Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA

Associate Portfolio Manager
  • T613.237.5544 x 313
  • 1.800.230.5544
  • F613.237.5949
  • 265 Carling Avenue,
    8th Floor,
  • Ottawa, Ontario K1S 2E1

Describing a Market Based Approach

Investors and institutions try to categorize investment managers into one of two groups: active or passive. It is important to define what is meant by these respective labels.

Active management is typically defined as an approach that attempts to outperform markets using fundamental or technical analysis; an active approach relies on forecasting. Investors taking an actively managed approach accept increased costs in the form of higher management fees, higher trading costs, and increased concentration risk in hopes that they will outperform the market.

Passive management is typically defined as an approach that tethers a portfolio to a commercial benchmark or index. The objective of a passive manager is simply to minimize tracking error to their index. The outcome of a passive approach tends to be returns that lag their benchmark in the amount of management fees and trading costs.

PWL Capital does not approach portfolio management as a traditional manager, active or passive, making it difficult to describe our philosophy in those terms. We believe that capital markets work; liquid publicly traded securities are fairly priced and reflect the aggregate risk and return expectations of all market participants.

Under this belief system, the rules are different. We aren’t trying to pick winning stocks, and we don’t want third party indexes to govern our portfolio structure. Risk and return are related, and diversification becomes essential to reduce uncertainty and control risk, while also creating an environment for efficient portfolio management and trading. We look to academic finance which has identified characteristics observable in market prices that have strong correlations to higher expected returns. There is strong evidence that it is possible to add value to a portfolio by efficiently maintaining exposure to these premiums. Once these premiums are identified, effective implementation involves providing consistent exposure to these premiums, while balancing the trade-offs of trading costs and diversification.

A traditional manager will want to buy certain securities on a short timeline in the event of a perceived buying opportunity, or may need to sell specific securities quickly to exit a position. Index managers have the same issue. Index reconstitution causes index managers to have to buy high-demand securities that are being added to the index, simultaneously having to sell securities removed from the index, along with all other index managers, all at the same time. Traditional active and indexed portfolios demand liquidity, and pay a premium to others for the flexibility to trade quickly. Without the “need to get done” constraints imposed by indexed or traditional active portfolios, patient traders can capture this liquidity premium and enhance portfolio returns.

Our largest provider of investment instruments employs a flexible and patient trading approach that offers a tangible economic benefit. Portfolios are structured to provide consistent exposure to the dimensions of higher expected return, while minimizing portfolio turnover. Lower turnover means lower transactions costs. Their products do not follow a third party index, meaning that they gain degrees of freedom by not attempting to minimize tracking error. Securities with similar characteristics can be treated as interchangeable. This substitutability means not having to cross bid-ask spreads or move market prices due to urgency, reducing the implicit costs of trading.

This investment philosophy requires a scientific approach to markets. It relies on decades of asset pricing research to identify robust and reliable dimensions of higher expected returns that are persistent, pervasive, and sensible. When portfolios are thoughtfully structured based on science, and rebalanced to provide consistent exposure to the dimensions of higher expected returns, the ideas of active and passive management are no longer sufficient descriptors.

By: Ben Felix | 0 comments

Is it time to get out of the market?

We are in the midst of a long Bull Market. Robert Shiller popularized the idea of Irrational Exuberance when he explained that people get overly excited about stocks when stocks are doing well, bidding prices up to an unsustainable level. Shiller’s Irrational Exuberance can be observed using the Shiller Cyclically Adjusted Price Earnings Ratio (CAPE 10), a price earnings ratio based on the average inflation adjusted earnings from the previous ten years. The measure simply shows us how stocks are priced relative to their average level of earnings over time. When prices reach an extreme relative to average earnings, Shiller would say that we are in a bubble. The logic of an investor might follow that when the Shiller PE gets too high, it’s time to bail out of the market and avoid the expected correction, getting back in when things are back to normal.

The current Shiller PE is starting to edge up on the high side, relative to history, at 25.09. It was 32.56 before the crash in 1929, it was at 44.2 before the crash in 2000, and it was at 27.53 before the crash in 2008. The overall historical mean Shiller PE is 16.54, and the median is 15.93. So, we are currently well above the historical average, and pushing up toward levels that have preceded a crash in the past. Does this mean that everyone holding stocks should sell into cash until the market has corrected? The data says no.

Tobias Carlisle (@Greenbackd) recently ran an experiment where he back tested the Shiller PE as a mechanism to move a portfolio of value stocks into cash at predetermined levels of overvaluation relative to historical Shiller PE levels. The value portfolio was defined as the Fama and French value decile, and the back test ran from 1926 – 2014. The result? The portfolios that used Shiller PE values to go into cash at various levels above the historical mean underperformed the control portfolio which maintained consistent exposure to the value decile. The underperformance was due to cash drag, and missing out on recoveries.
This doesn’t necessarily tell us that it’s impossible to time the market, but it does show that the Shiller PE is not particularly useful in doing so. Investors need to focus on holding the market portfolio with a consistent tilt toward established risk premiums, and stay invested.

By: Ben Felix | 1 comments