As an investment advisor, Lee Hull’s clients can’t afford to have down years.
They’re retirees looking for steady income — no matter what Mr. Market has to say about it. Where traditional advisors are willing to ride the market’s ups-and-downs, Hull uses a different approach.
His returns have trounced the markets while he puts less of his clients’ capital at risk. Over the past 10 years where the markets have literally gone nowhere, Hull’s investment firm has averaged over 8% per year (net of inflation!).
That’s pretty darn good but when you see that he was “only down” 9% in his largest losing year during the same time period, that should make you sit up and listen (if you’re not already).
Announcer: You’re listening to Tradestreaming Radio with your host, Zack Miller. Expand your mind. Become a better investor with tools, tips and technology from the smartest investors on the planet.Zack: Welcome to Tradestreaming Radio. I’m your host, Zack Miller, and this is the place where investors learn directly from experts. I’m really excited for today’s program. We’ve got a great show put on for you today. It’s going to run a little longer than our normal programs, which run around 30-35 minutes. This is going to be about 45 minutes, but it’s definitely worth it. Stick with us.
Today’s guest is Lee Hull. He is an investment advisor. He’s also the author of a new book called, “Less Risk, More Return”. Obviously, that’s the Holy Grail for all of us as investors. Hull has taken the approach as an investment advisor, has clients particularly in pre-retirement or in retirement, who are looking for returns, no matter what the market is doing. Obviously, you can go the alternative route and look at hedge funds that are aiming to do that. As an investment advisor with managed accounts, it’s not so simple.
But anyway, Hull has sort of experimented a lot, and we’re able to enjoy the fruits of his research and his experience. He’s returned huge returns. I’ll post that on the blog. Go to Tradestreaming.com to go get that. But he has done really well with this strategy. And he also provided us, and thank you, Lee, with another document called, “Ten Things Investors Can Do to Improve Their Returns and Lower Their Risks”. So, you can get that for free by coming to the website, Tradestreaming.com. You can download that.
That is the essence of the book. The book goes through a lot more research, a lot more ‘how to’, but I asked Lee if he would create that document for us to really sort of crystallize all of his research, his time and his energy into sort of the ten commandments of how to do this. It’s a good book. Go out there and read it. You can find more about his book. I think you can even download the first four chapters free at Less Risk More Return.
You can also check Lee out and what he’s doing at hullcapital.com. I’ll have links to both of those on the website, as well. Thanks for joining us today. If you are coming to the website, you’ll find our archives there and transcripts of most of our episodes. So come and check that out. You can also find the episodes of Tradestreaming Radio on iTunes. You won’t have the transcripts there, but you can definitely get all of our episodes. And I think this marks Number 51.
So again, thanks for all the new listeners out there who are enjoying Tradestreaming Radio. We’re excited to present this to you. We’re excited to keep going. We’ve got a lot of good ideas down the pipe. And we’re hoping that it’s helping you enhance your investment returns and lower your risks. This is Zack Miller, your host. Peace out.
Lee: My name is Lee Hull, the author of “Less Risk, More Return”. I started out in the financial services business, probably like most of us as a stockbroker at firms like Merrill Lynch, and went the financial planning route, and then ended up working as a money manager now for the last 12 years. We specialize in managing retirement plans.
Zack: “More Return, Less Risk”, that’s sort of like the Holy Grail in the investment field. What’s your approach there?
Lee: My approach was basically working as a traditional financial advisor, financial planner. Almost everyone’s portfolio is basically correlated to the stock market, meaning when the stock market goes up they make a ton of money. But when the stock market goes down, they lose a ton of money. And the stock market goes through very long periods of below-average performance–10, 20 years. That would kill most of my clients’ retirement plans.
Zack: Like this past decade, right?
Lee: Well, this past decade. Right. My conclusion was in 1998, 1999, that if people really want to match the market, or the indexes, they can do that for free, almost through funds like Vanguard. What they needed was a non-correlated investment strategy that could be executed inside of a profit-sharing plan, a defined benefit plan, an IRA, that wasn’t complicated, that was transparent, didn’t use leverage–all those things that would be negative; and basically could get ahead when the stock market wasn’t getting ahead.
Nobody comes to a money manager or investment advisor, say, a Vanguard Fund, saying I want to match the market, but only if the market goes up. Nobody wants to index their way to a 10 year or 12 year losing period. What they want is a positive return–a positive period–not the negatives. That’s one of the big misnomers about index investing. The longer term averages hide what goes on over shorter time periods.
Zack: The draw downs, specifically, right?
Lee: Well, the low returning periods, that say that the market has averaged 7.5% approximately ahead of inflation for the last hundred years. That’s great. But what people forget is that in some 20-year periods it was as high as 12%, and in other 20-year periods it was as low as 2.5% or 3% for 20 years. That’s an awful long period of time for most investors. They have a very finite amount of time to grow their retirement plan. They don’t have 70 years, 80 years, 100 years. They don’t have 15, 20, 30 years in a lot of cases.
And as they get closer to retirement, it even becomes more important that they make sure the last 20 years before retirement that they do well. Most people are planning on making 7%, 8%, 9%, 10%. If they draw a bad decade or a bad 20-year period out of the hat and get 2%, 3% or 4% average return for that time period, they’re going to fall dramatically short of their goals. And the biggest thing for me was there’s no backup plan.
Let’s say that you invest today, and you do a hypothetical portfolio with your advisor, and they project out 30 years from now that you’re going to make 8% per year. What happens when you get into that 30-year period and you’ve only made say 5% a year, and you’re several hundred thousand dollars short? There’s no backup plan for falling short with traditional investment strategies. You get to the end of the period and whatever happens to you happens to you. And that doesn’t seem like the best approach to me. It seems very risky, in my mind.
Zack: Well, I hope later in the call we can get to how your approach helps to address that very issue. One of the things I’d like to go to, and I want to tell our listeners, is you were kind enough to put together a Top Ten List that investors can do to improve their returns and lower their risk. Can we go quickly through those ten points?
Zack: The first one is learning to evaluate investment in light of your bigger risk. Can you tell us what that is?
Lee: If you think about it in the most simplistic terms possible, only three things can happen to your retirement plan or your investment strategy for the next, say, 20 years. The market will deliver above average returns, average returns, or below average returns. And only one of those scenarios is risky for you, and that’s the last one. What you need to ask is the ‘what if’ question. What if returns for the next 10, 15, 20 years are much lower than expected? What’s going to happen to your retirement plan? You need to think about the ‘what if’, not just assume that you’re going to get as high a return as in the past.
Zack: Do you find that investors have the language even to ask the ‘what if’ questions?
Lee: No, they don’t.
Zack: It’s like, what they don’t know doesn’t hurt them?
Lee: I think that’s our job. Well, they don’t know, and I think that’s our job if we want to be good advisors. We need to be asking those questions on behalf of our clients.
Zack: I guess that’s a good segue into your second point, and that’s understanding the limitations of traditional investment theory. Where does the traditional investment theory fall flat?
Lee: Let’s say, you take a look at asset allocation probably being the most widely sold investment strategy, and that’s viewed as a cure for everything, and sold that way. The truth of it is, if the stock market has a poor period, so will your asset allocation plan. And if you look at mutual fund returns between 1999 and 2010, most, not all, take balance on indexes as allocation indexes, averaged about 1% net of inflation. And on a compound basis, some of them were worse than that.
We had a 12-year period where the most widely accepted investment strategy yielded a 1% net of inflation return. Most of my clients, for example, cannot afford to go 12 years without making a profit, hardly. What they have to understand is that despite asset allocation, despite bonds, despite international stocks, at the end of the day you’re still tied to the U.S. stock market, because it’s correlated with all of your investments in some form or other; to such an extent that it is going to drive your performance. So the limitation is that in traditional investments your fate is going to be determined by the stock market, and the stock market only. Since we can’t predict the future, we don’t know what that return is going to be.
Zack: But, investors have been sort of bred to, on two specific pieces of information. One is that you got to be in it to win it, specifically because of the second reason. Most people don’t have the ability to time in and out, to harvest those gains when the markets are up and then get out and not suffer the losses.
Lee: Right. Well, if you look at the core argument for passive index funds, for example, it’s one of cost, that no load index funds are cheaper than actively managed mutual funds. OK, that argument is pretty foolproof. I think it’s a true argument. When you take one broadly diversified fund that you’re paying 25 basis points, a quarter of a percent in fees, and you take another fund that does the exact same thing and is charging, say, 1.7%, the lower cost fund is going to do better, because they’re basically doing the exact same job.
To get different results, you have to do something completely different than the market. And that’s where I think people have a very narrow vision, here. There is more than one way to invest. Balanced, diversified funds is one strategy. But that strategy robs you of all your opportunity in ways to get ahead during a tough period, for example. So, a bigger picture is, most of us want to say, I want to be OK with my retirement plan no matter what the future brings–whether it’s good or bad–not just if we have a good year.
Zack: Foolproof investing, right?
Lee: Well, everything is going to have losing years, and every strategy is going to have trying times. But at the end of the day we all want to hit our goals, regardless of what happens in the market. And that’s really inconsequential. Tying ourselves to the market may be a great decision. In hindsight, it may be a horrible decision. You won’t know until you get to the end of that period, and that’s a very risky position to be in.
Zack: These are all important questions. I guess this leads us to point number three. You recommend that when investors come in to meet with an advisor, or even if they’re not looking for an advisor and were going to invest on their own, they should have some goals set out for themselves, before they even begin that process.
Lee: Exactly. Let’s say that you’re not sure, and you go on the Internet. You can find theories on everything–the next big boom, the next big crash, the next big depression; the reason why this investment strategy is the right way to go, this one. All of that really doesn’t matter. What you want to be able to figure out is what do I want, what do I have to achieve. And for most of us, like I just said before, is we want to do well no matter what happens.
For the first time in history, we have a 12-year period that’s pretty horrible, and investors have track records, they have books, everything at their fingertips that show what real performance was during that pretty horrible period. This wasn’t around in the 90s. It was a great period; everything and everybody looked great then.
So, I think you have to decide what you want. And I think most of us want to get ahead no matter what happens. But you have to think of investments in those terms when you’re looking for mutual funds, advisors, money managers, those types of things.
Zack: Number four, never invest or risk money on hypothetical portfolios or investment strategies. How do we get around this one?
Lee: The biggest thing is, if you’re going to put money at risk with someone, you need real track records. You want to know what happened. Take, for example, 2008, probably the poster child for risk control for us. What happened was losses cut, the losses were larger than the market. What happened to that person?
A hypothetical portfolio is a fictional account of the past, and when I was at Merrill Lynch I think it was 1954, clients in a row came in and thought I was a genius. I opened accounts. But it wasn’t because I was a genius; it was because of the computer program I was using to optimize those portfolios. You can try thousands of combinations in a few seconds.
So, we all looked like investing geniuses, because there was no real accounting of the past. It was all fictional. If all of our clients did poorly for the past ten years, we can look like a genius still today, because we’re presenting a fictional account of the past. Now, I think that’s very dangerous for people looking for an advisor, because there’s no quality control there. There’s no accepted way to optimize portfolios; no guidelines for that. And they really don’t know what happened to all the other clients. And that’s very [inaudible 13:35].
Zack: A very interesting point. So, there has been a lot of talk on the industry side about this whole fiduciary requirement on the brokerage side. Can you tell us a little bit about why you think it’s so important to hire an advisor that has that fiduciary responsibility?
Lee: Basically, it’s traditional stock brokers, let’s say [inaudible 13:57]. And a fiduciary has to have your best interests at heart by law, like the investment advisors back in 1940. Registered investment advisors, which are mostly smaller firms, must have your best interests at heart. And it doesn’t guarantee that you’re going to make money, or get any great advice. What it does mean is that your interest comes first, not that person’s or that employer’s.
If you take a hundred financial advisors, and they all give you the same advice, I would still rather have the one that is a fiduciary relationship with me, and has to put my best interests first. I’ve known great advisors that are not fiduciary, and I’ve known great advisors that are. But I can’t think of one reason not to stack the odds in your favor and go with a fiduciary advisor. You’re less likely to get sold [inaudible 14:51].
Zack: In general, the industry seems to be moving in that direction anyway. It’s just a matter of time, I think.
Lee: If we’re charging fees, we should be a fiduciary, I think.
Zack: Number six. Understand the difference between creating wealth and average annual returns. Can you talk about the difference?
Lee: This actually came from a meeting I had several years ago with a small pension fund. They were looking at averaging annual returns, evaluating different managers. And this is a board of directors in charge of pension, and the idea of compounding it completely–they knew it intellectually, they just didn’t apply it to their investment selection process. Let’s say you take the S&P 500 Index for the last 12 years. It’s averaged, I think, 3.97%, right around there.
So the average person thinks they’ve made basically 4% a year the last 12 years, but on a compound basis and that of inflation the return is actually negative for the 12-year period. So, the real world is that no wealth was created. They think they made, you know, 40% for that time period. That didn’t happen at all. Average annual returns don’t take into account losing years in compounding.
When investors look at track records, they have to re-look at how much money did I really grow? How much is in my account now, today? Not what average annual returns go, and they always overstate returns. The only time average annual returns don’t overstate them is if there has been no losses, and that doesn’t exist. And so, when you’re looking at investment returns, you need to look at compound returns, the amount of wealth created. And you should also make that net inflation–and see what really happens.
Zack: I see in your marketing materials for your firm that you quote everything sort of net of inflation. I thought that was pretty intellectually honest.
Lee: Well, I think it represents the truth–what really happened, you know.
Zack: And this is something that cuts across many of the other points you make here on this Top Ten List, but understanding the limitation of past performance, right? Sometimes, that’s all we have to hang our hat on, even though we’re told time and again that it’s no indicator of future performance. It’s what people use to judge, I guess, a manager.
Zack: How do you begin to sort of look forward instead of backward?
Lee: It’s a huge dilemma that all we have to judge investments by is past performance. But we all know that it doesn’t predict the future. In fact, there were several papers when I was researching for the book, I think, I found 19 different studies showing past performance. And basically, they were all inconclusive. The results were: this asset class worked during this time, and this one didn’t. And in the study it worked, all the time, and in this study it didn’t work. So basically, no one knows if it works or not.
We have to get past the idea that we can use past returns. And take, for example, the index fund argument. Say, for the past 100 years the stock market’s averaged X. Does that means it’s going to average that the next 100 years? There’s nothing in any research that says that it will. So we don’t know what future returns are going to be. And that’s very important when you sit and look at a manager and say, okay. Back to an earnings return we talked about, “What do I want?” You may want like I do. For one thing, I hate, I cannot stand big losses.
You can say, okay, in the worst losing years I want to make sure that I didn’t lose very much money. Or, in the big years I want to make sure I beat the market. Whatever your criteria are, you can look at those things and find out if the manager values the same thing as you do. I think that part is very important, and you can use past performance for that. I just don’t think you can use it to predict what the future will be. And you have to be more careful doing that.
Zack: It’s more a qualitative indicator of the type of manager than really a prognostication tool, right? That’s essentially the assumption?
Lee: There are thousands of managers out there and funds. If you say, I only want to be a socially conscious investor. I only want to do X. If you look hard enough, you’ll find somebody who does that, no matter what you want. Be as picky as you can be. There are thousands of people out there doing this.
For me it was: Hhow do I make the long-term averages of the stock market 7.5% a year net of inflation through good markets and bad? Who care what happens in the economy, I still need to get ahead this year. And when I looked at it, that’s what I was looking at. And I think you have to say, OK, this would have gotten me ahead in the past. It may not get me ahead in the future. Looking at returns again for the last decade, you can see what really happened to a lot of these investment strategies that were supposed to be foolproof.
Zack: Yeah. Part of the thing is traditional investment theory is somewhat defensive, right? It says, well, we stink at this; we’re particularly bad at that, and we’re OK at this. Let’s do it in a way where we mitigate our losses and giving up sort of the dream of our performance where we hook ourselves onto the coat tails of Mr. Market. To do what you’re talking about though, requires abandoning again, traditional theory, right?
Lee: Maybe. You have to abandon traditional theory if you look at things in a more common sense way. And I had that way common sense way is: I don’t know what’s going to happen in the future. So, I want to invest so I’m OK no matter what happens. When you do that, you have to abandon, at least in part some of the traditional investment theory. You have to, unless you somehow know for sure what future returns are going to be. You have to. It’s a given.
One tidbit on that is if you take incentive fee payment plans, where advisors are only paid if they produce a profit for the year. For the last 12 years, someone using an S&P 500 Index proxy, the advisor would only have been paid two years out of the last 12 years, for example. So one thing that hit me, looking all this many years ago, was that if we were required, if clients could pay us if we only produced a profit for the year, with a high-water mark.
Basically, it would wipe out the business. So if we were really held accountable for making gains for people, it would wipe out the industry. And that was a very scary realization for me. Basically, we’re good at making money when the market goes up, and we’re good at losing when it goes down. But I think investors can do that on their own.
Zack: Right–with or without the experts.
Lee: The thought process has to be different about, I want to be okay no matter what happens, and I want investment strategies that help me accomplish that goal, instead of saying, I trust the market will always go up, or the returns will always be as high as the past.
Zack: On this show, we’ve talked about previously with sort of the struggle that we have with describing risk, sort of like you know it when you feel it, or you see it.
Zack: You couldn’t really describe it. But you talk about using in point number eight the largest losing year as a measure of risk. Can you explain why that makes sense?
Lee: I think it shows people what the worst case is. It might be 2002, for different strategy, or 2008. We can’t assume that the worst year has happened yet. But 2008 gives you an idea of what can happen. And in the industry we have all kinds of ratios to measure this, but for the average person who’s not up on all this, I think the largest losing year is as good as anything. And you can really see it happen in the worst possible circumstances.
If you’re going to hand someone your money to manage, or to a mutual fund, or whoever, you want to know what happened in the worst case scenario, and know that it could be worse than that. And I think that’s shorthand instead of learning a lot of financial jargon that is not even predictive in most cases of the future anyway. The largest losing year is the simple way that you can look up on the Internet in five minutes, and it’ll give you an approximation of risk.
Zack: And I think even for mutual funds, at least on Yahoo Finance, I think they even quote that ‘worst year’ out of the past ten, or something like that. What I really like about all these points is that you’re walking the talk. I know that in your marketing materials you use these tools as part of your disclosure and your transparency in your own practice. So, you’re not just recommending these things. These are things you actually do in your own business.
Lee: We try to. You know, we’re not perfect. We have our good years and our bad years, but over the long haul I think that we add a tremendous amount of value for investors, when we offer something that’s simple and non-correlated to the stock market. This last 12 year period, I guess, has been the worst 12 years in 80 years. So, if someone’s gotten ahead in this period, they’re doing something dramatically different. And that’s what I think you have to be. I think investors need to be tough on potential managers or funds, and ask really hard questions. What happens in the worse scenarios is a good one.
Zack: I guess a corollary of that is your number nine, right? You call this trial by fire. So, somebody would basically tally up the worst years they’ve had and sort of create an aggregate return based on those numbers. How do you put that in perspective?
Lee: That came out of something that happened to me personally. The investment manager we were using first started in 1999 with an investment strategy. We had gone through all the back testing optimization, everything that we all do in this business, and I still couldn’t get comfortable with it. Every change I made and asked the manager to make, the results didn’t change. And then, we caught a flaw in it later and we got out in March of 2000, right at the top, just by coincidence with that strategy manager. And they would only have 6-7% losses with that strategy after that.
The issue is there was no bear market during the test period, from 1987 to 1996-1997. There was no bear market to test in, so everything we did looked great. You just couldn’t break it, basically. But it wasn’t because the investment strategy was so great. It’s because the test period was so fantastic. And that goes back to when we talked about hypothetical portfolios before, and the way they can’t tell you everything.
If you say, okay, here’s the worst the market has to offer. Here are four or five losing years; here are two or three years the market hit below the long-term average of, say, 7%. Was I able to get ahead during the worst of the worst? And you’ve got multiple years to look at here, not just one year. And you can decide for yourself what the strategy was. Was I able to get ahead during the some really, really hard times? And the critique I got on that approach is that no one looks good in the scenario. It’s just too hard. And I think that’s a cop-out. It’s just hard.
Zack: Well, part of it is that you’re stacking the deck in your favor, right? I’m talking about Lee Hull and his practice, because a) you did really well during those periods given your strategy; and b) given some mandate constraints in traditional mutual funds and stuff like that, if I’m a long, only mutual fund guy that has to be 85% invested all the time, he’s not going to do very well during those periods.
Lee: In a way. I wrote the book about what I believe, and what my beliefs are after being 16 years in this business. Naturally, our returns would mirror how I feel. So, from that perspective there was probably some bias there, built in. But I think when you look at investors, the choice is: do I pay this investment advisor or this financial advisor a rap fee to manage my money, when he got murdered during the times I needed him most? So if you think about it, most of us if we worked in a retail business, investors come to you because they pay somebody so that nothing bad will happen to them. In its most simplistic terms, that’s the reason they pay somebody. They want to make sure that nothing bad happens to them.
Lee: You know, you can find out what really happened now by using year 2000, 2001, 2002, 2008, 2005, 2007, and you can see what happened. Did something bad happen to those people? And if so, do you want to pay that person when you can just do the market for free through Vanguard, almost?
Lee: You understand what I’m saying.
Zack: Absolutely. So, number ten, which is looking for long-term track records. Our industry is really good at creating new products, right? So, what started with mutual funds is now happening in the ETF in terms of innovations of new products coming online.
Zack: I almost look at that as Mutual Funds 2.0, right? Every week we’ve got a slew of new products. Some of these strategies have been tested in laboratories, and are not real money strategies.
Zack: There’s such a slew of new product out there that has such a little runway of performance history. How do you go out and actually find people that have spent ten years doing the same thing? They are few and far between, I think, at this point.
Lee: At the end of the day, I think that’s where you’re buying the manager or the person, not the investment product. I think we’re a good example. When I started in 1999, we were using open ended mutual funds strategies exclusively. We weren’t using stocks or ETFs. And as you know, there were only a handful of ETFs available then. And those same ETFs were available as mutual funds, as well. The ETF market didn’t really take off until 2003, 2004, 2005.
Now we’re using ETF strategies that don’t really apply to our track record in some ways. But as a manager, we’re always looking for what we can do better; how can we always do the things we want to do, which is increase returns and reduce risk. And the ETFs help us in that now. But our track record technically we can’t say that our track record really represents our ETF strategies, because they weren’t around back then. And it’s true for a lot of managers these days.
You’ve seen the growth of the ETF market. What you’re looking at is a long-term track record. There are a lot of flashes in the pan. I’m sure you’ve seen lots of these, too. A one or two-year track record and they just knock the lights out. Then usually something bad happens sometimes after that. You want as long a track record as possible. If you want to evaluate how that person did during the tough times, and overall, how they respond to change. And change is the only constant.
We can stick our head in the sand and say the market will always go up. We can say: this kind of mutual fund is always best. We can value investing is always best, whatever. But I think a long-term track record shows you how well that manager’s kept up with what’s gone on as well. Getting past the startup phase is important; someone who’s only been around for two or three years may be a little bit risky. Someone who has been around for ten years is going to be around probably for another ten and a long- term track record.
Zack: I also think that your average investor when he comes into a shop, anybody’s shop, even if it’s explained well, sometimes they lack the understanding of exactly what’s being sold, or what kind of service is being provided. I talk about some advisors who don’t do any hands-on stuff, sort of the inverse of you, and outsource the entire investment process. And even though they’re transparent and they tell that to the client, and I hope they are, the client doesn’t still understand that.
It’s almost like you can explain all these things, but the end of the day I guess clients want to hear what they want to hear. It’s not a fundamental gap. Obviously, it’s easy enough to understand if somebody were willing to spend the time. I just find in my own practice and stuff like that, people still are unclear about that.
Lee: As I say, the worst financial advisor knows more than the above average investor. And so, it’s not a very level playing field, and never will be, because of the nature of the industry. They’re seeking out expert advice. The key here is to look at those track records, to look at what they’ve actually done. Is that something that you want? It may not happen again, and it might happen again, because you know how past performance works, right? I think you can go through some very basic steps and say, okay,
I want an investment manager to keep my losses below 10% in the worst years. I’m just making this up. I want to know that I’m going to make money if the market’s going through a bad period. And you can write down these things, too, and you can start judging based on those criteria. You can make a list of five things; you can make a list of 20 things, whatever you think is appropriate, and start working through that list. But if you’re walking in, not knowing what you want, you’re going to walk out being sold something useless. That sounded good after a long presentation, not getting exactly what you wanted.
Lee: I think that’s the key. I was at a pension fund in Tennessee, and they called me back on three different occasions. They loved my track record, but they couldn’t decide what to do with me.
Zack: You know, today [inaudible 32:04] silos.
Lee: Exactly. I didn’t fit. I wasn’t a small cap guy. I wasn’t this kind of guy. I wasn’t that kind of guy. And I couldn’t fit with the asset allocation. They were so frustrated, and didn’t realize it. Here’s a group of guys in charge of many millions of dollars, the pension plan for the company. But they really didn’t have a clue about what their job really was. The job is to grow the pension plan no matter what–in my eyes, at least– and not conform to a certain asset class.
Zack: You’ve definitely whet my appetite. And I know you share a lot of your ideas in your book. Can we talk about some of the practical things that you’ve researched and that you utilize in your investing that has helped people abide by the same tenets that you just described in the ten points?
Lee: Well, I decided that I wanted to build, do something different for my clients, and really add value from my perspective. I started researching different investments. What could I do inside a retirement plan? What could I do cost effectively commission- wise, all these types of things? I started working through all these investment strategies. At the time I knew nothing about computerized trading strategies, quantitative strategies.
I know all that now. So I started working through, because I couldn’t hire a manager to do what I wanted. And one of the things that always surprised me was doing the opposite of traditional wisdoms is usually a pretty good move. Very rarely is traditional investment logic correct.
Zack: Isn’t that the truth.
Lee: It’s amazing. And nobody wants to index their way down to a 30-40% loss. You want to get ahead all the time. So there were two issues that basically came out. One is I didn’t want to be correlated to any one market, whether it be stock market, the bond market, gold, commodities, because the second you choose to be correlated or track that market, that market can take you down. That was a biggie for me.
Zack: That’s on the other end of the spectrum from passive indexing, right?
Lee: Yes, it’s opposite. They want to be. Well, I can’t know returns in advance, so saying I want to be one with the market, so to speak. In my mind it’s a very risky decision. And it has been risky for the past 12 years. That’s one issue. But the main thing is: what could I do that didn’t require options and leverage, and all these complicated strategies that couldn’t be done in an IRA anyway?
What we tested out, after looking, reading tons of books, investing thousands and thousands in software, is basically a pretty good approach was just buying the biggest losers, and that means buying what everybody else is selling the hardest. And sometimes they’re wrong, and it bounces right back, and sometimes it doesn’t. You know this is mean aversion. It’s fairly common in the hedge fund world. But you don’t ever see this on a scale where the average person with an IRA or defined benefit plan could do it.
And that’s what we brought to the table–something somewhat watered down from a hedge fund point of view, because of no leverage, no shorting, that type of stuff, a long only strategy. It’s systematically placing orders to buy the biggest losers every single day. And that’s what we come in and do every day. Over time we’ve done really well with that strategy, including being profitable in 2008 and profitable for the three-year bear market, 2000-2002. Traditional investment logic says that can’t happen.
Zack: Right. You read a lot of academic literature, mean reversion hasn’t really been shown to be a very profitable investment strategy.
Lee: It’s not in a lot of ways. It’s only when you take it to extremes is it profitable, I believe.
Zack: So, what do you mean by that?
Lee: When you really wait for some real panic to buy–when the market is down three or four days in a row, and it’s down big and everybody’s worrying it’s going to be down big again today, and you’re buying in when everybody’s really, really selling hard. That’s what has worked for us. The mediocre trades with a little bit of a pull back, a little bit of a drop, just seems like a waste of money.
Zack: Can we talk about quickly, in the next few minutes, some of the parameters you laid out in your book? What exactly are you doing? Are you looking for three days in a row of down, and then buying? Can we just specifically bring these up?
Lee: It evolved into 11 different strategies now. Some look for very dramatic sharp pull backs over even five days, and others only at one or two days if the stock has good momentum, for example.
Zack: And you could do this for stocks or ETFs?
Lee: Stocks or ETFs. It’s somewhat different; ETFs are more reliable. I like country funds the best. [inaudible 36:54] and commodities are the worst.
Lee: As a group, commodity trades pop up. We still take them because we want exposure to all the markets we can, but we tend to limit our exposure more than we would with, say, a country fund that can’t drop 30% overnight, like a stock can, for example. We tend to have a variety of them.
Zack: Given behavioral finance, we know that investors have a very, very hard time buying when things look bad. Do you automate this, or do you just have certain parameters and something gets triggered and you do it?
Lee: It’s fairly automated. We enter our orders before the market opens. I’m just as susceptible to the motions as the next guy, and I find that entering my orders the night before, or before the market opens, and not looking at it too much for the day, has helped me.
Zack: If you’re going to buy a stock, you look at its past trading history. Does it even matter? It sounds like it doesn’t matter what industry it’s in, what security class it’s in. But does it really matter, the underlying business?
Lee: No, it doesn’t.
Lee: If somebody hates it, then that’s a good thing.
Zack: I’m an academic. I look at your portfolio, look at your strategy and I’m saying, well, how can you always be right? Of course, you never claim that you’re always right. You’re right much of the time.
Lee: We’ve had our losing years, like everybody else. The issue for us is we have a very specific mandate. We’re managing for retirement plans. We’re a fiduciary for those retirement plans, which requires that we be low risk, in my mind, at least. Some clients like us to be higher risk. And we’re trying to get ahead, no matter what. Every December 31st I want to be profitable, even if it’s by .1%. I don’t ever want to have a loss. That’s our goal. That’s not a promise or a guarantee. That’s a goal. And our investment strategy reflects that. If we can’t find a good risk to take today, we just sit in cash.
I think our exposure to the market is around 20% on average for the year. And I may enter 50 orders tonight, before the open for tomorrow, and none of them may get filled tomorrow–or ten of them may get filled. We don’t ever know the day before, because they have to drop further that day. A mean aversion only works when you’re really buying during the panic–not after the panic.
Zack: And then you’ll hold those stocks for how long?
Lee: Anywhere from a day or two to several weeks, depending on the price behavior that I want. It just depends. We have different exit strategies. To have more non-correlated strategies in the same realm; we have different exits for different strategies.
Zack: Obviously, you’re spending your entire day, you have staff; is it the type of thing an individual investor can do in their own account, obviously in a more simplified way?
Lee: I think so. In fact, I’ve had several people come to me and I actually worked with them. But at the end of the day everybody falls down at execution. Everybody understands it intellectually and emotionally, but going in day after day, especially when you’re in a drawdown period, say you’ve had a several percent draw down, had four, five, six, whatever, losing trades in a row. Everybody tends to throw in the towel at some point. And that’s true for all trading strategies.
Lee: That’s the value in hiring someone, you’re hiring that discipline. This is what I want done, and do this for me.
Zack: In my book and on the podcast, I mentioned this book that John Reese wrote called, “The Guru Investor”, where he’s created algorithms to recreate historical investor’s investment criteria. He’s been writing them for ten years, and has real money behind them. One thing he said that’s so clear is that obviously having a strategy is better than not having any strategy, or a flip- flopping strategy. And without fail, all winning strategies do under perform for anywhere from a year to a couple of years. But typically they make that back.
I think to quantify and to automate an investment process is so hard, not just for retail investors. Through the writing of the book and this podcast and my blogging and stuff, I’ve moved my own investment practice more into the sort of automated quantitative realm. But, it’s so hard to do, just shut off your brain and just follow these rules. I hear what you’re saying, that that would be the hardest part for individuals.
Lee: I think they can have all the knowledge. And it’s been hard for me. I think all of us who do this for a living struggle with it, as well. I think the difference is we realize the struggle we’re in versus someone may not.
Mark Douglas has written a series of books, basically the summary of one of them was, “As long as you’re risking so little that if you lose you’re okay with that, then you can handle it.” And as simplistic as that is, we evolve to it; we put just a small amount, that if we lose it’s OK. Another trade will make that up, and it’s not enough to hurt us really. We’ve gone back and forth with different risk management models.
Zack: Do you spend any part of your day looking at balance sheets? It’s like a different paradigm. You’re not growing your business in doing what you do. You don’t do that.
Lee: We don’t, especially for ETFs and indexes, because it’s very hard to look at an individual stock. What we want is something that just got killed. They’ve taken it out and just shot it, and it just drops. [inaudible 42:18] is dropping down and gapping today. That’s ideal. Sometimes we’re right, sometimes we’re wrong.
The goal is if we can’t find a good risk reward and it looks historically like a good risk, we don’t take any risk. People say: How did you make money in 2008? Well really, it was with a lot of cash, because the market was falling. And what we did buy a lot of were scratch trades, or lost money. But we didn’t enter the market enough over and over again to get hurt.
Zack: In a market that continuously goes up, you’re sitting on the sidelines in cash most of the time. You’re going to probably under perform in that market.
Lee: We do. We typically under perform in a really strong market. We try to work to fix that, but every time we worked to fix that we ended up being more and more correlated to the market, which kind of knocks out our first mandate, which is we don’t want to be correlated to any market. So, we’re typically going to lag in the big up years because nothing’s dropping dramatically. That is an issue for us.
Zack: One last question, and it’s something I ask of everybody who is on the show. And I guess you’re a little bit of a different animal in the sense that you’re not researching individual stocks. But, where do you go for information, to get smart on the markets? Are you looking at traditional publications? Are you looking at blogs? What are you reading that you find yourself coming back to?
Lee: That’s interesting. “Seeking Alpha” has a lot of great opinions on it. And I think that’s where we’re separating fact from opinion. The Internet is full of opinions. If you go to any, whether it’s Google Finance or Yahoo, on a day a stock is moving, you can see a thousand people making comments on it. Where you go for facts, I like Bloomberg. It’s probably my favorite. I go to that more than anything else.
But more and more I find myself going away from traditional investment sites. Just like, for example, you may have seen this the other day. A chart came out that mirrored what happened in 2000 is that 98% of stocks are buys right now, like 2% are sales. On the stocks, I have a hard time on that. What I do like- -I’ve enjoyed your blog, on the part about keeping up with technology. I’ve been very behind the times on technology, on sites like the co-vestor sites and other sites that are available to investors I was not aware of before–Todd Regibrook [SP], for example. But, we’ve limited our outside. If we can’t be quantified and tested, I try to block it out and not listen to it, from that standpoint.
I’m not sure where I got it, because I found it to be such bad information in the past. You’re an author; how many investment books can you buy and actually go and back test the theory and it shows promise or not?
Zack: I speak about this all the time.
Lee: I’ve got hundreds of investment books, and the answer is almost none.
Zack: Yeah, I speak about that all the time with my business partner. There’s so much noise out there, and everybody’s trying to sell you something in this industry. It’s really hard to decipher what you need, and what you get from each one of these sources.
Lee: And I’ve gotten cynical, because if none of it’s predictive, what’s the point?
Lee: And you know this; a mediocre investment strategy with phenomenal execution is going to out perform a strategy the other way around. We have a great strategy with mediocre or poor execution. And so, we know we’re going to have our good years and bad years, but every day we’re trying to work on really, really good execution, positive slippage, all those kinds of things. And we work hard on those issues. But as far as looking around and wondering, I guess I’m getting a little too cynical these days. That’s my problem.
Zack: Aren’t we all; but I think that’s part of the process of the evolving investors, to sort of break out from traditional theory and we’re sort of captured by it, to some extent, to explore new ways of doing things, just because the text books say that you should do something in a particular way doesn’t mean you need to.
Thank you so much for your time. I’m sorry to have to wrap it up, here. Just quickly, where should people go to find out more information? I’ll obviously put some links up with the podcast of where people should go. Hopefully, we can provide these ten tips.
Lee: They can go to the book website and download the first four chapters for free.
Lee: The book is LessRiskMoreReturn.com, or they can look at our investor advisory practice at HullCapital.com.
Zack: Great. And I’ll link to all that stuff from this post. Thanks again for your time. This was a great conversation.
Lee: Hey, thanks so much, Zack.
Zack: Good luck with the book.