This guest commentary was written by our friend Joseph Calhoun from Alhambra Investment Partners.
Prudence: noun
- The ability to govern and discipline oneself by the use of reason
- Sagacity or shrewdness in the management of affairs
- Skill and good judgment in the use of resources
- Caution or circumspection as to danger or risk
Synonyms: alertness, care, carefulness, cautiousness, chariness, circumspection, gingerliness, guardedness, heedfulness, caution, wariness
Origin and etymology: Middle English, from the Anglo-French, from Latin prudential, alteration of providential. More at providence.
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"Plastic bears abound today. There are well-known investors and fund houses that will frequently raise their concerns about bubbles in various markets in research notes, or when they are on TV, but then hold large amounts of the asset class they claim to hate. Very few are actually short the market or in cash." From the FT article, Beware the Plastic Bears Who Dishonestly Peddle Market Doom |
It has become fashionable these days to dismiss, with some degree of prejudice, anyone who has the temerity to express concern about the state of the global economy and markets. The article from the FT quoted above makes the case that much of the bearish commentary is no more than a cynical marketing strategy designed to play upon the fears of the average investor. These “plastic bears” aren’t eating a sufficient quantity of their own cooking for the author, investing contrary to their public views. The author does grant that “those who express caution in an intellectually honest way should be commended”. One wonders who gets to draw the dividing line between “intellectually honest” and “thoughtless” bearishness.
The author of the “plastic bears” article identifies only one of the “well known investors and fund houses” that he believes engages in such duplicitous behavior, Marc Faber. That may be because Mr. Faber has recently disgraced himself with some rather startlingly racist remarks. Not much chance of Mr. Faber trying to claim the moral high ground. But to give Faber his due, he appears to be following his own advice and investing outside the US, specifically in emerging and frontier markets. No doubt he owns a generous slug of gold and may well be long bottled water, canned goods and ammo for all I know but he doesn’t seem to be a bear of the plastic variety despite naming his newsletter Gloom, Boom and Doom.
There are, of course, plenty of professional investors who have expressed concern about global markets and the role of central banks in creating the current environment. John Hussman certainly fits the bill but anyone who reviews his funds’ performance will know he is practicing what he preaches. Howard Marks of Oaktree Capital would probably not object to characterizing his views of the current market as, at least, skeptical and I’m pretty sure in private he’d be more strident. But as he explains in his recent memo, he takes issue with this notion that investing is black and white, all in or all out:
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"All I’m saying is that prices are elevated; prospective returns are low; risks are high; people are engaging in risky behavior. Now nobody disagrees with any of the four of those, and if not, then it seems to me that this is a time for increased caution. . . . It’s maybe “in, but maybe a little less than you used to be in.” Or maybe “in as much as you used to be in, but with less-risky securities.” |
I think what the writer of the FT article – and most of the general public – doesn’t appreciate is that professional investors, those investing other people’s money, have a responsibility, a legal obligation, to invest under a standard of care that doesn’t exist for many of the people opining on markets. A newsletter writer is exercising his first amendment rights and has no fiduciary duty to his readers other than, possibly, to deliver a certain quantity of content. He has no responsibility to be responsible and his financial incentive is to attract the maximum number of readers. His content and advertising will, logically, be designed to attract attention. And let’s face it, doom and gloom sells. Keeping those subscribers though requires that the purveyor of these pamphlets of panic provide something of value to his readers. Which explains the very high rate of turnover in the newsletter business.
I suppose the same could be said of the thousands (maybe millions) of investment advisers who now have a medium to reach millions of potential customers. They are exhorted by marketing consultants to engage in “content marketing” to attract attention, to stand out amongst a sea of competitors. Do some of them engage in hyperbole when doing so? I’d be shocked if that were not the case. But I’ve been in this business for a long time and the cost of acquiring a new client has never been higher. It makes no sense to write a research note that requires a certain, extreme course of action and risk losing clients if it turns out wrong. There is no certainty in this business of predicting the future.
But investment advisers are held to a standard that the newsletter writer or journalist is not. An investment adviser is a fiduciary, a word whose derivation is “trust”. In a very real sense, a fiduciary is a trustee to the person or entity to which (s)he owes that duty. And being a trustee is a well-defined relationship with legal obligations. Fiduciaries must act solely in the interests of their client and when investing the clients’ funds must adhere to the Prudent Man Rule or, to update the appellation for modern times, the Prudent Person Rule. This rule directs trustees “to observe how men (and women) of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regards to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”
Unfortunately, I think there are plenty of people in our business who don’t understand, any better than the general public, what it means to follow the Prudent Person Rule, lending some credence to the FT article warning about plastic bears. Following the Prudent Person Rule, for instance, does not require that one have the ability to see the future. It does require though that one observe the present in a clear-eyed manner and invest accordingly and, yes, prudently. It does not require either, as the FT article implies, that one take an extreme position; indeed being prudent would require the opposite. The Prudent Person must also be a humble person.
I’ve been doing this for a long time though and most of the people I know in the business are sincere in their beliefs – about the economy and markets – and understand what it means to be a fiduciary. Their beliefs do not impede them from fulfilling their legal responsibilities to their clients. There is no tension between writing research or articles that are “bearish” about US stocks and also maintaining an investment in those securities. Pointing out that the US stock market is valued very dearly does not require that our client portfolios be short US stocks. The Prudent Person Rule though does require, at least in my humble opinion that one adjust and respond to this condition.
If a client is classified as a moderate risk investor – that classification best accomplished not by a short questionnaire but through a genuine effort to “know your client” – and their adviser has the same allocation to stocks today as when valuations were much cheaper, the client now has a portfolio that is too aggressive for a moderate risk investor. If the adviser has been rebalancing on a regular schedule that is at least a partial fulfillment of the fiduciary duty but it seems unlikely to be sufficient. Surely it is not prudent to maintain a full allocation to a stock market trading at the extremes of its historic valuation range. But neither does being prudent require that the fiduciary sell all stocks or sell short. The allocation must take into account the adviser’s sincerely held view that stocks are expensive and some probability that (s)he is wrong, that some unforeseen event makes today’s prices less extreme than they appear.
Even those who take a passive approach to investing their clients’ funds are not excused from applying the tenets of the Prudent Person Rule. Passive should not be confused with permission to stop thinking and acting like a fiduciary. A prudent professional must still choose an underlying strategic framework – what assets will be included in this passive portfolio? And they must be vigilant about rebalancing, maintaining a constant allocation (within some tolerance) rather than allowing the portfolio to grow untended. I would also argue that they have a responsibility to adjust their strategic approach when asset prices are at extremes to ensure their client’s portfolio still matches their risk tolerance and capacity. Yes, strategic changes should be rare but they should not be haughtily dismissed as “market timing”. What is most important to the fiduciary adviser is risk not reward.
Prudent advisers don’t get to live in a world where there is objective truth, the market either headed straight north or south based on some known value. Expensive markets can get more expensive, cheap ones cheaper. But true advisers are not paid to be “right”, to find exact turning points in markets capturing all the upside in a bull market and avoiding all the downside in the bear phase. That is an impossible standard and one that every adviser should reject. Advisers get paid to make judgments about value not the immediate direction of the market.
We here at Alhambra have been accused, at times, of being too conservative or too negative about the economy and markets. That is I believe a complete misunderstanding of our role. We are not trying to predict the future and no one should hire an adviser who thinks that is their job. We are merely trying our best to describe reality as we see it, to keep our clients informed about the risks they are taking. We don’t do all or nothing decisions because we are never certain about the outcome. We make decisions using reason, discipline and experience and we are always careful about the risks we take on for our clients. We are skeptical of the new, wary of the untried and despite the first definition of providence above, we rely on research not divine guidance.
We are not always right in our observations about the economy and markets. No one is. But we are not plastic bears or bulls. Our views, like most of our colleagues in this industry, are sincerely held and guide our conservative approach to investing. We are conservative because that is, in a sense, what it means to be a fiduciary adviser. You shouldn’t be surprised when we say and do conservative things.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Joseph Calhoun, CEO of Alhambra Investment Partners. Prior to founding Alhamra Investment Management in 2006, Calhoun was a Director of Investments at Oppenheimer & Co. and before that proudly served in the U.S. Navy’s nuclear submarine service for 8 years (1983-1990). This piece does not necessarily reflect the opinion of Hedgeye.
