The Big Picture for the Week of April 10, 2011

Larry Swedroe was interviewed at Seeking Alpha and as always had some interesting things to say. I generally disagree with him on most things but he is usually interesting. Swedroe is an index investor who favors DFA funds (in many instances anyway) and does not think that any real value can be added with analysis in the context of making active decisions.

There are several points made in the interview that while they can be correct do not have to be universally correct which calls for a little more detail for people to decide what is better for them based on both sides of these issues.

In pointing out the potential folly in economic forecasting he notes that a year or so ago, the chief economist from Goldman Sachs said the biggest risk to the economy was deflation while the chief economist from Morgan Stanley was more worried about inflation. Swedroe noted that both are smart but that one would have to be wrong. Actually it could be argued that both were wrong as over the ensuing 12 months neither proved ruinous.

In what I think is a related example, when asked about commodity exposure Swedroe said he prefers the actual commodity with the thinking being that gold could go up but the mining stock you buy could have its assets seized for some reason or have some other calamity where the price goes to zero. In an interview this week at IndexUniverse, noted indexer William Bernstein said he prefers the stock instead of the metal because the stock will pay a dividend. Both are smart guys, can they both be right?

Another point that is a little more concrete is about sectors. Swedroe says "there's no reason to think any sector-specific information you have is value relevant. If you know it, so does Goldman and Morgan Stanley and it's likely already baked into the price." Um, not necessarily. The notion of healthcare, staples, ma bell telecoms and utilities doing better in a declining market and lagging during large rallies has been repeating for decades. Sectors growing to more than 20% of the SPX as a warning for trouble is pretty reliable too--although this happens rarely. There are also reliable sectors and industries early in the cycle.

The way I read this part he seemed to be saying that a sector can't be picked to forever be the best performer but of course that is simply not how it works. If this is how he is framing this part of the discussion (my interpretation could be wrong) then either he is missing the point or he is spinning the point. The fundamentals of sectors ebb and flow, as mentioned above there are cyclical issues and so not addressing this aspect of sector analysis makes the conversation incomplete.

Elsewhere in the article Swedroe makes the argument for there only being a finite amount alpha;

There's no indication active managers outperform in even the most inefficient of these areas and there's no way they can. If a market returns 10%, that means that both active and passive investors on aggregate receive 10%. So since active management is more costly, by definition active investors take home less than passive investors.

IMO this line of thinking only exists on a theoretical island. When he says if a market returns 10%, which market does he mean? He might be referring to a domestic market or some global index. Whatever benchmark is selected there are stocks that are outside that benchmark that can be bought. The iShares MSCI World Index Fund (ACWI) is certainly a broad fund. It has 977 holdings allocated over 44 countries (I manually counted the countries so I may be off by one or two). One country not included is Vietnam. Another one not included is Argentina. Someone comfortable with country selection could put 90% into ACWI and put the other 10% into some combo, long or short, of the Vietnam ETF and the Argentina ETF to generate alpha. This example is not put forth as a plausible strategy but to point out that in practical sense, alpha does not have to be finite.

ACWI allocates 0.09% to Colombia. I'm not sure what Colombian stocks are in there but I know one that isn't; Cementos Argos (CMTOY). Someone who understand the Colombian cement industry could put 95% into ACWI and the rest into CMTOY at the right time and generate alpha. And again this example is not put forth as a plausible strategy but to point out that in practical sense, alpha does not have to be finite.

What if you bought a foreign stock and you were literally the only one in the United States to trade that stock and that stock went up more than the market in the time you held it, would that be alpha? This example is real, I bought a small foreign stock and based on reported volume on Google Finance (so it could be flawed) I am literally the only person who has traded it in weeks; incidentally it took Schwab less than one minute to execute it. The stock is up about 10% since I bought it versus 5% for the SPX. While I am not willing to take this type of liquidity risk for clients, is this not alpha? (Please note, that this example could be more about luck is not lost on me).

You might have read the three preceding paragraphs and said to yourself "he is ignoring the risk taken with those examples." Well, in the interview above and other ones I've read, so does Swedroe. What I mean is risk adjusted return. Depending on how it is structured, an equity portfolio that achieves a market equaling result with 10% in cash has achieved a pretty good risk adjusted result. An other example could be 75% of the market's return with only 50% of the market's risk. What about the approach Hussman takes (which I emulate up to a point) in targeting a result over the course of the entire market cycle? Another example similar to Hussman is John Serapere's 75-50 (targeting 75% of the upside with only 50% of the downside).

Swedroe's interviews strike me as being very limited conceptually. Active management means many things. And while it may not be right for many people the conversation is simply not cut and dried in the manner Swedroe frames it.

Manny? What the hell dude?