The Bill Gross' Way of Making Money
(October 20, 2005)
Dear Subscribers and Readers,
In last weekend's commentary, I discussed the basic principles of mean reversion trades - and how it fits in with the investing philosophy of this author and why it actually may be the easiest way to make money from a macro standpoint going forward. For readers who haven't read last weekend's commentary, I urge you to read it ASAP - reading it will allow you to understand where we are coming from and what we intend to do and discuss with our commentaries going forward.
In this Thursday commentary, I would like to discuss the Bill Gross' way of making money. Most of our readers should know who he is, but for those who don't know: Bill Gross is Chief Investment Officer and a managing director of PIMCO, one of the world's largest fixed income manager. Gross also manages the world's biggest bond fund - and helps manage over $250 billion in assets at PIMCO. For readers who would like to read more about Bill Gross in detail, you can do so by purchasing his latest (and only) biography at Amazon.com.
In an article within the latest issue of the Financial Analysts Journal (FAJ), Gross discusses the concept of "Consistent Alpha Generation through Structure." I will explain what this means in a minute, but in a nutshell, Gross believes that successful investment in the long-run (whether it is in bonds or in equities) rests on two foundations - the ability to formulate and articulate a secular outlook and having the "correct structural composition" within one's portfolio over time. Since Mr. Gross can articulate this many times better than I can, I will shamelessly now quote the text of his article which seeks to explain these two foundations:
After more than 30 years of managing institutional and individual bond monies, I have gradually come to the understanding that successful money management over long periods of time rests on two, somewhat disparate, foundations. The first is "a secular outlook"- that is, a three-year to five-year forecast that forces one to think long term and to avoid the destructive bile arising from the emotional whipsaws of fear and greed. Such emotions can convince any investor or management firm to do exactly the wrong thing during "irrational" periods in the market.
The second foundation is what might be called the "structural" composition of portfolio management, and whether the reader agrees or disagrees with the secular thesis, I would argue that those who fail to recognize the structural elements of the investment equation will leave far more chips on the table for other, more astute investors to scoop up than they could ever imagine. A portfolio's structure is akin to its genetic makeup: It is how it is constructed without regard to short-term strategic decisions. Structure incorporates principles that are longer than secular, principles that are nearly paramount and should be able to deliver alpha during years when the manager's magic touch-to use a basketball metaphor-seems to have disappeared or when there's simply a time-out on the court, with secular investment opportunities few and far between. Duration, curve, credit, volatility, and other less obvious tilts to a portfolio's steadystate status are what I mean when I speak of a portfolio's inherent structure, although some tilts are more volatile than others and, therefore, produce less risk-adjusted alpha.
Gross then gives a couple of examples of institutions with investment structures that will succeed over time. The first example involves the traditional role of a bank - where it borrows short and lend long - thus making the spread between the short-end and long-end of the yield curve. Gross acknowledges that: "If a bank does not overdo the structural model (and they can and have), profits are almost guaranteed on a long-term basis as long as capitalism as we know it survives." The second example involves insurance companies - which takes in a steady flow of revenue stream from its policy holders, and where liabilities are usually well-known given the predictability of death and disability of the general population over time (the actuarial models are really not too complicated). Such a "financial structure [is] almost guaranteed to generate a positive return on capital." Of course, a discussion of insurance companies is not complete without a mention of Warren Buffett and the structure of Berkshire Hathaway, where Gross opined: "Closer to portfolio managers is the structure of Warren Buffett's Berkshire Hathaway, which depends on "float" (about which he frequently writes and talks). This structure, combined with his bottom-up, secular stock picks, has produced one of the world's great fortunes and investment success stories."
Bill Gross then highlights the important characteristic of this structural composition advantage: "In addition to their profit-generating elements, these structures share the common element of longevity, near permanence. They span time periods beyond the secular segments of three to five years, which define typical forecasting periods, and secular stretches of inflation/disinflation that have endured for several decades. An investment's structural magic, then, comes from its "Methuselahian" ability to persist."
So Henry, how can we use Bill Gross' investment philosophy to our advantage? Let's first briefly touch on the secular outlook, or the three to five-year forecasts. Our purpose of starting this commentary is to educate our readers about the financial markets - including but not limited to new investment trends, individual industries, investing psychology, and financial history. In doing so, we are also educating ourselves, but more important, writing a commentary twice a week forces us to formulate a clearer view of where the financial markets are heading and what they mean for our investment portfolios. Sometimes, we may be able to come up with a good three-year or five-year forecast. At other times, this picture will be murkier - with our "crystal ball" so muddled that we won't be able to see beyond even a few months from now. However, as our readers should know, we are always thinking long-term - since we know that the huge profits are usually made by first spotting the beginning of a secular trend and riding with it until it ends. The mean reversion trade is a reflection of such thinking. By brain-storming and formulating ideas, weaving them altogether, and writing them down on paper for others to judge, we are invariably forcing ourselves to be objective - or, as Bill Gross puts it, "avoid the destructive bile arising from the emotional whipsaws of fear and greed."
As for having the correct structural composition, the question to ask is: How, as individual investors, can we replicate the structural composition advantage of a bank or an insurance company? How does PIMCO accomplish this feat? PIMCO accomplishes this by using two primary structures:
- Similar to a banking structure, PIMCO borrows at the short-end via futures at close to the risk free rate, and then places the proceeds into longer-dated and slightly riskier investments. This allows PIMCO to pick up a consistent spread of 50 basis points a year, "in almost all yield-curve scenarios except that of an extended negative yield curve (à la 1979-1981)."
- Selling volatility without utilizing leverage. The avoidance of leverage allows Bill Gross to stay with his trades, as opposed to most hedge funds where they have a limited amount of time to "get it right." Such was the case of Long-Term Capital Management - whose concepts looked great on paper but who were very vulnerable given it held huge levered and illiquid positions. Gross argues that it is in PIMCO's advantage to utilize this structure, simply because of the inherent overvaluation of interest rate options, the "lottery ticket mentality," the mean reversion trade, and the fact that there are two significant parties that are, at all time, inherently long volatility. Since the first three characteristics can also be observed in the equity option markets, I will not discuss this at length here. Instead, I will focus on his final characteristic.
Gross starts off this discussion by citing parts of a 2002 speech made by Peter Fisher, former Under Secretary of the Treasury - which can be found in our discussion forum. The part cited is reproduced below:
Two major players hold positions that require the rest of the market systematically to be short volatility. One is the federal government, and the other is the American homeowner, through the mortgage market.
Again, Gross can explain this in a much better way than I can. In a nutshell, Gross argues that by owning a disproportionately large amount of mortgages relative to an index, one should outperform the index over the long-run. I will quote:
Turned upside down, with a PIMCO slant tacked on, Fisher's statement says that because the U.S. government and U.S. homeowners are systematic buyers of volatility (with little recognition of the price they are paying), others can profit structurally by taking the other side of the bet.
How does one get in line to do this? First, it can be done by owning a disproportionately large percentage of mortgages relative to an index. Owning a mortgage is nearly the same thing as owning an agency note (e.g., a Freddie Mac, Federal Home Loan Mortgage Corporation, note) and selling the attached prepayment option to the individual homeowner. It results in a higher yield while carrying the risk of prepayment (or, conversely, duration extension) at exactly the wrong times in the interest rate cycle. Although Fisher argued in his speech that the mortgage volatility market is not necessarily "complete" with regard to price discovery, I believe that historical returns and sociological factors involved in the pricing of the mortgage "option" overwhelmingly favor the holder of the mortgage-backed security and, therefore, the explicit seller of prepayment options. Long-term performance numbers for mortgages versus straight agency notes, for instance, favor mortgages over almost any five-year (or longer) period since the origination of the Ginnie Mae (Government National Mortgage Association) pass-through in the mid-1970s.
The mispricing/overpricing of the prepayment option is the fundamental explanation. The U.S. homeowner, it appears, knows little about the worth of his prepayment option but is more than willing to pay for it via higher interest rates. The opportunity to prepay seems to be an inherent component of a U.S. homeowner's cultural ethic. No amount of massive buying by us or by the agencies themselves in the past decade or so seems to have "arbitraged" away the overpricing of this option. Over the years, our overweighting of mortgages has added perhaps 10 bps annually to performance.
Going back to our question, how does an individual investor take advantage of this knowledge, such that he or she can implement a structural composition similar to PIMCO's in one's portfolio? First of all, this author would argue that buying and owning a home (and having a mortgage) is fine, as long as one recognizes that a home shouldn't be your primary investment (some people would take this further and argue that their automobiles are their primary investments). As Bill Gross argued, home mortgages are invariably overpriced, and the option to prepay is also overpriced as well. Moreover, it is interesting to note that the data on real estate (even in the U.S.) is not that extensive, and putting your home first as your primary investment is most probably a bad idea. Property taxes and maintenance costs aside, Robert Shiller, Yale Economics Professor, had this to say about the housing market in a recent Fox News article (real estate statistics can be found in the second edition of his book "Irrational Exuberance" as well):
When he started researching the housing market Shiller says he was dumbfounded that no one had ever looked at the trend in U.S. residential real estate prices over any extended period of time. So he meticulously constructed his own.
Which led him to a rather startling conclusion: residential real estate has not been the wonderful investment most people believe it to be.
In fact, except for two periods - the early 1940s and the late 1990s - when adjusted for inflation, home prices in this country "have been mostly flat or declining."
This trend holds true even in what Shiller calls the "glamour cities" such as Los Angeles - where you hear of recent double-digit price increases. That's because while these areas get a lot of publicity when real estate prices skyrocket, they also tend to experience periods of significant price declines (which get less media coverage). As a result, the average inflation-adjusted price increase in Los Angeles real estate since 1980 isn't much higher than that seen in Milwaukee.
Put another way, this author would rather be buying the NASDAQ 100 for the long-run rather than buying a home as a primary investment right now.
Second of all - based on the FAJ article and based on my studies and other research that I have seen, there are two things which retail investors should not regularly indulge in. Both of these have consistent "negative alpha generation," and they are:
- The "investors" who are consistently short the market without a major theme to go on. As a rule, this author does not like to short - except in potential bankruptcy situations or in very cyclical stocks that are very overextended on the valuation side. Unfortunately, shorting Google at a P/E of 100 does not qualify.
- The "investors" who regularly purchase call options or put options. Like I mentioned in our discussion forum, even George Soros himself has previously emphasized that the Quantum Funds never purchase options - only sold them. If Soros does not believe in speculating with option purchases, then I suggest the average retail investor does not either. Been there, done that.
Keeping the above in mind is important, since cutting or avoiding losses is an integral part of investing. If one can consistently avoid making the stupid and obvious mistakes that most investors make, then one is already much better off than most of his or her peers. One can extend this argument further and adopt PIMCO's strategy of selling unlevered volatility (which will involve writing options in this case), although the temptation to overreach is high for the retail investor. However, make no mistake: Before one uses options as an integral part of one's portfolio, it is necessary to rigorously study the subject - as there are many other investors (and hedge funds) adopting this same strategy. Readers who want to discuss this issue further can do so in our discussion forum.
I now want to discuss a little about the current stock market. Today's rally was impressive in some ways - even as breadth was disappointing - as evident by the rally in homebuilding stocks and by the dramatic upside reversal in the Dow Transports today. In after-hours trading today, the NASDAQ 100 after-market indicator was down a little bit over 5 points on the heels of eBay's and Amgen's earnings and guidance. In terms of our 25% short position in the DJIA Timing System, it is imperative that the decline resumes soon - otherwise, we will be looking to cover our 25% short position most probably by early next week. For now, we will continue to be vigilant and watch for any signs of renewed strength.
In last weekend's commentary, I also promised to discuss more about the long bond and what the future may hold for it going forward. In the short-run, it is no surprise that there is downward pressure in the long bond, as we continue to see signs of inflation going forward. As we have previously discussed, the ECRI's Future Inflation Gauge is at a five-year high (the last high being the June 2000 reading), while the cost-of-living-adjustment for Social Security recipients is scheduled to be 4.1% - the highest adjustment since 1990. Interestingly, however, the CPI peaked in both 1990 and 2000, and long rates subsequently declined soon after those high CPI readings. Since the world of the long bond is so efficient, it may be a better strategy to look at sentiment rather than fundamentals when it comes to gauging the future direction of the long bond. Sentiment-wise, I have found the Rydex Bond Ratio (which is calculated by taking the total assets in the Rydex Juno Fund (bearish on bonds) and dividing that by the total assets in the Rydex Government Bond Fund) as a very useful overbought/oversold indicator. Following is a two-year chart showing the 30-year Treasury yield vs. the Rydex Bond Ratio, courtesy of Decisionpoint.com:
Note how the peaks in the Rydex Bond Ratio have coincided with recent peaks in the 30-year Treasury Yield. Right now, the level of the Rydex Bond Ratio is at 21.97 - essentially a neutral reading relative to the readings we have seen over the last 18 months or so. My guess is that there will be continued downward pressure on the long bond (and thus, upside pressure on yields) but come early or the middle of next year, this will dissipate.
Conclusion: I urge our readers to study what Bill Gross has articulated and think long and hard about the strategies they have been implementing in their portfolios. In the event that one's secular view is wrong, which part of your portfolio can compensate for such a downside streak? Is there a way you can consistently make money, such that when your trading gets "cold," you don't become desperate - which is a surefire way of losing even more money? Even if one cannot take advantage of any "structural advantages," it is equally important to avoid the "structural disadvantages," such as consistently shorting the stock market or buying call and put options - both strategies which tend to generate "negative alpha" over time.
Henry K. To, CFA