- Begin at about 21:30 if you’d like to skip an opening session on starting a business (including the vocabulary around accounting and capital markets). The second half is purely focused on investing.
- Mr Ackman speaks of mutual funds being the obvious solution for those not wanting the effort of choosing their own portfolio companies. I’m sure he wouldn’t begrudge me a pitch for ETFs which do the same things, but usually carry lower fees.
- Given Mr Ackman’s value-oriented investment approach, I wasn’t surprised to hear his cynicism for investment styles outside of value (namely ‘technical’ or systematic approaches). I disagree here, noting that both Mr Ackman’s approach and other approaches can work in the long term, and frequently provide different sorts of investment returns.
One of the first investments in my portfolio was the Fairholme Fund, run by Bruce Berkowitz. I know what you’re thinking: in your Finance 101 piece, you said to stick with index-tracking ETFs. That is true, up to a point: some strategies must be actively managed (e.g. managed futures), or are better actively managed (e.g. deep-value investing). Fairholme fits in the latter category: Mr Berkowitz has proven over many years a capable deep-value, contrarian investor.
Why worry now? Fairholme has had investments in Fannie Mae/Freddie Mac preferred shares for some time now, with the thesis that the US Government would eventually see the merits of privatising the companies. So these securities, which were priced at a tiny fraction of par value, should eventually be worth something far greater. Classic deep-value play. And what recently happened? The courts found no issues with the US Government continuing to keep Fannie/Freddie nationalised. Fairholme lost about 10% in a day.
Why keep Mr Berkowitz in charge of a portion of my portfolio?
- A diversifying strategy: deep-value investing tends to work at different times than other strategies; in particular growth or momentum. Deep-value also seems to have an enduring risk premium, so it’s worth staying invested in this one. Long-term outperformance of Fairholme versus the S&P500 is a good example.
- A seasoned manager: Mr Berkowitz has been doing this a long time, and has an enviable track record. He won various awards for his risk-adjusted performance, including Morningstar’s ‘Fund Manager of the Decade’ for the 2000s.
- Too undiversified? Mr Berkowitz believes in keeping a very concentrated portfolio – around 10 holdings maximum. These days, the fund is stacked in financial services companies (AIG, Fannie/Freddie). That means the fund’s fortunes are tied to not only market-level moves, but individual snafus (like Fannie/Freddie of late, or Sears in the past few years).
- What about risk management? An important question to ask, after a big loss like Fairholme suffered, is whether risk management has gone awry. For a 10% daily loss to be within reasonable expectation (e.g. 95% confidence level, or 2 standard deviations), the fund needs to be running annual volatility of around 80% p.a. – assuming average return of zero, which is being easy on the fund. That volatility is around 5-6x the S&P500 volatility; should I then be expecting 5-6x the return of the S&P?
In sum, the one-day performance of Fairholme throws into question some of the portfolio management basics I discussed in my Finance 101 piece. Being undiversified, particularly in more exotic and illiquid securities such as the preference shares of Fannie/Freddie, may be a step too far. So what’s the alternative? If I’m happy with a 10% down day, perhaps a levered investment on the S&P500 Value index would help me achieve some of the Fairholme magic, without the worry of being too overconcentrated.
What do you think?