Friday, August 27, 2010

Diane Garnick: The power of compounding

Diane Garnick, investment strategist with Invesco, discusses global trends and highlights her financial viewpoint in an interview with The Markit Magazine

2007 - Present Invesco, investment strategist
2001 - 2003 State Street Global Advisors, chief investment strategist
1998 - 2001 Merrill Lynch, global derivatives strategist
1996 - 1998 Deloitte and Touche, certified public accountant
2001 - Present Ladies in Red, founder and board member
2007 - Present Christus Health, chair of Investment Committee

"It took 50 years for GM to achieve economies of scale, five years for Google to grow but only five months for Facebook to reach 4m households. The difference between companies that survive versus those that do not will be the speed and scope of their efficiency."

"The quality of the data that goes into these models is the single largest contributing factor to the quality of the data coming out. The more time and effort we can invest in the quality of the data, the better off we are as an investing community in understanding what has changed about the market and how valuable the models are."

"As scientists, we are just as excited to have a failure from an experiment as we are a success. There is a tremendous amount of information in failure. Sadly, as business professionals, we are not nearly as excited to have a failure, although the opportunity to learn is just as strong."

Q What broad-based investment opportunities do you currently see?
A There are two opportunities for investors that are consistent over time. The first is capturing the small cap premium. Fewer analysts cover small cap companies and these investments have the opportunity to change pretty quickly. They are also not under the same type of market pressure like large caps and can outperform large caps over the long run. Small caps are particularly compelling now. That is because of the unemployment situation. Our unemployed population currently has a sizeable element with three magical characteristics that did not exist in previous unemployed populations: it is highly educated; it has a wealth of experience; and it is used to being in positions of influence. These individuals will begin working with smaller companies in the near future on a formal or consulting basis. They are in a position to lead the next wave of innovation and change in the small cap space. Eventually this works its way into mid and large caps too, but small caps will benefit first. The second broad-based strategy that makes a tremendous amount of sense now is for investors to look at active investment managers that can go long and short. The last two market moves have been major ones. First, there was the decline from the credit crunch. Then we saw a strong recovery in asset prices in 2009. Macro investors on the right side of the market have had the opportunity to do very well. The next opportunity for investors will be to distinguish the better companies from their competitors. Forecasted earnings dispersion is so wide right now that proper investment selection is critical.
Q What is your outlook for the US economy, specifically in the area of Fed policy, unemployment and the housing market?
A We know that tightening is somewhere on the horizon. There has been unprecedented Fed activity and liquidity to support the markets to stop economic demise. It is equally important that we reflect on the fact that we have just as little experience in withdrawing these programmes as we have in implementing them. We run a really big risk of taking these programmes off too quickly or leaving them on too long. A measured pace of tightening is needed. It is going to be a very slow and delicate process. A measured pace probably means 25 basis points increases, on a more frequent basis than when liquidity was added, with significantly more signalling from the Fed. Ten per cent of the workforce is unemployed right now. We also have another 500,000 Americans who are underemployed as they wish to find additional work but cannot. We are in a new era of underemployment with people accepting jobs well below their skill and pay levels. This will hurt the economy in the long run as the underemployed will be hesitant to spend. One of the results of this could be an explosion of the number of part-time jobs. The new healthcare legislation essentially supports this. Full-time jobs used to provide healthcare and pensions. As companies stop making 401K contributions and there is guaranteed, portable healthcare, the benefit of a full-time job with one company becomes arguably less valuable. In housing, at long last we now see both residential and commercial prices flattening out or no longer dropping. However, we still have an overabundance of inventory. The truth is that not every family is ready to own a home; for whatever reason, some should be renters. Take, for example, baby boomers. As baby boomers retire they may not need or want homes. We are likely to see growth in community living.
Q The emerging markets have been leading the global economic recovery thus far. What trends do you see there?
A I think the biggest mistake people make with emerging markets is that they think it is one market. China dominates manufacturing by leading with cheap labour. India dominates services by leading with cheap labour. Russia and Brazil lead in commodities. Eventually the differences in labour costs between emerging markets and developed markets will have to narrow as expectations for standards of living go up in emerging markets. Developed markets will have to work harder in order to maintain their relative position in the world. The good news is that the opportunity to grow and improve your human capital still rests with intellect and work ethic. It is in our control. MIT puts some of its courses up for free on the web. The percentage of people in China and India downloading this content is disproportionate to those in developed markets. Those in developed markets need to reignite their passion for learning.
Q What is the outlook for exchange traded funds?
A There is a difference between a vehicle and a strategy. It is more important to focus on the strategy. One of the wonderful developments is that institutional quality products are now being offered in exchange traded funds (ETFs). Before, it was just basically indices and a lot of the ETFs only found their way into hedge funds or to institutional investors. Many great active managers now have ETFs and are willing to let households invest instead of just institutional investors. This is fuelling the popularity of these vehicles.
Q What opportunities do you see in high-yield and distressed investing?
A Now is a fantastic time to look at companies that are short of cash and could use some sort of turnround strategy. It took 50 years for GM to achieve economies of scale, five years for Google to grow but only five months for Facebook to reach 4m households. The difference between companies that survive versus those that do not will be the speed and scope of their efficiency.
Q We have undergone a fairly long period of volatility in the market. What are your volatility expectations?
A Right now there are a couple of mitigating factors that are shocking the market. The credit situation in Portugal, Italy, Ireland, Greece and Spain (Piigs) is an example. But right now, every government around the world has some type of fiscal challenge. According to a Boston University study, since the crisis began, stimulus packages around the world represent 3 per cent of total GDP. That is an unprecedented amount of stimulus. The second series of shocks that we will see is what happens as we remove this stimulus. There is also a potential concern with municipal securities. Opportunities here are good because yields will be higher but the probability of a default is low. The US government cannot politically bail out the banks and then abandon states should they get into trouble. The real question is how far can or will the US government go? I do not know if it would stop at the city or county level, for example. We are already seeing an increase in hidden taxes to compensate for the shortfall in receipts coupled with increase in payments. Road tolls are increasing. New York City even has an obesity tax. As unemployment payments are a direct obligation of the state, states have struggled with the unemployment problem.
Q How are you utilising derivatives to execute your investment strategies? Do you see that changing in any way? Do you have a view on pending regulatory changes in derivatives?
A At Invesco, we have PowerShares ETFs, some of which focus on option writing (i.e. selling covered calls on the S&P 500). Many households want to use this type of strategy but simply do not have the expertise. We also have ETFs that do this directly. Increasingly, customised risk/return profiles are becoming available to retail investors. Our Premia Plus product takes the primary asset classes (stocks, bonds and commodities) and allocates the portfolio based on risk rather than on dollars, trying to get an equal amount of risk across each asset class. Lastly, we also use futures for some of our macro and portfolio strategies. There are a whole host of politicians concerned about derivatives. There is a fear or a horrible misperception that the more instruments we give people, the faster they will lose their money. It seems odd that as a society we require people to buy car insurance, which is protection on rapidly depreciating assets. We also have this implicit requirement that people save for their own retirement but then limit the tools available to them to achieve their goals. Some of the regulatory reform may be overboard or not well thought out. I think most investors would welcome the reforms regarding more transparency.
Q What are the key differences in your approach to managing and hedging risks for a pension portfolio versus other types of portfolios? How have actuarial assumptions used in pension management changed in the last few years?
A The time horizon is key. Take longevity risk: if people live longer than expected, then the annuity needs to be able to pay out for longer. Inflation risk is also a concern. As for actuarial assumptions, as there is a tremendous gap between professors in universities teaching one thing in the classroom and practitioners applying the concepts correctly, this might be a five to 10-year gap; there is a similar gap between the actuaries and technology or medical professionals regarding life expectancy. Pensions rely on actuaries. Perhaps they should talk to the biomedical experts directly. It can take a significant amount of time to measure and detect trend shifts. Another point I want to make about pensions is that when you talk about pensions, you are really talking about a portfolio of people. Contrast this to the world of people saving for retirement on their own. They lose the diversification benefit. The life expectancy is now a single number as opposed to some average with a normal distribution around it. So as an individual you have to significantly outperform or more likely overfund.
Q With the increased application of technology, such as algorithmic trading, to the financial markets, how has this changed the role of investment strategists? Is there more focus on tactics now and less on strategy?
A I will give you an example. In the past, market strategists might have recognised that there was a dislocation or opportunity in the market. However, the due diligence process was so time consuming that the opportunity could not be realised. Today, pension plans are allocating roughly 3-5 per cent of their plan assets into a tactical allocations category as part of their strategy. Thus, they can take advantage of temporary opportunities more quickly. The pace of change in the market has altered the markets significantly and the strategy has had to adjust. If you think about the largest asset management firms in the world and divide the assets by the number of employees, each employee is responsible for a large sum of money. There is a need for investment intellect and strategists are used to identify investment management opportunity. It used to be very frustrating trying to identify a great investment but the window of opportunity would disappear before an investment committee could complete its due diligence. Now I can actually spend more time discussing the issues: appropriate size of the investment, strategic fit, exit strategy, etc. We now talk with the chief investment officers more frequently than at board meetings.
Q Some people have suggested that the requirements for mark to market (MTM) and fair value accounting for illiquid instruments may have accelerated or exacerbated the credit crisis. As you were actively involved with the Financial Accounting Standards Board (FASB) at one point in your career, would you share your perspective with us?
A I was invited to speak at an American Bankers Association conference right at the height of the argument. I am very pro-MTM accounting. I approached the podium and said: I am so pleased and honoured to be here to speak about MTM accounting on the day that happens to coincide with my 21st birthday. At that point, the whole room grew quiet and was a bit confused. I then said, If you are willing to suspend MTM accounting, then so should I. It is very unrealistic to believe that we can get valuable accounting data without MTM. There are so many financial instruments that trade so infrequently that there is a legitimate question of whether the valuation is accurate on some of these instruments.
Q That brings us to valuation and risk models. Many of these were criticised for not being able to predict the global credit crisis. Can these models be improved to be better forecasting tools? If so, how?
A There were two fundamental problems with models. People believed that our models were complete. They are not complete. They are very wonderful approximations of a complex world. We still have a lot of work left to do as financial engineers. Second, the quality of the data that goes into these models is the single largest contributing factor to the quality of the data coming out. The more time and effort we can invest in the quality of the data, the better off we are as an investing community in understanding what has changed about the market and how valuable the models are.
Q Wall Street’s reputation has suffered quite a bit in light of the recent economic challenges. Is a career in the financial markets still the noble pursuit it once was? If not, how can it be again?
A As for Wall Street’s reputation and attracting new people to a career there, we really had a problem of allocative inefficiency for the last five to 10 years before the crisis. This is what I mean. Let’s look at all the graduates and ask where they should go to work. Before the crisis, they all wanted to come to Wall Street. We really did not need all those smart people. While Wall Street is a noble pursuit, it is not the only noble pursuit. There are two benefits to all of this. If Wall Street does not attract people as much as it used to do, we have the opportunity to see this next generation of bright people pursue careers where they are needed, for example in medicine and the sciences. The ones left working on Wall Street will be those who are the most passionate about finance. They are where they should be. Allocation of labour resources is a self-correcting process, even though it takes time.
Q We understand that you are currently teaching a class at Massachusetts Institute of Technology on the topic of learning from one’s failures. What was your worst investment decision and what did you learn from it? How do you analyse your mistakes and apply the lessons?
A As scientists, we are just as excited to have a failure from an experiment as we are a success. There is a tremendous amount of information in failure. Sadly, as business professionals, we are not nearly as excited to have a failure, although the opportunity to learn is just as strong. We frequently do not reflect on these failures. I learned that you need a straightforward process that includes further examination of the investments that were rejected and understand why they were rejected. Without it, you have survivorship bias.
Q Your personal story is a tale of how one woman rose from rather humble beginnings on Main Street to pursue her dreams on Wall Street. Do you have any advice for our readers?
A I just have an excitement and eagerness to learn. There is no one grandiose thing that I have ever done. I just try to do one very small thing better each day and I counted on the power of compounding. Compounding is one of the things we are first taught in finance. The secret is actually very basic.

The Markit Magazine would like to thank Elise Rosenberg, director and head of account management North America and Otis Casey, vice-president of credit products for the interview with Diane

(from Markit, August 27, 2010)


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