know, I am a big fan of Joel Greenblatt, and this is the latest iteration of his fund operation. Initially, he had Formula Investing funds but shut those down and started these new funds. Why? Why is he running a long / short fund when he said about shorting that it is really difficult and that guys that do this are like the baseball outfielders that go, “I got it, I got it…” and then inevitably at some point go, “I don’t got it…”?
He also said that buying the Magic Formula stocks and shorting the most expensive stocks on the list would have led to much more volatility on the overall portfolio than just being long because you can get really killed on the short positions.
But here we are with Greenblatt running long/short funds.
I’ll get to that in a second, but first let’s take a look at the cool website and his returns so far.
Here’s the website:
There are some nice links there of Greenblatt’s interviews on Bloomberg and CNBC. Also, his interview in Value Investor Insight
is posted there too and it’s a great read. Read that here
And these are the funds that they offer:
I know, I know. This looks suspiciously like the long/short funds that was popular with the big mutual fund companies not too long ago. I think most of those haven’t done too well over the years. The problem, I think, with the long/short funds that the mutual fund giants put out was that they were usually run by long only managers who suddenly had to start shorting stocks and they had no idea how to do that.
They would buy a nice value stock and then short an expensive mo-mo stock. It makes sense on paper, but then the value stock goes up 15% for a nice return and then the mo-mo stock goes up 50%. Oops.
So running a long/short portfolio requires different skills than running a long only equity portfolio. I’ve actually seen this happen (a long only manager transitioned to a long/short manager) with predictable results (even though this manager turned it around eventually; it helped to have been part of a legendary hedge fund firm).
Plus, if you are working for one of the big mutual fund firms and can actually do long/short well, you would either get hired at a hedge fund or start your own. Why would you not go out and earn your own 2 and 20?
The funds are too new to really evaluate them, but here are the figures anyway:
The S&P 500 total return isn’t listed with these figures, so here are the year-to-date and one year returns of these funds versus the S&P 500 index (the figures below are as of June 10, 2014):
YTD 1 Year
Gotham Enhanced Return +10.5% +34.4%
Gotham Absolute Return +6.4% +21.5%
Gotham Neutral +7.4% n.a.
S&P 500 Index +5.5% +18.7%
So it looks like even the Neutral fund is outperforming the S&P 500 index year-to-date. Of course, the time period is way too short for this to be relevant.
But, you know, I have been a big fan of this approach (Magic Formula) and I have a lot of confidence in Greenblatt so I would have no problem recommending any of these funds to anyone interested in this sort of thing. I don’t own any mutual funds but if I had to pick funds to invest in, I would definitely consider one of these.
I usually don’t like these long/short type funds unless they are run by people with a proven track record of doing well with the strategy.
And I am also very skeptical of quantitative/mechanical investment methods. Yes, value has been proven over and over to work in study after study. But when things get mechanical, I start to worry and have never been a big fan of investing mechanically (I actually don’t know how purely mechanical these funds are because there does seem to be some room for input from the managers).
But Greenblatt is different. He came up with something after years of experience in the markets. Usually, it’s the other way around: Some folks in academia or research departments at wire houses come up with some sort of screening method to try to create baskets that outperform. I’ve seen tons of these things over the years but never saw anything that was as simple and consistent as Greenblatt’s Magic Formula.
And whatever they do here in these newer funds is an improvement on that (partly going long/short, and then an added layer of weighting the portfolio according to how cheap or expensive something is instead of equal-weighting it).
The Evolution of Joel Greenblatt
So, let’s get back to the question: After dismissing shorting as too difficult and saying people eventually get killed doing it, why is he now running a long/short fund!?
In order to understand this, we must go back and look at how Greenblatt has evolved over the past decade or so.
Stock Market Genius
After a nice long run as a hedge fund manager and putting up some impressive figures, Greenblatt wrote You Can Be a Stock Market Genius
. He said that he initially wrote this for individual investors. After it was published, he realized that much of the material was over the head of most individual investors. It turns out that this book was used successfully by many young hedge fund managers. So he said, hmmm… How can I reach the less experienced, more typical individual investor?
Then a few years later he wrote The Little Book That Beats the Market
. This was meant to explain how value investing works, and he even gave readers a formula to calculate return on capital and earnings yield. He even set up a website to list the cheapest stocks according to this methodology.
And then he realized that even with all of that stuff provided to the public, people still didn’t act correctly and ended up not doing too well. I think he had a record of people using the formula but human intervention prevented some from actually doing well (I forget the details, but it was something like not wanting to buy the crappy (cheap) stocks on the list, or getting scared out of the market during declines).
So he set something up where someone will do all the work for them.
I don’t really know what went on between the Formula Funds and Gotham Funds, but my guess is that it went something like this:
Greenblatt realized that even if Formula Funds did all the work, people will still get scared out of the market at the worst time. I’m sure he had some experience with that and studies show that individuals tend to do way worse than the funds they own as they put money in at the highs and run away at the lows. Some research even showed that investors collectively actually lost
money in a fund that performed well.
This reminds me of the person (I mentioned this on the blog before) who told me that he has never made money, ever, in the stock market and he has been investing in the stock market during the period the Dow went from 4,000 to 12,000 (or something like that). How can you be an “investor”, have the stock market triple, and not make money?! I think this is very typical.
And at some point he wrote The Big Secret for the Small Investor
. This book was about value-weighting the indices. Market capitalization-weighted indices didn’t make sense for value investors because you were forced to own the larger cap names regardless of their valuation level. Someone improved on this by removing the big-cap bias by equal-weighting the index. The Big Secret is to take it a step further; the value-weighted index would give a higher weighting to the cheaper stocks and less to the more expensive ones. This makes a whole lot of sense and I was sort of looking forward to some development in this area.
I wrote about that here
, but it seems to have gone nowhere (the website data only goes through 2010).
But hold this thought for a second, the idea of putting more into cheaper names (instead of equal-weighting it like the Magic Formula).
So now we get to Gotham Funds. He once said that shorting is very difficult and that trying to long/short the Magic Formula would create more volatility, not less. But I guess he revisited the idea after realizing that even if a method worked well, most people won’t benefit from it because they can’t sit tight long enough to make any money.
So he must have been working on figuring out a way to get the long/short to work. Plus the Magic Formula was so incredibly consistent that it must work, somehow. By consistent, I mean that the 1st decile stocks through the 10th decile stocks performed exactly as expected over time according to their relative cheapness. This sort of vertical consistency was strongly indicative that some sort of long/short strategy must work.
By using a larger number of stocks and weighting the components by how cheap/expensive they are, he figured the volatility of the portfolio will be more stable (than say, buying a basket of 20 cheapest stocks and shorting the 20 most expensive ones).
With the various options above, an investor can choose how much market exposure he wants. Someone who is comfortable with the stock market can just buy the Enhanced Return fund, and others who don’t like stock market volatility can go with the Neutral Fund.
He did say in an interview that he wouldn’t use these funds as market timing devices because most people won’t be able to do that well.
I can see the temptation to roll into the Neutral or Absolute Return funds when things look expensive and then get into the Enhanced Return when the market goes into a bear market (and gets cheap). I imagine the fund flows would actually be the opposite of that, though.
There is a fee for redeeming early so there will be a cost to doing that.
And I wouldn’t really advocate that at all.
But this would still be far better than switching in and out of the stock market versus cash and bonds. If you have to time and switch, it would be far better to do so between funds that would probably do well either way.
Plus I would guess that that would be far better than owning a fund that tries to outperform over time by switching between stocks, bonds, cash, commodity proxies and whatever else based on economic forecasts, market valuations and things like that. Again, good luck with that.
Why Kill Formula Funds?
So why did he have to get rid of the Formula Funds? I don’t know. My guess is that he thinks he found a better way so why bother keeping the old funds if these new ones are better? He doesn’t want to build a mutual fund giant by offering many variations of funds. Most mutual fund companies love putting out new funds and using every new fad to increase AUM. That works great for them; more funds, more work for their employees (young apprentices can gain experience by trying to run a new fund etc…).
But that’s not what Greenblatt is trying to do. He is trying to help the average individual investor make money in the market, and as long as he finds better ways to do that, he will replace the old strategies with the better ones. If you invent and start selling refrigerators, maybe you can just stop selling ice.
But this is just my guess. Plus, the cost of running multiple funds is probably a big factor too. He probably wants to keep this a small, simple operation and invest resources into research and improving the product and not wasting money increasing administrative overhead by running a bunch of different funds.
Has Greenblatt Really Evolved?
One question is, has Greenblatt changed his views on investing after all these years? He said in the Value Investor Insight interview that he hasn’t changed. In fact, if he started all over again he would do exactly what he did the first time; run a highly focused fund of special situations. He said that this approach is highly volatile and he was OK with that. In the early years when he made high returns (40-50%/year), every two or three years he would have a 20%-30% drawdown that happened pretty quickly. But he didn’t mind that.
These recent ideas are his ideas that he thinks will work better for most people.
So this evolution is more of Greenblatt’s evolution in trying to help the average investor make money in the stock market. He wrote a book. That didn’t work. He wrote another book. That didn’t work. He did the research for them. That didn’t work. He set up a fund for them. That may or may not have worked, but he found a better way to make the average individual investor stick to the strategy and not get scared away.
By the way, here again is the performance figures for the Superinvestors of Graham and Doddsville from 1966 through 1982, a period when the stock market went nowhere. The market was overvalued back in the late 1960’s and the Nifty Fifty peak was in 1972.
But these Superinvestors did well overall through the period. I use this table to remind myself (and others) that the overall stock market level is not always the most important thing in long term performance.
The other point, looking at this table now, that I realize is that during this time the market was probably highly bifurcated. The mo-mo stocks were expensive back in the late 1960’s, and then having been fooled by the conglomerates boom and tech stocks (-onics was the .com of the time; end your company name with these and the stock price went to the moon), investors rushed into the nifty-fifty one decision stocks (they were high quality blue chips, not fad stocks. What can go wrong, right?). My guess is that these Superinvestors did well during this period because they stayed away from the bubbled up areas.
I think we may be in a similar period now. I don’t really see the overvaluation that people keep talking about; I don’t see excessive margins in the companies I am interested in and I don’t see high p/e ratios there either.
But there are pockets of silliness here and there. If you look at TSLA, AMZN, NFLX not to mention FB, TWTR, things look a little bubbly. As Einhorn said, this area is not as big a part of the market as internet/tech bubble back in 1999/2000. The collapse of some of these names may or may not take down the whole market, but either way, it’s not such a big part of the stock market.
This is one reason why I am not a big fan of looking at the stock market valuation as a whole in making investment decisions. The Superinvestors wouldn’t have done so well if they sat out the market in 1966, 1972 etc… And there was plenty do to even in 1999/2000 despite the market trading at 30x p/e (or whatever it was).
So why is this relevant to this post?
A highly bifurcated market is a great time to be long the market (if you own the right stocks) but can also be really interesting for a long/short strategy. But of course, only if the person running it is competent. I don’t think just any long/short fund will do well; I think most will do horribly; they will get killed on both sides (the shorts will go up and the longs will underperform!). But if I’m right, Gotham Funds may do well on both sides; at least relatively.
So although nothing has changed as far as I’m concerned (with respect to what to do in the markets) I like to follow Greenblatt and I think he is the real deal.
I am usually not a fan of long/short mutual funds (or even hedge funds unless run by someone with a good track record; never buy these things offered by the large mutual fund companies!), and I am not really a big fan of mechanical investing either.
But again, Greenblatt is a veteran that has a proven track record in the markets so he is not just some academic coming up with a nice theory trying to sell you something. So I wouldn’t have much reservation about these funds based on it being a long/short strategy and quant-based.
Also, I know that the Magic Formula has been controversial in the past; that people have not been able to duplicate Greenblatt’s results. I haven’t done any work on that myself but I suspect a lot of that is going to be because of the data.
When I worked at big firms, a lot of resources went into cleaning up the database (that were presumably already cleaned up by the vendor). So it would be really difficult in any case to duplicate results without a good staff actually going over the raw data first. You’d be surprised how much silliness gets into these backtests if you don’t actually check the data yourself (or have someone do it for you). This would include things like dropping stocks where the financial data is suspect or meaningless (data vendors won’t do that).
- In this bifurcated market we know that there are decent stocks to buy and the Magic Formula type things will outperform over time. No need to get out of the market even if the whole market is expensive (and some great investors say it’s not) if there are reasonably priced stocks to own. And the Magic Formula is not a bad way to be long (assuming the Gotham Funds use a similar methodology).
- On top of that, the returns in these funds will be enhanced by the weighting strategy of buying more of things that are cheaper instead of equal weighting them (read the The Big Secret for the Small Investor and go to the website (valueweightedindex.com) to see how that works).
- And then you have a short portfolio overlay on top of this using the same strategy in reverse; shorting more of the more expensive things. The short book is risk managed by having smaller positions per name so as not to get killed by the occasional NFLX / AMZNs.
- People will always be afraid of some stocks due to recent bad news (and therefore underprice them) and will always adore others (and therefore overprice them). As long as this continues to be the case, the strategy should work.
It’s such a simple idea and it sounds too good to be true. And yes, the mutual fund industry is littered with funds that tried similar things in the past.
I will tell you, though, that this is different than those past attempts by a wide margin; mostly due to the experience of Joel Greenblatt, the research that he has done and disclosed to demonstrate that the ideas actually work etc…
The $250,000 minimum investment might be a high hurdle for some younger individual investors, but if I wasn’t actively managing my own account, I would certainly consider putting a decent chunk of my risk capital into these funds.
Anyway, I don’t recommend mutual funds here all that often, but take a look!