Letter

IFA's Quote of the Week - 30 (Bill Miller)

Letter

Step 1 - Active Investors

 

“It seemed like we needed a 12-step program to cure us of our addiction to buying beaten-up stocks..."

 - Bill Miller, chairman and chief investment officer of Legg Mason Capital Management, second-quarter update letter to shareholders

 

 

 

 Bill Miller’s quote displays an enormous degree of self-awareness. While IFA welcomes Miller’s stunning epiphany, his revelation comes tragically late for shareholders who have been punished with a 34% loss in the last year.

For the 15 years from 1991 through 2005, Miller seemed unstoppable as he consecutively outperformed the S&P 500. But, Miller has fallen hard and his widely regarded reputation has begun to unravel. According to a Fortune article dated August 1, 2008(1), Legg Mason Value Trust Fund (LMVTX) has dropped 34% since last July while the S&P 500 fell 12%. LMVTX has hemorrhaged losses as assets have fled the fund. According to the article, the fund was valued at $9.7 billion after the exit of more than $2.4 billion in the first six months of this year. However, losses accelerated according to a Bloomberg article dated August 6, 2008(2) which reports that the Massachusetts state pension fund pulled its assets from the fund. 

True enough, Miller is in need of a 12-step program and IFA is the perfect sanctuary for his recovery. As you know, IFA president Mark Hebner has developed his 12-Step Program for Active Investors as chronicled in his highly praised book Index Funds: The 12-Step Program for Active Investors. Miller’s stockaholic rehab can begin immediately with the following program:

 

Step 1. Active Investors: Recognize an Active Investor.

As a seasoned active investor, Miller knows that active investors hope to pick winners among the many stocks, times managers or investment styles. He also appears to have learned at the school of hard knocks that markets are moved by news. News is unpredictable and random. Markets are also efficient, so news is rapidly reflected in market prices. As a result, active investing is not a viable strategy for anyone, not even Bill Miller.

Miller seems well-prepared for Step 1 as his second quarter letter to shareholders states, “We were commiserating over how badly we had done in this market…and how we were all losing clients and assets over and above our losses in the market.” This revelation should aid in his recovery.

Click here to go to Step 1

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Step 2. Nobel Laureates: Recognize that Nobel Prize winners researched the market.

Nobel Prizes have been awarded to academics for their analysis of how stock markets work. In stockaholic rehab, Miller would undergo a steady transfusion of unbiased academic studies that comprehensively reveal the error of his stock-picking ways and the overwhelming data that supports a passively managed indexing strategy. Additionally, Miller would be cut off cold turkey from sensationalistic news articles and analyst reports which are all generated for the purposes of driving commissions or selling papers.

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Step 3. Stock Pickers: Accept that stock pickers do not beat the market.

This is a crucial step for Miller to undergo so he may achieve a complete recovery. He would have to accept that the primary factor influencing the success of a stock picker is simply luck. Miller would receive concentrated doses of studies and visual aids in the form of pie charts, each of which compares the performances of active managers to a corresponding asset class benchmark. An average of these studies shows that the corresponding index outperforms their actively managed counterparts by a margin of 92%.

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Step 4. Time Pickers: Understand that no one can pick the right time to be in or out of the market.

In this Fourth Step, Miller would gain an understanding that investors are unable to time the markets due to the high concentration of returns and losses that occur in a time period of a few days. In a recent 10-year period, 100% of the total gain was concentrated in just 20 days – an average of just two days per year. It is impossible to pick that handful of days in advance.

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Step 5. Manager Pickers: Realize that winning managers were just lucky.

This step is a critical hurdle for Miller, one that will test his commitment to a full and complete recovery as a stockaholic. Miller’s so-called hot streak could render him reticent to accept the important premise that winning managers are lucky, not skilled. However, Miller did admit to the Wall Street Journal in January 2005 the following, “We’ve been lucky. Well, maybe it’s not 100% luck — maybe 95% luck.” Miller would have to take a bold leap and accept that his so-called streak was based on bad benchmarking. Yes, Miller’s track record did exceed the S&P 500 — a large-blend fund, but Legg Mason Value Trust is more comparable to a large value index.

The figure below plots the risks and returns for Miller's fund LMVTX, IFA's Large Value and Large Company Indexes and for IFA Index Portfolios 80, 85, 90, 95 and 100 for the time period from January 1991 to June 2008. This time period was selected because 1991 is the beginning of Miller's winning streak. As you can see, Miller's Legg Mason Value Trust carried significantly more risk than each fund or index depicted in the chart. However, investors were not adequately compensated for the risk they took. LMVTX earned returns in line with Index Portfolio 80, but it carried nearly 60% more risk. LMVTX also carried risk far greater than Index Portfolio 100 which earned significantly higher returns than LMVTX.

The risk and return story is even worse for investors who purchased LMVTX after Miller's streak was hyped. New money that poured into the fund as a result of a fresh "5-star rating" from Morningstar would likely experience even greater risk and lesser returns than plotted on the figure. To that point, it is worthwhile to consider that Morningstar ratings consider past performance. Past performance of actively managed funds is no guarantee of future returns. Just ask recent investors of LMVTX (which was recently downgraded to 1 star). Click here to go to Step 5

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Step 6. Style Drifters: Comprehend active management style drift.

Most mutual fund managers drift from once recent winner to another, altering a fund’s stated objective. Miller appears to be no exception as he describes chasing the latest trends — albeit most unsuccessfully:

“…it was obvious we should not have owned homebuilders, or retailers or banks, and that I should have known better than to invest in such things. It was also obvious that growth in China and India and other developing countries would drive oil and other commodities to record levels and that related equities were the thing to own. While I am quite aware of our mistakes, both of commission and omission, when I ask what is obvious NOW, there is little consensus. If there is something obvious to do that will earn excess returns, then we certainly want to do it.”

In Step 6 of The 12-Step Program for Active Investors, Miller would learn to understand that there are no obvious ways to earn excess returns, and that style performance rotates randomly so it is not possible to consistently predict tomorrow’s winning style. In other words, don’t try to beat the benchmark, buy the benchmark.

Click here to go to Step 6

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Step 7. Silent Partners Recognize the partners in your returns.

There are partners that silently and subtly take a large slice of investment returns. Over a 15-year period of time, active investors keep only about 50% of the total return earned by their investment while index investors keep about 85%. Manager fees, higher taxes, transaction costs all eat away at an active investor’s returns pie. For Miller’s LMVTX fund, investors pay an expense ratio of 1.7%. In contrast, the expense ratio for an all equity index portfolio is about 0.45%.

 

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Step 8. Riskese: Understand how risk, return and time are related.

In this important step in Miller’s recovery, he would have to fully comprehend the language of stock market risk. Lawyers speak legalese and the best investors speak riskese. Learning the language of riskese requires investors to have a basic understanding of the concepts of risk, return, time, correlation and diversification. Most investors chase the short-term returns of stocks, markets and styles and concentrate their investments in just a handful of stocks that are highly correlated and his fund is very poorly diversified. Miller’s LMVTX, for example, holds 97.5% of its investments in just 39 stocks. Additionally, Miller’s fund invests in value companies, which are known to be risky. Again, Miller earned a return in excess of the S&P 500 because he took more risk that the S&P 500. Similarly, Miller has underperformed the S&P 500 because he took more risk that the S&P 500. This is the downside of excessive risk, a downside that investors were likely unaware of as Miller was compared to the S&P 500. Simply put, you cannot cheat risk.

Click here to go to Step 8

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Step 9. History: Understand the historical risk and returns of indexes.

Moving into the homestretch of The 12-Step Program for Active Investors, Bill Miller would likely be encouraged by Step 9. During this phase of the recovery program, Miller would be faced with reams of data regarding style-pure asset class indexes. He may very well find himself enjoying a sense of calm as he delves into 80 years of risk and return data and rolling periods analysis. He will then likely abandon his desire to pick stocks, markets and styles, choosing instead to focus on quantifying risk so he might rebuild his investing efforts upon a strong foundation of index data. 

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Step 10. Risk Capacity: Analyze your five dimensions of risk capacity.

A risk capacity survey helps self-professed stockaholics determine how to invest their assets properly. Prior to investing, each individual should learn the extent to which they are able to take on stock market risk. A risk counselor or Investment Advisor Representative can help such investors quantify the appropriate amount of risk for their investments. This phase of stockaholic rehab includes analysis of five dimensions of risk capacity to arrive at a score that is matched to a corresponding index portfolio. These five dimensions are time horizon and liquidity needs, investment knowledge, net income, net worth, and attitude toward risk.

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Step 11. Risk Exposure: Analyze your five dimensions of risk exposure.

Step 11 of The 12-Step Program for Active Investors provides the magical moment when a recovering stockaholic learns their risk capacity score and is matched with a corresponding Index Portfolio. At this point, they can view the asset allocation that is just right for them, not too much risk and not too little. They can replace their compulsion to speculate with a more logical and moderated understanding of returns and volatility data. They will learn where their Index Portfolio sits on the risk reward chart known as Harry Markowitz’s efficient frontier. They can view the bell shaped curve that will show their average expected returns and the highs and lows for the portfolio for the last 80 years, and for many other time intervals.

Click here to go to Step 11

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Step 12. Invest and relax.

The road to recovery for all stock market addicts, including Bill Miller, comes to a happy conclusion when they fully recognize that a strategy of buying, holding and rebalancing a portfolio of index funds is the best way for them to maximize the expected returns of their investments. They will be able to design, implement and maintain a portfolio that makes good use of risk, diversification, style purity and passive management. And when they do so, they will finally be able to invest and relax.

Click here to go to Step 12

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IFA would be pleased to lead Bill Miller through stockaholic rehab. Additionally, IFA welcomes the opportunity to assist disheartened investors of LMVTX and other actively managed funds, as well as stock pickers, market timers and style drifters in learning the benefits of proper risk management and broad diversfication.

Index Funds Advisors is an expert in measuring and quantifying risk capacity for the long-term investment needs of individuals, 401(k) plans, institutions and corporations. This important measure enables investors to make sound decisions that can help them earn returns commensurate with the risks they take. IFA specializes in the passive rebalancing of risk-appropriate, globally diversified index portfolios that are low cost, tax managed and efficient.

 

1. Bill Miller: Toughest market I've seen, Fortune, August 1, 2008http://money.cnn.com/2008/07/31/news/companies/miller_levenson.fortune/index.htm?source=yahoo_quote
2. Bill Miller's letter to investors, Fortune, July 31, 2008
http://money.cnn.com/2008/07/31/news/companies/miller_letter.fortune/index.htm?postversion=2008073109

 

IFA’s 20 Index Portfolios provide risk-appropriate allocations to as many as 15 IFA Indexes that carry 80 years of risk and return data.  Through global diversification, IFA’s Index Portfolios are able to maximize investors' at the level of risk determined by their risk capacity.

What’s your risk capacity? Take the no-obligation 10-minute survey, or call to speak with an Investment Advisor Representative 888-643-3133.