Tony Soprano: My estimate, historically? Eighty percent of the time it ends up in the can like Johnny Sack. Or on the embalming table at Cozzarelli’s. Bobby Bacala: Don’t even say it. Tony Soprano: No risk, no reward. Bobby Bacala: I mean, our line of work, it’s always out there. You probably don’t even hear it when it happens, right? ― The Sopranos, “Soprano Home Movies” (2007)
I’m going to jump right into this sequel to Things Fall Apart (Part 1), without a heavy recap of that note. The skinny recap is that if you have a two-party political system with high-peaked bimodal electorate preferences, as the United States began to develop in 2014 and has now fully formed, there are no winning centrist politicians and no stable centrist policies. Instead you have – politically speaking, at least – what Yeats called a widening gyre, where a steady stream of extremist candidates, each very attractive to their party base, pull the overall electorate into a greater and greater state of polarization. In other words, if you enjoyed the choices America had in the 2016 presidential election, you’re gonna love 2020.
Just as our politics are falling apart, our portfolios are falling apart, too.
It’s a different kind of falling apart. A less urgent kind of falling apart. Our current market equilibrium is not a widening gyre. It’s something else, which I’ll elaborate on in a second, where our prevalent emotions are bland disappointment and ennui, not urgent fear and loathing like in our political lives. If the signature image of Things Falling Apart in our modern political context is an enraged Tony Soprano pointing a gun at one of Phil Leotardo’s crew, the signature image of Things Falling Apart in our modern investment context is a weary Tony Soprano sitting at that diner in the very last episode, thinking that everything is … okay … definitely not great, but okay, totally oblivious to the reality of how his life has actually already fallen apart, how lethal decisions have been made away from him in ways he cannot observe or control, how his life is literally about to fade to black in 3 … 2 … 1.
The doomed-but-doesn’t-know-it Tony Soprano portfolio isn’t infamous. It’s not a meme. It’s not the public pension plan that is so dramatically underfunded that it contemplates selling billions of dollars in taxable bonds so that it can lever up in the equity market after a nine-year bull run. It’s not the 25-year-old who put the $30,000 he inherited from grandma into crypto because you gotta take chances when you’re young, right?
No, the Tony Soprano portfolio is the private endowment that has done … okay, I guess … but more because operating draws have gone down over this nine-year expansion than because investment performance was good. It’s the IRA that is … up a bit, yeah … but somehow always seems to zig when it should’ve zagged, so that it lightens up at the bottom of every two-week swoon and goes all-in in months like this January. It’s the wirehouse model portfolio that has done everything right in its analysis and its diversification and yet STILL underperforms the S&P 500 every year. Every. Freakin’. Year.
The Tony Soprano portfolio is, I would guess, 95% of us. What drives our disappointment? For a decade now …
It is a fact that NONE of us have done as well in our individual real-life portfolios as ALL of us have done in aggregate hypothetical indices.
It is a fact that Value has waaay underperformed the S&P 500.
It is a fact that Trend has waaay underperformed the S&P 500.
It is a fact that Quality has waaay underperformed the S&P 500.
It is a fact that Emerging Markets have waaay underperformed the S&P 500.
It is a fact that Real Assets have waaay underperformed the S&P 500.
It is a fact that Hedge Funds have waaay underperformed the S&P 500.
It is a fact that smarts and experience of every sort have waaay underperformed the S&P 500.
And if that weren’t enough, here’s the kicker that’ll get everyone mad at me, because it challenges the central tenet of the Church of Modern Portfolio Theory.
It is a fact that diversification has failed us for a decade.
The entire edifice of diversification and Modern Portfolio Theory is built on a simple and powerful idea – that it is meaningful to talk about uncorrelated asset classes and factors with positive expected returns. It’s built on the belief that all of these Things we call asset classes or factors will work over the long haul, but not all of them will work all of the time or in lockstep with each other, so you’re (much) better off owning a mix of these Things rather than just one of these Things.
Put another way, well-diversified portfolios work great in a widening gyre.
But our current market equilibrium is the opposite of a widening gyre. Where our politics have moved from a roughly single-peaked distribution of electorate preferences to a bimodal distribution, so that there is no effective center, our markets have moved from a multi-modal distribution of investor preferences to a single-peaked distribution, so that it’s all US large-cap stocks all the time.
If our politics are a widening gyre, our markets are a black hole. In both cases, resistance is futile. Fight the political centrifuge spinning you into the extremist arms of a two-party system … and you are left behind as an impotent “centrist”. Fight the investment gravity pulling you into passively managed large-cap US stocks … and you are left behind as an impotent “diversifier”.
Here’s the bottom line for how Things Fall Apart in the widening gyre of modern politics. In a two-party system with high-peaked bimodal electorate preferences:
There is no winning centrist politician. There are no stable centrist policies.
And here’s the bottom line for how Things Fall Apart in the black hole of modern investing. In a multi-asset class market with high-peaked unimodal investor preferences:
There is no winning diversification advocate. There are no outperforming diversified portfolios.
I can’t overemphasize how damaging the failure of diversification is to both our portfolios and the stability of our financial advisory system. As both investors and advisors we have put our faith in the power of diversification, and when that Greater Power deserts us we are left open and exposed. We are all Tony Soprano sitting in that diner, aware that something is not quite right, but also not quite able to put our finger on it. So we go on about our business. We order a basket of onion rings. And then it happens.
The bullet for so many smart and competent and well-diversified portfolios is the next recession. Why? Because these portfolios have not made nearly enough money in this long-running bull market to achieve their owners’ investment goals over an investment cycle. A 20% down move in the S&P 500 index would hardly make a dent in that hypothetical price series. But for a real-life portfolio that’s up half that … maybe a third of that … down 20% is a disaster.
The bullet for so many smart and competent and well-diversified financial advisors is also the next recession. Why? Because your clients will tolerate an underperforming theology in their investment lives so long as they are doing okay in their non-investment lives. Begrudgingly. Complainingly. For the most part. But the thing about recessions is that they’re not just a market phenomenon, they’re also a real-life phenomenon where jobs are lost, businesses are strained, and debts come due. Your clients have zero tolerance for disappointment in both their investment AND their non-investment lives. Zero. So unless you’re making money for your clients when the next recession hits, and that’s NOT what that well-diversified wirehouse model portfolio will do, then you’re going to lose clients. Because no one ever thanks a financial advisor for losing money, and you’re already on thin ice.
Here’s the thing about recessions.
Just like the bullet that gets Tony Soprano in the end, you never hear it coming.
Anyone who tells you otherwise is either kidding you or kidding themselves. I mean, we can’t even identify a recession when we enter one, much less predict the timing of the next one. (Seriously, the official adjudicators of recession dates – the National Bureau of Economic Research – always backdate the start of a recession to several months before we first realize we’re in a recession.)
Wheee! Well, Ben, as usual you’re a total downer. And we didn’t get the usual quota of movie lines, so this is shaping up to be even less enjoyable than usual, if such a thing is imaginable. I don’t suppose there’s anything we can, you know, maybe DO about all this to improve our situation?
Well, yes. Yes, there IS something we can DO about all this, as both investors and as citizens. Maybe not to rekindle some Golden Age, but at least to improve our chances above the 20% that Tony Soprano figures as the odds of avoiding prison or a violent death. To mark out that path, though, first I need to cut through what I think is the origin story for our sorry state of affairs.
What links the widening gyre of politics and the black hole of markets? They’re caused by the same thing. They’re what happens when emergency government action to rescue the financial system from political ruin becomes permanent government policy to use the financial system for political gain.
They’re what happens when an emergency QE1 becomes a permanent policy of QE2 and QE3 and QE Forever-and-Ever-Amen, not just in the US but (even more so) in Europe and Japan. They’re what happens when an emergency bank recapitalization becomes a permanent policy of Get Out of Jail Free and interest on reserves and consolidation and Treasury-backstopped debt. They’re what happens when central banks buy $22 TRILLION of stuff.
Central banks don’t care about Value. Central banks don’t care about Trend or Quality or anything else that rewards “good” investments and punishes “bad” investments. No, all they care about is lifting the price of ALL financial assets, which means – let’s be real here – if central banks have a bias on Quality, their bias is to protect low quality companies. Particularly European low quality banks.
Every policy decision made by China and Europe and Japan and the US in the wake of the Great Financial Crisis was made with a singular goal in mind – to prop up and inflate financial asset prices. Originally, it was to keep the status quo financial system from imploding. But soon after … and still now … it was to keep the status quo political system from imploding. What started as an entirely laudable effort to keep capital markets from collapsing became an entirely problematic effort to turn capital markets into political utilities. This has been a Team Elite goal since at least 1997.
You can see this effort most clearly in the relationship between U.S. household net worth (how rich we are) versus U.S. GDP (how much our economy has grown). I created these charts with data that the Fed has collected on a quarterly basis since 1951. They’re, ummm, kinda crazy.
Here’s the full relationship since 1951. To be clear, both data sets are nominal (meaning neither is adjusted for inflation), measured in exactly the same units – billions of US dollars – and normalized at 100. That’s an excellent way to make an apples-to-apples growth comparison in these circumstances, so don’t @ me about semi-log charting. Also to be clear, the Fed’s Household Net Worth category includes nonprofit organizations, so it includes the assets of pension funds (but not social security).
For 46 years, from 1951 to 1997, we were no more and no less rich than our economy grew. Which makes sense. That’s the neutral vision of monetary policy, where you’re not trying to pull forward future growth through leverage and easy money in order to create more wealth today. For the past 20 years, however, we have had a series of wealth bubbles – first the Dot-Com bubble, then the Housing Bubble, and today the Financial Asset Bubble – that have made us (temporarily) richer than our economy grows.
And yes, that’s what a bubble IS … it’s when you’re richer than your economy grows. Can you do it? Sure! Here’s the proof. But can you keep it?
If I could ask Alan Greenspan one question, because he’s the guy who started all this “wealth creation” effort, it would be this: do you think it’s possible for a country to be long-term richer than it grows, and did you talk with the White House about this? Okay, that’s two questions. Sue me. Same questions for Bernanke, Yellen, and Powell. My guess on answers: “Define long-term.” and “Define talk.”
So what’s the problem with being richer than you “should” be? The problem is how those riches are distributed. The problem is that the road to hell is paved with good intentions, sure, but even more so with hubris and post hoc rationalizations. Here’s a 2016 chart from Torsten Slok at Deutsche Bank that illustrates what I’m talking about.
Because financial assets are primarily held by the rich – and by the rich I’m not even talking about the 1%, but the 1/10th of 1% – a bubble in stocks and bonds primarily works to the benefit of the very rich at the expense of the non-rich. The well-off to merely-rich (the top 9.9% of US households by income) own pretty much the same share of US household wealth throughout this ONE HUNDRED YEAR DATA SERIES. All of the action is a give and take between the top 1/10th of 1% in US households and the bottom 90%.
And before everyone at the Hoover Institution has a fit … did the 1997 Greenspan Fed’s bubble-blowing start the wealth redistribution from the non-rich to the very rich? No. Rock-bottom wealth ownership by the very rich coincided roughly with the Jimmy Carter administration, and it’s been a nice ride for the 1/10th of 1% ever since Ronald Reagan came to the White House. Is it the same US households in the 1/10th of 1% by income over the past 30 years? No. There’s still more income (and wealth) mobility in the US than pretty much any other country. Does it make a difference for questions of wealth that social security exists today and didn’t in the 1930s. Yes, it makes a difference.
But I’m not trying to say that wealth inequality per se is a bad thing or a good thing. I’m not trying to make a close comparison between the meaning of wealth inequality today and wealth inequality in the 1930s. What I’m saying is that wealth inequality in 2018 is greater than it has been in 3+ generations. I’m saying this is a fact. I’m saying that wealth inequality has been exacerbated by the inflation of financial asset prices. I’m saying that if you don’t think this is a problem for political fragmentation … well, then you’re just not paying attention.
But wait, there’s more. This aggregate picture doesn’t do justice to how wealth inequality is experienced in America. Why not? Because of debt, particularly student debt.
If you’re young in America, you don’t feel the wealth inequality that bears down in truth and in spirit on the old non-rich. You don’t feel the wealth inequality because you have unlimited credit to live in a collegiate or graduate school bubble. If you’re young in America you FEEL RICH even as you BECOME POORER. This is not an accident. It is part and parcel of the widening gyre of American politics and the intentional use of the financial system to buy off young Americans and their adult parents. Ditto with Medicare buying off old Americans and their adult children. All while making the very rich very richer.
Okay, so there’s a common core for both the widening gyre of politics and the black hole of markets. But how does this move us from description to prescription? How does this put us on a path where we can DO something to improve our lot?
Let’s go back to that definition of diversification. Let’s go back to that central assumption of Modern Portfolio Theory that the investing world is made up of meaningfully different Things we call asset classes and factors, that all of these Things will work over the long haul, but not all of them will work all of the time or in lockstep with each other, so you’re (much) better off owning a mix of these Things rather than just one of these Things.
What if it’s really just one Thing?
Or rather, what if there’s a New Thing – call it the intentional policy creation of global wealth bubbles through insanely easy credit and, most recently, $22 trillion in outright asset purchases – that DID NOT EXIST when Harry Markowitz was calculating efficient frontiers and all that? What if this New Thing is so big and so powerful, what if it exudes so much gravity, that it has altered the basic geometry of our political and economic systems?
In both our political lives and our investing lives, we are prisoners of the Three-Body Problem.
What is the “problem”? Imagine three massive objects in space … stars, planets, something like that. They’re in the same system, meaning that they can’t entirely escape each other’s gravitational pull. You know the position, mass, speed, and direction of travel for each of the objects. You know how gravity works, so you know precisely how each object is acting on the other two objects. Now predict for me, using a formula, where the objects will be at some point in the future.
Answer: you can’t. In 1887, Henri Poincaré proved that the motion of the three objects, with the exception of a few special starting cases, is non-repeating. This is a non-predictable system, meaning that the historical pattern of object positions has ZERO predictive power in figuring out where these objects will be in the future. There is no algorithm that a human can possibly discover to solve this problem. It does not exist.
This is the foundational statement for a new path through the investing and political wilderness:
Geometry is not true, it is advantageous.
It’s not that diversification and Modern Portfolio Theory and Markowitz and all that is wrong in the sense that there’s a mistake in the math. It’s that when the geometry of our world changes enough, then these elegant and smart constuctions we have made to make sense of the prior geometry are no longer particularly advantageous. I say this not to bury diversification, but to rehabilitate it. I say this because diversification as a tool is extremely useful. Diversification as a religion … not so much.
Ditto with our path forward as citizens. We’re going to have to rethink a lot of things.
And unfortunately, there is no Answer waiting for us at the end of the rainbow, no algorithm or equation or religion or anything else. That’s life in the Three-Body Problem. A “general closed-form solution” does not exist. It’s just math, as the cool kids say. What there is, though, is a Process. And that will be enough.
This is Part 2 of a three-part series. Next, what do we DO about all this, as both investors and as citizens? What is the Process for living safely in a Three-Body Problem? It’s not an Answer, because there is no Answer. But it is a start.
If I may begin at the beginning? First, there is the cherry fondue. Now this…is extremely nasty. But we can’t prosecute you for that.
Mister Milton, Owner and Proprietor of Whizzo Chocolate Company:
Next, we have Number 4: Crunchy Frog. Am I right in thinking there’s a real frog in ‘ere?
Yes, a little one.
Is it cooked?
We use only the finest baby frogs, dew-picked and flown from Iraq, cleansed in the finest quality spring water, lightly killed, and sealed in a succulent Swiss, quintuple smooth, full cream, treble milk chocolate envelope, and lovingly frosted with glucose.
That’s as may be, but it’s still a frog!
What else would it be?
Well don’t you even take the bones out?
If we took the bones out, it wouldn’t be crunchy, would it?
Constable Parrot ‘et one of those!
It says “Crunchy Frog” quite clearly.
Well, never mind that. We have to protect the public. People aren’t going to think there’s a real frog in chocolate. The superintendent thought it was an almond whirl! They’re bound to think it’s some kind of mock frog.
Mock frog? We use no artificial preservatives or additives of any kind!
Nevertheless, I advise you in the future to replace the words “Crunchy Frog” with the legend “Crunchy Raw Unboned Real Dead Frog” if you want to avoid prosecution.
What about our sales?
— Monty Python Live at the Hollywood Bowl, “Crunchy Frog” sketch (1982)
It has been pointed out to us that we write rather a lot about philosophy and psychology for a website/blog/newsletter about investing.
Is this surprising? This should not be surprising. All of us are in the business of prediction. Thankfully, not all of it is explicit prediction, like saying that we think that the price of Walmart stock will be $120 in three years, or that Tesla will be bankrupt in four years. Most of it is implicit prediction, like the way that investing money in something risky implies all sorts of things about the returns we expect from it. Predictions all the same. And any activity like this relies on developing confidence in some basis for creating (or assuming) those predictions.
Philosophy, and specifically epistemology, asks how we can know the things we need to make those predictions. Are conditions, traits, features of the thing we’re predicting observable? Are their responses observable? With what confidence may we infer traits from similar things we have observed? Further, may we reason how those traits might interact with other things to allow prediction? Psychology asks how accurate those human observations might be. It asks what evolutionary processes may have colored or influenced what we know, and what we think we know. It posits heuristics that might substitute for empirically-driven reasoning, whether helpfully or harmfully. Furthermore, in a field like investing that is responsible for making predictions about human behavior itself, psychology is recursively relevant, in that it studies both the tool of the observer and the observed.
Psychology and philosophy are critical tools for the investor. But in addition to being particularly ripe fields for bullshit, they also suffer from one of the same tendencies that plagues investors: people get so hung up on terminology and conventions that they start saying and doing dumb things. As always, the shrewd investor avoids that behavior himself and for his clients and capitalizes on it in others.
The Tyranny of Terminology
Of course, that gasbag introduction was just a way to tell you that I got into a little debate about Jordan Peterson.
If you don’t know much about him, Peterson is a professor of psychology at the University of Toronto, a cultural commentator and a bit of a rabble-rouser. As a psychologist and academic, he is heavily cited and as far as I can tell (which is not very far, but judging by citations alone), well-thought-of in his field. As a cultural commentator, he is thoughtful and incisive as a proponent of self-control, advocate of free speech, and opponent of what he characterizes as Neo-Marxism and Postmodernism, especially in the American university. As a scientific historian of philosophy? Well, this is where things get a little more controversial.
You see, the piece I was discussing with a very thoughtful senior staffer at a large U.S. university endowment (don’t tell my salespeople I’m getting into philosophical debates with clients and prospects, please and thank you) made the argument that Peterson was the wrong choice for a public conservative intellectual. The argument, if I may summarize, finds fault with him because (1) he attracts an audience of mostly young white males, (2) the traits he ascribes to Postmodernism are cherry-picked and not entirely correctly as derived from the history of the movement, and (3) he uses the terms “Neo-Marxist” and “Postmodern” seemingly interchangeably despite the different heritage and intellectual evolution of the terms and associated philosophical movements. The piece is a rousing little number, and almost enough to make you want to sit through that whole documentary on Jacques Derrida. (No, not really. Good Lord.)
Guess what? All the claims are pretty much true. Guess what else? None of them matter. I’ll get back to why, but first, I want to talk about another very current example.
You may have seen that Steven Pinker, cognitive pyschologist scientist at Harvard, published a new book called Enlightenment Now. Now, the reality is that the book doesn’t really undertake much discussion of the specifics of schools of enlightenment thought per se, but rather tells the story of human progress over the last 200 years. It makes the argument that these improvements are vastly underestimated and underappreciated. It also connects those achievements to specific influences of science and reason, sometimes very compellingly and sometimes somewhat less so. It is an encouraging and energizing read, even where its contentions are less well supported. I, for one, think there’s rather a lot in the 20th century alone that a purely scientific approach to curing society’s ills has to answer for. But much of the criticism has little to say about that, instead grousing that the science and reason the book discusses aren’t really about THE Enlightenment, but about principles of the Scottish Enlightenment specifically, and even then only about a subset of principles that Pinker particularly likes. After all, Marx was just a natural extension of the French Enlightenment!
Are you detecting a pattern here?
There are a lot of different kinds of talk about Enlightenment Principles right now. Ben and I write about them a lot. Ben wrote about them back in 2016 in Magical Thinking, and later in Virtue Signaling, or…why Clinton is in Trouble. I wrote about them in short last year in Gandalf, GZA and Granovetter. The remarkable new web publication Quillette provides a platform for writers who are thinking about them. The Heterodox Academy is building a strong core of support for them in universities. Pinker is talking about them. Chomsky has been speaking about them for decades. Hitchens, too, before he passed. In his own way, Taleb is talking about them (although he’d dislike the company I’ve chosen for him thus far). Peterson won’t shut up about them. Many of these same people — and some others — are simultaneously issuing criticisms of what is purported to be a diametrically opposed philosophy. In the early 2000s, the scandalous moniker applied was “Cultural Marxism.” Today this opposition is usually generalized into references to “Neo-Marxism” and “Postmodernism.”
But here’s the biggest shocker. Get out the fainting couch: they’re not all saying the exact same thing.
These are thinkers focused on many different areas, and so there are all sorts of topics where they disagree, sometimes vehemently. All would say that they believe in logic, truth and rationality, I think, but would define those things very differently. Most of the folks in the list above, for example, believe in a rationalism that inherently excludes faith. They are among the most prominent atheists of our time. They typically adhere to empiricism and the scientific method as the primary — even sole — method for transforming observations about the world into predictions. For two of them, Taleb and Peterson, rational thought means also incorporating evolved heuristics, intuition, instinct and long-surviving human traditions. This is not fringe stuff, but the logical conclusion of any serious consideration of Hayek and spontaneous order. It also means particular sensitivity to scientific techniques that end up equating absence of evidence with evidence of absence. All this means when you see many of the above names together, it’s…not always friendly. Like, stuff you can’t really walk back. Even among the two primary authors of this blog there are differences in how we see these things. I haven’t talked to Ben about it, but if I gave him the list of the above, I’d guess he’d hitch his wagon to Hitchens. Me? I’m probably closer to Taleb or Peterson.
What I doubt you’d find much of from this group is navel-gazing about terminology on the issue of postmodernism. While Voxsplainers and science historians quibble (very justifiably in the latter case) about whether there is a “discrete, well-defined thing called the Enlightenment” or whether it is fair to use “Postmodernism” in reference to a movement to esteem individual experience as peer or superior to free inquiry and free expression, the rest of us know exactly what people are talking about when they talk about this issue.
Don’t believe me? Fine. Go Full Cosmo and ask people you know these four questions:
Should governments and other important institutions abridge or allow (e.g., through Heckler’s Veto) the abridgement of some speech to protect people from speech which we think may be harmful to society, especially to historically oppressed groups?
Should we restrict the examination or evaluation of certain topics, especially when allowing them would prop up harmful social structures (especially power and class structures)?
Should we be skeptical that certain features and traits of the material, cosmological and biological world can ever be objectively true or important, considering the biased social lenses through which they are observed?
When making predictions about the world, should we consider personal experience and truths as equal or superior to whatever is uncovered through rational evaluation of the empirical merit or survival of a fact, idea or principle?
If you don’t think there’s a real thing happening in academia, in the public sphere, in politics and in creative media between those with three or four responses on opposite ends of the spectrum, I don’t know what to tell you. But I do know that this intuitive, arbitrary, subjective scale that I made up right just now is going to do a lot better job telling you about what people are referring to as a conflict between “Enlightenment” and “Postmodernism” than any etymologically thorough review of the terms themselves. How do I know this? Because it asks the question we should all ask any time that we see prediction or analysis oriented around terminology, categories, benchmarks, titles and jargon:
“Yes, but what is it, really?”
What is it, really?
There isn’t a question I can think of that an investor ought to ask more often, especially when it comes to any interaction they have with a representative of a financial services company trying to sell them something. And as Ben has written, all financial innovation is either finding a new way to sell something (securitization) or a new way to borrow money on things (leverage). The name of the thing being sold isn’t always a very good representation of what the thing is, sometimes for innocent reasons, and sometimes because crunchy, raw, unboned, real, dead frog doesn’t sound very appetizing.
Now, obviously the origin of most investment terminology, conventions, and even jargon IS innocent. Usually their purpose is to reduce complicated or large sets of data or principles to like dimensions. This is pretty helpful for communication and analysis. If we were constantly redefining the generally accepted conventions for a concept like “U.S. Large Cap Stocks”, for example, we would find it difficult to do a great many things with much efficiency. Economic constructs like sectors and common investment styles also have their appeal for this reason.
The problems, however, come in one of two flavors: first, as terminology becomes convention within an industry, we get further and further removed from a fundamental understanding of what the thing actually is. When we talk about U.S. Large Cap Stocks as a sort of monolithic entity unto itself, we forget that there is a lot going on underneath the hood. Sectors are changing. Companies, even entire industries are born and dying. New IPOs, companies slipping out into small cap land, companies bought out by private equity. We forget the nature of our fractional ownership, and the limited mechanical reasons why a stock’s price might rise and fall. The nature of what you own at any given time and the underlying risks attached to it really does change rather a lot, and that’s without getting into the massive sentiment-driven influences on price variation.
One of my favorite analogues to this is the ubiquitous reference to the “Top 1%” of wage earners. The concept is interesting and useful as a simplifying term, but like an asset class, it is by no means a static construction. Consider, for example, that more than 10% of wage-earners will, at some point in their lives, be among the Top 1%! Perhaps more impressively, more than 50% of Americans will at some point be in the Top 10%. Consider the impact that this has on a wide range of policies considered and rhetoric used — not invalidating, to be sure, but relevant.
The second class of problems stemming from the long-term path from terminology into convention is the inevitable realization by market participants that they can — and once enough people do, that they must — game the system. That’s where the coyotes and raccoons come in, but also your garden-variety professionals justifiably worried about career risk. But all of these folks hope you’re hungry for some delicious Crunchy Frog.
Fight Fiercely, Harvard!
What do I mean? Well, sometimes it’s obvious. Let’s consider the curious case of the Harvard Endowment.
A week ago, multiple media outlets reported that alumni from the Class of 1969 (“an artist, a clergyman, and two professors” one article reports, but disappointingly does not finish the joke) wrote incoming Harvard University President Lawrence Bacow to encourage him to force HMC to move half of the $37.1 billion endowment out of “hedge funds” and into ETFs tracking the S&P 500. The reason? This passive management strategy would have worked better over the last several years, and would have saved a bunch of money in fees.
It goes without saying that the alumni recommendation is just really, really terrible. Like, Fergie-singing-the-anthem terrible. It’s terrible because it would arbitrarily change the risk posture of the endowment by a massive amount. It’s terrible because it would shift what has historically been a well-diversified portfolio into a woefully underdiversified portfolio with extraordinarily concentrated exposure to the performance of common stock in large U.S. companies. It’s terrible because the confluence of those two changes would massively increase the drawdowns of the endowment, its risk of ruin, and potentially impact the long-term strategic planning and aims of the greatest research university on the planet.
But mostly, it’s terrible because the proposal isn’t passive at all. Not even a little bit. It’s a massively active roll of the dice on a single market! While alumni, executives and investors bicker over whether the portfolio ought to be “passively managed”, the origin of the term and the nonsense they’re proposing couldn’t be more at odds.
Now, you may be saying, “It’s a silly alumni letter. Most people get this.” No, they really don’t. Remember, the goofy letter was covered throughout the financial media, and they are the same media who triumphantly report the annual difference in return between literally anything and the S&P 500, regardless whether it is the return on a completely different type of security or vehicle with vastly different risk and diversification characteristics. This is how most of the world thinks about investing. This is how the damned Center for Economic Policy and Research thinks about investing, for God’s sake. People who are otherwise very smart think they’re making an intelligent point about fees when they’re really making a dumb point about asset allocation — about quantity and sources of risk. Even the aforementioned Steven Pinker contracted Gell-Mann Amnesia and retweeted an article attributing the Buffett bet between S&P 500 and hedge funds to a question of cost rather than the dominating risk differences between the two.
How do we cut through terminology confusion on an issue like this?
We ask: “What is it, really?”
If you’re being sold a portfolio based on principles of “passive management”, does your advisor or manager mean “low-cost”, does he mean “not making active bets against a global market portfolio”, or both (or, y’know, neither)? If it’s a low-cost story, what is it, really? Does it have a low headline fee, but with expensive underlying implementation using swaps or external funds that don’t get included in the stated fee? Does it have a low headline fee that your advisor is layering high additional costs on top of? What is the asset allocation you’re being sold on? Is it implicitly making an active bet against a global portfolio of financial assets? Is it the right amount of risk? Is it taking sufficient advantage of the benefits of diversification?
If you’re being asked by a client or prospect about “passive management” or “indexing”, are you sure they’re asking you about low-cost investing? Are you sure they care whether the portfolio is avoiding making bets against market cap-weighted indices? Are you sure they care whether you’re in-line with some measure of a global market portfolio? Or are they asking you why you weren’t invested 100% in the S&P 500?
Because whatever the “real” definition of passive management, we all know that we all know that this is almost always what people mean.
Deeper down the Rabbit Hole
The fact that people really mean, “why don’t you just buy the S&P 500” when they say, “why don’t you just invest passively” tells us something else about most investors. When it comes to what they buy and what they own, and especially when it comes to conventions that manifest in indexes and benchmarks, they frequently haven’t given much thought to what it really is.
Try this yourself, with your boards, your financial advisor, or with your clients. Ask them, “What is it, really, that you invest in when you buy a stock?”
I’ve done it, so I’ll give you a preview: you’ll get a huge range of answers, usually relating to “ownership” of companies or businesses. So what is an investment in a stock, really? It is a fractional, juniormost claim on the cash flow of a company, usually denominated in the currency of the country where it has its headquarters, the price of which at any given moment is determined by the investor out there who is willing to pay you the most for it — and nothing else. It has no “intrinsic value”, no “fundamental” characteristic that can be evaluated without knowing how a hundred million others will value and perceive it. It is a risky and inherently speculative investment.
In my experience, this is not what most investors mean when they say to their advisor, “just buy me a portfolio of stocks.” What they really mean is “I want to own things I understand.” They believe that investments in businesses are simple and straightforward. Unfortunately, while the businesses and how they make money may seem perfectly sensible on the surface, the forces influencing the returns from ownership of a common stock are anything but simple and straightforward. Sure, diversification helps a lot, and there are decades of relevant data to help us build some confidence about some range of likely outcomes. There are also theories of varying quality about rational behavior in that spontaneous order we call a market. But what you really own is something whose value may confound any attempt at analysis or linkage to economic fundamentals over your entire investment horizon.
Think this is just a misunderstanding of individual investors? Think again. This is a systematic problem. Consider, for example, that every Series 7-trained professional — by which I mean most of your brokers and financial advisors — is told that alternative investments tend to be “riskier” than traditional investments. In isolated cases this is true, and it’s certainly true that there are strategies by which the complexity of so-called alternative strategies introduces new dimensions of risk — usually as a way for financial intermediaries to confuse people into paying them more. But by and large, it’s an unequivocally false statement. Still, the dimension of complexity vs. perceived simplicity dominates how investors think about risk, even though the relationship is rarely strong. Don’t believe me? Ask a client, or better yet, your financial advisor to rank the following in terms of their riskiness: (1) $100 invested in an S&P 500 index fund, (2) $100 invested in centrally cleared financial futures contracts on German bunds, (3) $100 invested in fully collateralized, centrally cleared credit default swaps on U.S. IG credit. My guess is that nearly all individual investors, a majority of financial media members and a plurality of financial professionals would put #1 somewhere other than the top of the risk list. And it’s Not. Even. Close.
As it intersects with familiarity bias/availability heuristics (i.e., we are biased in our analysis toward things that we think that we know), the tyranny of terminology becomes less insidious and more obvious in its influence. Terms like stocks, bonds, commodities or real estate have readily ascertainable meanings and definitions but mean something very different when they come out of the mouths of most investors. They mean familiarity or foreignness. Whether we are individuals working with advisors or advisors ourselves, we must understand that when most investors say risk, they mean complexity. When most investors say simple — or something they think of as simple — they mean “low risk.” These are dangerous misconceptions.
And friends, any time there’s a dangerous misconception, there’s someone in the financial services industry poised to weaponize it. Plenty of Crunchy Frogs to go around, you see.
In every sub-field of money management, the name of the game is benchmark arbitrage. It’s a game played in three parts: risk layering, benchmark selection and multi-benchmarking. In each case, the affinity investors have for the comfort of indices makes them susceptible to marketing and fee schemes that have the potential to cause them harm.
Risk layering is the oldest of the three games. I wrote about it last year in I am Spartacus. The basic premise here is to select a benchmark that will feel attractive, familiar and conventional, and then to take additional risk on top of it to either (1) earn a better fee for the return generated by that risk or (2) generate better-looking performance to improve marketing potential. This IS the business model of private equity buyout funds, who since the massive fund raises and valuation increases of the mid-2000s, now take your cash, buy a company at a premium, layer on debt and sell it a few years down the line without having really done much of anything else. They’re not alone. Keying on the intellectual attraction of an “absolute return hurdle”, many so-called hedged and market neutral funds take on credit, equity and other risks beyond what exists in the benchmark, happily collecting incentive fees on garden-variety sources of return. Long-only funds do this too, of course. Most actively managed funds tend to buy higher beta, higher volatility stocks, and nearly all are smaller capitalization than the benchmark they are measured against.
Benchmark selection is often just a variant of risk-layering, but where the fund manager tries to control both the measurement and the measuring stick. Think of this like “venue-shopping” in the criminal justice world. Have you hired an international manager benchmarked to the MSCI EAFE Index? They do this. I don’t know who you hired, but they do this. They always have 5-10% in emerging markets stocks, don’t they? There’s a reason they didn’t select the MSCI World ex-US benchmark, folks.
As for multi-benchmarking, well…I hate to tell you, but if you have ever hired a money manager, a financial advisor or even an in-house investment team, you’ve seen this one, even if you didn’t notice it. It’s very simple: you pick two benchmarks, and then you make sure you’re always positioned between them. And that’s it. Sometimes one of the benchmarks is a peer benchmark (e.g., Morningstar, Lipper, eVestment peer group, Wilshire TUCS, Cambridge for the alts folks), or sometimes it’s a “style” benchmark (e.g., Value, Growth, High Dividend, Quality, Low Vol, etc.). But the objective is to always be able to point to something that you’re outperforming. A lot of this is well-intentioned and human, and there’s often a good reason to do it. But if you’re not looking out for it, it can confound.
And that’s kinda the point.
We can’t avoid convention, or the taxonomy that emerges naturally from an industry like ours. Nor should we want to. It helps us have conversations with each other. It helps us focus on Things that Matter instead of getting bogged down in details. But if we are to be successful, we must recognize the influence it has on us, our clients, our advisors and other investors. My advice?
Try to understand what your clients really think their investments are. Know what they really mean when they ask why you are or aren’t doing something.
Know what your advisors and managers think something is. Ask questions. Don’t assume based on terminology, and don’t be steamrolled by jargon.
Know what the things you own actually are, and build a risk management program to ensure that the baser temptations of people in this industry don’t cost you or your clients money.
As we delve further into alpha in a “Three-Body Market”, this last point will come up a lot. You can’t seek alpha if you don’t really know how to measure it. Except for the Postmodernists. Y’all can still tell us how it makes you feel.
We’ve had a heckuva busy year at Epsilon Theory, so to ring out 2017 I thought it might be helpful to distribute a master list of our publications over the past 12 months. We’re long essay writers trying to make our way in a TLDR world, so even the most avid follower may well need a map!
It’s also a good opportunity to give thanks where thanks are due.
First, a heartfelt thank you to my partners at Salient for contributing a ton of resources to make Epsilon Theory happen, never once asking me to sell product, and allowing me the leeway to speak my mind with a strong voice that would make a less courageous firm blanch. Epsilon Theory isn’t charity, and it’s the smart move for a firm playing the long game, but no less rare for all that.
Second, an equally heartfelt thank you to the hundreds of thousands of readers who have contributed their most precious resource – their time and attention – to the Epsilon Theory effort. We live in a world that is simultaneously shattered and connected, where we are relentlessly encouraged to mistrust our fellow citizens IRL but to engage with complete strangers on social media. It’s an atomized and polarized existence, which works really well for the Nudging State and the Nudging Oligarchy, less well for everyone else. The lasting impact of Epsilon Theory won’t be in what we publish, but in how we’re able to bring together truth-seekers of all stripes and persuasions, because it’s your engagement with the ideas presented here that will change the world. I know that sounds corny, but it’s happening.
Now on to the 2017 publishing map.
Our big initiative for this year was to publish two coherent sets of long-form notes, one by yours truly and one by my partner Rusty Guinn.
My series of essays is called Notes From the Field. As many long-time readers know, I’m originally from Alabama but now live out in the wilds of Fairfield County, Connecticut, on a “farm” of 44 acres. I put that word in quotations because although we have horses and sheep and goats and chickens and bees, my grandfather – who owned a pre-electrification, pre-refrigeration, pre-pasteurization dairy farm in the 1930s – would surely enjoy a good belly laugh at my calling this a farm. Still, I’ve learned a few things over the years from the farm and its animals, and they’ve helped me to become a better investor.
Notes From the Field: The eponymous note has two essays: “Fingernail Clean”, introducing the concept of the Industrially Necessary Egg – something we take for granted as proper and “natural” when it’s anything but, and “Structure is a Cruel Master”, introducing the genius of both humans and bees – our ability to build complex societies with simple algorithms.
Horsepower: The horse and horse collar revolutionized European agriculture in the 10th and 11th centuries, a revolution that lives on in words like “horsepower” and changed the course of human civilization. Today we are struggling with a productivity devolution, not revolution, and there is nothing more important for our investments and our politics and our future than understanding its causes and remedies.
The Arborist: We are overrun with Oriental Bittersweet, privet, and kudzu — or as I like to call them, monetary policy, the regulatory state, and fiat news — invasive species that crowd out the small-l liberal virtues of free markets and free elections. What to do about it? Well, that’s citizenship, and I’ve got some ideas.
Always Go To the Funeral: Going to the funeral is part of the personal obligation that we have to others, obligation that doesn’t fit neatly or at all into our bizarro world of crystalized self-interest, where scale and mass distribution are ends in themselves, where the supercilious State knows what’s best for you and your family, where communication policy and fiat news shout down authenticity, where rapacious, know-nothing narcissism is celebrated as leadership even as civility, expertise, and service are mocked as cuckery. Going to the funeral is at the heart of playing the meta-game – the game behind the game – of social systems like markets and elections, and it’s something we all need to understand so that we’re not played for fools.
Sheep Logic: We think we are wolves, living by the logic of the pack. In truth we are sheep, living by the logic of the flock. In both markets and politics, our human intelligences are being trained to be sheep intelligences. Why? Because that’s how you transform capital markets into a political utility, which is just about the greatest gift status quo political institutions can imagine.
Clever Hans: You don’t break a wild horse by crushing its spirit. You nudge it into willingly surrendering its autonomy. Because once you’re trained to welcome the saddle, you’re going to take the bit. We are Clever Hans, dutifully hanging on every word or signal from the Nudging Fed and the Nudging Street as we stomp out our investment behavior.
Pecking Order: The pecking order is a social system designed to preserve economic inequality: inequality of food for chickens, inequality of wealth for humans. We are trained and told by Team Elite that the pecking order is not a real and brutal thing in the human species, but this is a lie. It is an intentional lie, formed by two powerful Narratives: trickle-down monetary policy and massive consumer debt financing.
The Three-Body Problem: What if I told you that the dominant strategies for human investing are, without exception, algorithms and derivatives? I don’t mean computer-driven investing, I mean good old-fashioned human investing … stock-picking and the like. And what if I told you that these algorithms and derivatives might all be broken today?
Rusty’s series of essays, Things that Matter (and Things that Don’t), connects to mine with his just published The Three-Body Portfolio. It’s a wonderful piece on its own (I can’t believe I didn’t think of the Soylent Green reference – Epsilon is people!) and is a great segue to his 2017 serial opus. In chronological order:
With A Man Must Have a Code, Rusty begins the conversation about why we think that all investors ought to have a consistent way of approaching their major investment decisions.
In I am Spartacus, Rusty writes that the passive-active debate doesn’t matter, and that the premise itself is fraudulent.
In What a Good-Looking Question, Rusty writes that trying to pick stocks doesn’t matter, and is largely a waste of time for the majority of investors.
In Break the Wheel, Rusty argues that fund picking doesn’t matter either, and he takes on the cyclical, mean-reverting patterns by which we evaluate fund managers.
In And they Did Live by Watchfires, Rusty highlights how whatever skill we think we have in timing and trading (which is probably none) doesn’t matter anyway.
In Chili P is My Signature, Rusty writes that the typical half-hearted tilts, even to legitimate factors like value and momentum, don’t matter either.
In Whom Fortune Favors (Part 2 here), Rusty writes that quantity of risk matters more than anything else (and that most investors probably aren’t taking enough).
In You Still Have Made a Choice, Rusty writes that maximizing the benefits of diversification matters more than the vast majority of views we may have on one market over another.
In The Myth of Market In-Itself (Part 2 here), Rusty writes that investor behavior matters, and he spends a lot of electrons on the idea that returns are always a reflection of human behavior and emotion.
In Wall Street’s Merry Pranks, Rusty acknowledges that costs matter, but he emphasizes that trading costs, taxes and indirect costs from bad buy/sell behaviors nearly always matter more than the far more frequently maligned advisory and fund management expenses.
Drummers are really nothing more than time-keepers. They’re the time of the band. I don’t consider I should have as much recognition as say a brilliant guitar player. I think the best thing a drummer can have is restraint when he’s playing — and so few have today. They think playing loud is playing best. Of course, I don’t think I’ve reached my best yet. The day I don’t move on I stop playing. I don’t practice ever. I can only play with other people, I need to feel them around me.
— Ginger Baker (founder of Cream), from a 1970 interview with Disc Magazine
La cuisine, c’est quand les choses ont le goût de ce qu’elles sont. (Good cooking is when things taste of what they are.)
— Maurice Edmond Sailland (Curnonsky) — 1872-1956
There are those who think that life Has nothing left to chance A host of holy horrors To direct our aimless dance
A planet of playthings We dance on the strings Of powers we cannot perceive The stars aren’t aligned Or the gods are malign Blame is better to give than receive
You can choose a ready guide In some celestial voice If you choose not to decide You still have made a choice
— Rush, “Freewill”, Permanent Waves (1980)
For the kingdom of heaven is like a man traveling to a far country, who called his own servants and delivered his goods to them. And to one he gave five talents, to another two, and to another one, to each according to his own ability; and immediately he went on a journey. Then he who had received the five talents went and traded with them, and made another five talents. And likewise, he who had received two gained two more also. But he who had received one went and dug in the ground, and hid his lord’s money. After a long time the lord of those servants came and settled accounts with them.
So he who had received five talents came and brought five other talents, saying, ‘Lord, you delivered to me five talents; look, I have gained five more talents besides them.’ His lord said to him, ‘Well done, good and faithful servant; you were faithful over a few things, I will make you ruler over many things. Enter into the joy of your lord.’ He also who had received two talents came and said, ‘Lord, you delivered to me two talents; look, I have gained two more talents besides them.’ His lord said to him, ‘Well done, good and faithful servant; you have been faithful over a few things, I will make you ruler over many things. Enter into the joy of your lord.’
Then he who had received the one talent came and said, ‘Lord, I knew you to be a hard man, reaping where you have not sown, and gathering where you have not scattered seed. And I was afraid, and went and hid your talent in the ground. Look, there you have what is yours.’
But his lord answered and said to him, ‘You wicked and lazy servant, you knew that I reap where I have not sown, and gather where I have not scattered seed. So you ought to have deposited my money with the bankers, and at my coming I would have received back my own with interest. Therefore, take the talent from him, and give it to him who has ten talents.
For to everyone who has, more will be given, and he will have abundance; but from him who does not have, even what he has will be taken away. And cast the unprofitable servant into the outer darkness. There will be weeping and gnashing of teeth.
— The Bible, The Gospel of Matthew 25:14-30
This note was featured in Meb Faber’s book The Best Investment Writing – Volume 2, alongside another Epsilon Theory note from Ben Hunt. Click here to get a copy.
I will never understand why more people don’t revere Rush.
With the possible exception of Led Zeppelin, I’m not sure there has been another band with such extraordinary instrumentalists across the board, such synergy between those members and their musical style and such a consistent approach to both lyrical and melodic construction. And yet they were only inducted into the Rock & Roll Hall of Fame in 2013. A short list of bands and singers the selection committee thought were more deserving: ABBA, Madonna, Jackson Browne, the Moonglows, Run DMC. At least they got in when Randy Newman did. I remember the first time I heard YYZ, the Rush tune named after the IATA airport code for Toronto’s Pearson International Airport, pronounced “Why Why Zed” in the charming manner of the Commonwealth. It was then that I decided I would be a drummer. I did play for a while, and reached what I would describe as just above a baseline threshold of competence.
That’s not a throwaway line.
There’s a clear, explicit line that every drummer (hopefully) crosses at one point. A step-change in his understanding of the role of the instrument. The true novice drummer always picks up the sticks and plays the same thing. Common time. Somewhere between 90-100 beats per minute. Eighth note closed hi-hat throughout. Bass drum on the down and upbeat of the first beat. Snare on second down beat. And then it’s all jazzy up-beat doodling on the snare for the rest of that bar until the down beat of four. Same thing for three measures, and on the fourth measure it’s time for that awesome fill he’s been practicing. I don’t know how many subscribers are drummers, but I assure you, literally couples of you are nodding your heads.
The fills and off-beat snare hits are all superfluous and not necessary to the principal role of a drummer in rock and roll: to keep the damned beat. But there are a number of reasons why every neophyte does these same things. Mimicry of more advanced players who can do the creative and interesting things without losing the beat, for one. We see Tony Williams, John Bonham, or Bill Bruford and do what it is we think they are doing to make the music sound good. The amateur often also thinks that these are the necessary things to be perceived as a more advanced player, for another. He doesn’t just imagine that his mimicry will make him sound more like the excellent players, but imagines himself looking like them to others. More than anything, the amateur does these things because he hasn’t quite figured out that keeping a good beat is so much more important than anything else he will do that he’s willing to sacrifice it for what he thinks is impressive.
This thought process dominates so many other fields as well. Consider the number of amateur cooks who hit every sauce or piece of meat with a handful of garlic powder, onion powder, oregano, salt, pepper and cayenne, when the simplicity of salt as seasoning dominates most of the world’s great cuisine. There is an instinct to think that complexity and depth must come from a huge range of ingredients or from complexity in preparation, but most extraordinary cooking begins from an understanding of a small number of methods for heating, seasoning and establishing bases for sauces. Inventiveness, creativity and passion can take cuisine in millions of directions from there, but many home cooks see the celebrity chef’s flamboyant recipe and internalize that the creative flourishes are what matters to the dish, and not the fact that he cooked a high-quality piece of meat at the right heat for the right amount of time.
If you’re not much of a cook, consider instead the 30-handicap golfer who wouldn’t be caught dead without a full complement of four lob wedges in his bag. You know, so that he can address every possible situation on the course. The trilling singer of the national anthem who can’t hold a pitch but sees every word of the song as an opportunity to sing an entire scale’s worth of notes. The karate novice who addresses his opponent with a convoluted stance. The writer who doesn’t know when to stop giving examples to an audience who understood what he was getting at half-way through the one about cooking.
I’m guessing at least one of these things pisses you off, or at the very least makes you do an internal eye roll. And yet, as investors we are guilty of doing this kind of thing all the time, any time the topic of diversification comes up.
It comes from a good place. We know from what we’ve been taught (and from watching the experts) that we should diversify, but we don’t have a particularly good way of knowing what that means. And so we fill our portfolios with multiple flavors of funds, accounts and individual securities. Three international equity funds with different strategies. Multiple different styles in emerging markets. Some value. Some growth. Some minimum volatility. Some call writing strategies. Some sector funds. Maybe some long/short hedge funds. Some passively managed index funds, some actively managed funds. Definitely some sexy stock picks. And in the end, the portfolio that we end up with looks very much like the global equity market, maybe with a tilt here or there to express uniqueness — that flashy extra little hit on the snare drum to look impressive.
This piece isn’t about the time we waste on these things. I already wrote a piece about that a few weeks ago. This is about the harm we do to our portfolios when we play at diversifying instead of actually doing it.
The Parable of the Two FA’s
So what does actually diversifying look like?
There are lot of not-very-useful definitions out there. The eggs-in-one-basket definition we’re all familiar with benefits from simplicity, which is not nothing. In addition, it does work if people have a good concept of what the basket is in the analogy. Most people don’t. Say you have $100, and you decide that a basket is an advisor or a fund. So you split the money between the two, and they invest in the same thing. You have not diversified. The other definitions for diversification tend to be more complicated, more quantitative in nature. That doesn’t make them bad, and we’ll be leaning on some of them. But we need a rule of thumb, some heuristic for describing what diversification ought to look like so that we know it when we see it. For the overwhelming majority of investors, that rule of thumb should go something like this:
Diversification is reducing how much you expect to lose when risky assets do poorly or very poorly without necessarily reducing how much total return you expect to generate.
Now, this is not exactly true, and it’s very obviously not the whole definition. But by and large it is the part of the definition that matters most. The more nuanced way to think about diversification, of course, is to describe it as all the benefits you get from the fact that things in your portfolio don’t always move together, even if they’re both generally going up in value. But most investors are so concentrated in general exposure to risky assets — securities whose value rises and falls with the fortunes and profitability of companies, and how other investors perceive those fortunes — that this distinction is mostly an academic one. Investors live and die by home country equity risk. Period. Most investors understand this to one degree or another, but the way they respond in their portfolios doesn’t reflect it.
I want to describe this to you in a parable.
There was once a rich lord who held $10 million in a S&P 500 ETF. He knew that he would be occupied with his growing business over the next year. Before he left, he met with his two financial advisors and gave them $1 million of his wealth and told them to “diversify his holdings.”
He returned after a year and came before the first financial advisor. “My lord, I put the $1 million you gave me in a Russell 1000 Value ETF. Here is your $1.1 million.” The rich man replied, “Dude, that’s almost exactly what my other ETF did over the same period. What if the market had crashed? I wasn’t diversified at all!” And the financial advisor was ashamed.
Furious and frustrated, the rich man then summoned his second financial advisor. “Sir, I put your $1 million in a Short-Duration Fixed Income mutual fund of impeccable reputation. Here’s your $1 million back.”
“Oh my God,” the lord replied, “Are you being serious right now? If I wanted to reduce my risk by stuffing my money in a mattress I could have done that without paying you a 65bp wrap fee. How do you sleep at night? I’m going to open a robo-advisor account.”
Most of us know we shouldn’t just hold a local equity index. We usually buy something else to diversify, because that’s what you do. But what we usually do falls short either because (1) the thing we buy to diversify isn’t actually all that different from what we already owned, or (2) the thing we buy to diversify reduces our risk and our return, which defeats the purpose. There’s nothing novel in what I’m saying here. Modern portfolio theory’s fundamental formula helps us to isolate how much of the variation in our portfolio’s returns comes from the riskiness of the stuff we invested in vs. the fact that this stuff doesn’t always move together.
Source: Salient 2017 For illustrative purposes only.
The Free Lunch Effect
So assuming we didn’t have any special knowledge about what assets would generate the highest risk-adjusted returns over the year our rich client was away on business, what answer would have made us the good guy in the parable? Maximizing how much benefit we get from that second expression above — the fact that this stuff doesn’t always move together.
Before we jump into the math on this, it’s important to reinforce the caveat above: we’re assuming we don’t have any knowledge about risk-adjusted returns, which isn’t always true. Stay with me, because we will get back to that. For the time being, however, let’s take as a given that we don’t know what the future holds. Let’s also assume that, like the Parable of the Two FA’s, our client holds $10 million in S&P 500 ETFs. Also like the parable, we have been asked to reallocate $1 million of those assets to what will be most diversifying. In other words, it’s a marginal analysis.
The measure we’re looking to maximize is the Free Lunch Effect, which we define as the difference between the portfolio’s volatility after our change at the margin and the raw weighted average volatility of the underlying components. If the two assets both had volatility of 10%, for example, and the resulting portfolio volatility was 9%, the Free Lunch Effect would be 1%.
If maximizing the Free Lunch Effect is the goal, here’s the relative attractiveness of various things the two FA’s could have allocated to (based on characteristics of these markets between January 2000 and July 2017).
Volatility Reduction from Diversification — Adding 10% to a Portfolio of S&P 500
Source: Salient 2017. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The index is unmanaged and is not available for direct investment.
The two FA’s failed for two different reasons. The first failed because he selected an asset which was too similar. The second failed because he selected an asset which was not risky enough for its differentness to matter. The first concept is intuitive to most of us, but the second is a bit more esoteric. I think it’s best thought of by considering how much the risk of a portfolio is reduced by adding an asset with varying levels of correlation and volatility. To stop playing at diversification, this is where you start.
Volatility Reduction by Correlation and Volatility of Diversifying Asset
Source: Salient 2017. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The index is unmanaged and is not available for direct investment.
If You Choose not to Decide
If there are some complaints that can be leveled against this approach, two of them, I think, are valid and worthy of exploration.
The first is that diversification cannot be fully captured in measures of correlation. If you read Whom Fortune Favors, you’ll know that our code recognizes that we live in a behaviorally-influenced, non-ergodic world. While I think we’d all recognize that U.S. value stocks are almost always going to be a poor diversifier against global equities (and vice versa), clearly there are events outside of the historical record or what we know today that could completely change that. And so the proper reading of this should always be in context of an adaptive portfolio management process.
The second complaint, as I alluded to earlier, is the fact that we are not always indifferent in our risk-adjusted return expectations for different assets. I’m sure many of you looked at the above chart and said to yourself, “Yeah, I’m not piling into commodities.” I don’t blame you (I’m still not satisfied with explanations for why I ought to be paid for being long contracts on many commodities), but that is the point. Not owning commodities or MLPs because you don’t get them isn’t the same as not expressing an opinion. If you choose not to decide, you still have made a choice.
When investors choose to forgo diversification, on any basis, they are implicitly betting that decisions that they make will outperform what diversification would have yielded them. It may not be optimal to own the most diversified portfolio you can possibly own, because anti-diversifying decisions might, in fact, be worth it. But it is exactly that thought process that must become part of our code as investors. It’s OK to turn down a free lunch, but you’d damn well better know that what you’re going to spend your money on is better.
So how do you quantify that implicit bet? Again, the Free Lunch Effect gives us our easiest answer. Consider the following case: let’s assume we had two investment options, both with similar risk of around 15%. For simplicity’s sake we’ll start from our naïve assumption that our assets produce, say, 0.5 units of return for every unit of risk we take. If the two assets are perfectly uncorrelated, how much more return would we need to demand from Asset 1 vs. Asset 2 to own more of it than the other? To own 100% Asset 1?
Well, the chart below shows it. In the case above, if you invest 100% of your portfolio in Asset 1, an investor who thinks about his portfolio in risk-adjusted terms is implicitly betting that Asset 1 will generate more than 3% more return per year, or an incremental 0.21 in return/risk units. If the assets are less similar, this implicit view grows exponentially.
Implied Incremental Return Expectation from Overweighted Asset
Source: Salient 2017. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The index is unmanaged and is not available for direct investment.
A Chain of Linked Engagements
If we do not learn to regard a war, and the separate campaigns of which it is composed, as a chain of linked engagements each leading to the next, but instead succumb to the idea that the capture of certain geographical points or the seizure of undefended provinces are of value in themselves, we are liable to regard them as windfall profits.
— On War, Carl von Clausewitz
The point of this note isn’t to try to convince you to focus your portfolio construction efforts on higher volatility diversifiers like those highlighted earlier (although many of you should). It’s also not to argue that maximizing diversification should be your first objective (although most of us are so far from the optimum that moving in this direction wouldn’t hurt). It is to emphasize that portfolio construction and the decisions we make are a chain of linked engagements. It is to give you pause when you or your client asks for a ‘best new investment idea’. If your experiences are like mine, the question is nearly always expressed in isolation — recommend me a stock, a mutual fund, a hedge fund. These questions can never be answered in isolation. If you really must tinker with your allocation, sure, I can give you my view, but only if I know what else you own, and only if I know what you intend to sell in order to buy the thing.
Anyone who will make a recommendation to you without knowing those things is an idiot, a charlatan, or both.
Most of us, whether we are entrenched in financial markets or not, think about our decisions not in a vacuum but in terms of opportunity cost. If we buy A, we’re giving up B. If we invest in A, we’re giving up on B. If we do A, we won’t have time for B. Opportunity cost is fundamental to thinking about nearly every aspect of human endeavor but for some reason is completely absent from the way many investors typically think about building portfolios.
Look, if you didn’t completely follow where I was going with Whom Fortune Favors, I get it. Telling you to think about risk and diversification separately is more than a little bit arcane. But here’s where it comes together: an investor can only make wise decisions about asset allocation, about selecting fund managers, about tactical bets and about individual investments when he has an objective opportunity cost to assess those decisions against that allows him to make his portfolio decisions intentionally, not implicitly. That opportunity cost is the free lunch provided by diversification.
If we take this way of thinking to its natural extreme, we must recognize that we can, at any point, identify the portfolio that would have provided the maximum diversification, at least using the tools we’ve outlined here. For most periods, if you run through that analysis, you are very likely to find that a portfolio of those assets in which every investment contributes a comparable amount of risk to the whole — a risk parity portfolio, in other words — typically provides something near to that maximum level of diversification. I am not suggesting that your portfolio be the maximum diversification portfolio or risk parity. But I am suggesting that a risk parity portfolio of your investable universe is an excellent place to use as an anchor for this necessary analysis.
If you don’t favor it for various reasons (e.g. using volatility as a proxy for risk is the devil, it’s just levered bonds, etc.), then find your home portfolio that accomplishes similar goals in a way that is rules-based and sensible. Maybe it’s the true market portfolio we highlight in I am Spartacus. If you’re conservative, maybe it’s the tangency portfolio from the efficient frontier. And if you’re more aggressive, maybe it is something closer to the Kelly Optimal portfolio we discussed in Whom Fortune Favors. From there, your portfolio construction exercise becomes relatively simple: does the benefit I expect from this action exceed its diversification opportunity cost?
How do you measure it? If you have capital markets assumptions or projections, feel free to use them. Perhaps simpler, assume a particular Sharpe Ratio, say 0.25 or 0.30, and multiply it times the drop in diversification impact from the action you’re taking. Are you confident that the change you’re making to the portfolio is going to have more of an impact than that? That’s…really it. Now the shrewd among you might be saying, “Rusty, isn’t that kind of like what a mean-variance optimization model would do?” It isn’t kind of like that, it’s literally that. And so what? We’re not reinventing portfolio science here, we’re trying to unpack it so that we can use it more effectively as investors.
Recognize that this isn’t just a relevant approach to scenarios where you’re changing things around because you think it will improve returns dramatically. This is also a useful construct for understanding whether all the shenanigans in search of diversification, all that Chili P you’re adding, are really worth the headache. Is that fifth emerging markets manager really adding something? Is sub-dividing your regions to add country managers really worth the time?
In the end, it’s all about being intentional. With as many decisions as we have to manage, the worst thing we can do is let our portfolios make our decisions for us. Given the benefits of diversification, investors ought to put the burden of proof on anything that makes a portfolio less diversified. In doing so, they will recognize why this code recognizes the intentional pursuit of real diversification as the #2 Thing that Matters.
 I don’t want to hear it from the “but they stole people’s music and weren’t super nice about it” crowd. Zep played better rock and roll music than anyone before or after, and it’s not even close.
 And it can. Pueblan and Oaxacan cuisine feature moles with extraordinary complexity that does come from the melding of a range of seasonings and ingredients. Traditional American chilis, South Asian curries and soups from around the world often do as well. Dishes en croute (e.g. pate en croute, coulibiac, etc.) are notoriously tricky, too.
 Cue the fund-of-funds due diligence analyst pointing out that we would have, in fact, diversified our fraud risk. Die on that hill if you want to, friend.
I have been in Cash for the last 4 years and feel like a Wet Monkey. Expecting a 50% Market reset that simply does not happen…
I feel that The Fed has been buying stocks via ETFs since 2013, notice the slope of SPY since 2013, with a “Buy the dip” program ….
Do you think that is possible, or just the Brain Worm talking? – James
Sorry, James, but that’s a Brain Worm talking. The Fed doesn’t need to buy stocks directly, not like the Bank of Japan, anyway. And not like the Swiss central bank. No, the Fed has deputized each and every one of us to act on its behalf, which is really the way you want to set these things up. You want to establish a meme of Central Bank Omnipotence … err, excuse me, I meant to say “expanded forward guidance” as part of “communication policy”, so that you don’t need to get your hands dirty directly. You want to control the meme. You want to control the Brain Worm. THAT’S the power of the Common Knowledge Game.
And now two letters for the time capsule. If one of my daughters ever asks me what investing was like in the Hollow Market, I’ll show her these.
I just read through your piece (and then I read it again) [“Tell My Horse”]. It was a sobering start to the day as it pretty succinctly captured and reflected back to me my broken spirit. I used to love this business. I used to believe in its methodology and the integrity of its analytics. Now, like a priest having had a crisis of faith, I can no longer stand in the pulpit and preach the gospel. I don’t [know] what to believe. I don’t know what the message is anymore. The “markets as political utility” meme strikes me as correct, but one can’t represent that to clients much less prospects. I have slowly made “accommodations” for this environment: including a quant sleeve, including more overseas exposure, including structured ETFs. All the while, I have held to my deflationary thesis and stayed long bonds and overweighted to alternative selections. Performance has been middling but sufficient. But, there is zero joy to it. The sole satisfaction comes from still believing that I am doing the “right” thing by my clients, even though the market rarely affirms my conviction. I do surround myself with like-minded (but open minded) folks, and while there is a risk of isolating oneself in an echo chamber, the constant cacophony of mainstream narratives is more than enough to provide balance with the “bull” thesis. My real fear is that we’re so far down the rabbit hole that we’ll never again see the light of day. I don’t think this business will ever be the same again (and I don’t really even know what I mean by that). Perhaps this business was never what I thought it to be! The sole goal at this point seems to be survival. I do think there will be a massive come-uppance at some point. But if so, I know there will be little satisfaction in having been “right”. Thus, it’s just one day at a time as I try to take some comfort in the wisdom of the ages that “this too shall pass”. – Bill
So I cannot thank you enough for expressing what is at the pit of my stomach. Both in the underlying distrust of the bull market, and in the Hollow Market analogy. You see our business is in fact losing its soul.
I met with a board member of the CFA Institute who lives in our area. After beating me up on fees for a half hour, he then asked about our recent GIPS compliance project. Did we find it helpful? Was it a benefit in managing accounts?
So being well trained after years of attempting to control reactions and impulses, with varying degrees of success, I was actually able to restrain myself from both dipping his head in his soup, or erupting into a cascading use of the f bomb in its many derivative forms. But I was tactful and I pray professionally pointed in my response. That compliance with GIPS costs a full analyst position, or PM position. That as fees decrease, and costs escalate we are squeezed. That as we are squeezed we cannot do more with less, so we either have to employ less CFAs or pay them substantially less, making the skill set less valuable. Did I find it helpful? No, I found it eroding my abilities to deliver the very product he wants with no pricing power.
What I did not say, but thought about substantially on my drive home, is that the other far-reaching consequence is that the institutionalization of money management has made career risk more and more an issue, as analysts and PMs become benchmark huggers, and allocators in varying percentages. That compliance standards which now prevent personal investment destroy the skill set of the “investors” that are professional PMs. That in fact the destruction of Alpha and investing skills has been the professionalization of the industry.
So I sit here invested, raising cash, feeling stupid, wondering about my personal investing skill, as I cannot figure out where to place funds with strong conviction. It’s a strange new world we work in, Ben. I feel disoriented in this Hollow Market, not trusting the upswing in the markets. Too afraid to sell out, but too afraid to implement cash into it either….. maybe I will buy some passive product…..wait, but what about excellence? –John
But what about excellence? That’s the cry that goes echoing through the canyons of Midtown Manhattan, fading more and more into the distance each and every day.
Lately I’ve been thinking about the old adage: “a broken clock is right twice a day”.
It is universally accepted (sans Yellen) that a correction will occur at some point in the future. The debate isn’t so much around the existence of economic cycles but around distance (time) until the back end of the current cycle arrives. I would place us (the broad Epsilon family) among the minority who believe that the inevitable correction will occur sooner rather than later. I would also admit that we (I) have been a believer of sooner rather than later for some time now. The question I keep asking myself is that if the correction does come over the nearer term. Will we (I) be vindicated, or will we (I) have been patient enough for that broken clock to be telling the current time?
I don’t have a good answer… at least not one that is satisfying. – Paul
You and me both, brother.
I wonder what you think of the following- We know that the feds QE and the govts build up of massive debt fragilizes (to use a N.N. Taleb word- another genius) the economy. However, I wonder if you think there is a chance that these ridiculous policies will get bailed out if they just reduce GDP by some percentage points, say from 5pct to 2pct annually for some amount of years. This would cost us trillions of dollars in never realized growth over the long run, but it could all be blamed away on other factors of course. In a similar way to how a Ponzi scheme can dig itself out of a hole with a really lucky grand slam investment (Pharma boy Shkreli did it until he mouthed off on twtr).
In this case there may not be a financial asset crash and instead we just blow up at a WAY later date when swaths of countries can no longer pay their debts.
Do you see this as plausible? Or is it inevitable that assets eventually tank and the economy gets into real trouble again? – David
Absolutely plausible, although I’d bet on joint U.S.-Japan-Europe debt monetization as the weapon of mass jubilee if it comes to that (google “trillion dollar coin” and try not to gag). There’s nothing inevitable about any of this, including an asset price crash.
I think this is more “sky is falling” stuff and “getting out” out stocks and bonds and establishing a “short bias” has been proffered by many over the past years. Those that have acted on that advice are much poorer today. Not because they were less prudent but because after they took action to get out of stocks and bonds no one told them what to go in to…the price friction of getting out of stocks and bonds and then back in (forget the timing aspect) is very expensive. The loss of income is catastrophic if not timed properly. You appear to know exactly when to get out. Not sure how…
We all know that recoveries don’t die of old age but are always due to a Fed that is over tightening money supply. With $4T in excess reserves on the books of the major central banks, having a market accident, given how well capitalized now the US banks are, seems like a remote possibility. This Minsky moment that you’re holding up to us is either not happening, or at the very least, not happening any time soon. – Steve
You could well be right, and I’ll be the first to admit that my risk antennae have been quivering violently at seven of the last two market corrections. But that’s my job and my nature — to have risk antennae that suffer Type 1 errors (false positives) to avoid Type 2 errors (false negatives). I think that’s better than the alternative, certainly for wealth preservation, although it makes me totally unsuited for any job on the sell-side, ever.
I’ve gotta call ‘em like I see ‘em, though (which includes noting a couple of narrative-driven investable rallies, so I’m not exclusively a Cassandra), and what IS demonstrably different today as opposed to five years ago or three years ago or even one year ago is that the Fed has turned their barge around to engage in a program of rate hikes and balance sheet reductions. The ECB is in the process of turning their barge in the same direction. To paraphrase Churchill, this is not the beginning of the end of QE and negative rates and all of the other exercises in Magical Thinking we have endured over the past eight years, but it IS the end of the beginning. It IS an inflection point. It IS a change in the second derivative of monetary policy accommodation, a reduction in the acceleration of policy even if we’re not yet at a reduction in the level of accommodation.
Because if I’ve learned one thing as a student of markets and human behavior over the years, it’s this: markets, no matter how big and no matter how small, happen on the margins. Inflection points not only matter, they are everything to the Game of Markets. Some of my very first Epsilon Theory notes were about this [“2 Fast 2 Furious”], and I think they’re worth reviewing again today.
Geez – when are you guys going to get off this “the Fed rules the world mantra?” Do you really think in the board meetings during the AMZN – WFM negotiations that anyone really got up and said, “maybe we should wait and see what the Fed might do?“ Outside of the financial industry how many board meetings do you think have The Fed on the agenda?? I have asked many CEOs and funny I get the same answer — none! I’ve asked the ex-CFO of WMT – same answer – never! I asked him did the Fed ever come up in any strategic decisions, any mergers or acquisitions – same answer – NEVER! I’ve asked the CEO of Simon, retail – one would think might be influenced by rates – same answer – NEVER came up. Wake up and smell the roses – businessmen run the world – not central bankers. – David
I once asked my boss, the founder of a very successful investment firm, what his most important lesson learned had been. “Remember this, Ben,” he said. “It’s not about the money. It’s. About. The. Money.”
So I ask you, David, who makes the money? I mean, who literallymakes The Money? And sets the price of The Money. And buys trillions upon trillions of dollars of stuff with The Money year after year after year. And has implanted a meme in everyone’s brain (except yours, apparently) that even if they’re not literally making money and buying stuff today … well, they might tomorrow. Or might not.
Do you think I enjoy delivering this message? Because I don’t. It makes me sick that global stocks added more than a TRILLION dollars’ worth of value over the past few weeks because Janet Yellen said something that was perceived as dovish. It makes me sick because global stocks will LOSE more than a trillion dollars’ worth of value if she turns around next week and says something that is perceived as hawkish. It’s a joke. It’s a perversion of what a small-l liberal market should be. But that doesn’t make it any less real.
“Businessmen run the world” … I wish that were true. But if wishes were horses, beggars would ride. Don’t be a beggar.
Where I continue to struggle, is why in the world a man like President Trump, who I believe cares about winning and self-promotion, more than the long-term success of our country, is going to appoint a Fed chair that will continue raising rates in 2018, when he knows that higher interest rates are anathema to higher stock and real estate prices, at least in the short-run?
What I have been telling my clients is that I have a hard time believing President Trump will elect someone who will make it harder for him to “appear” successful. You and I both know that our country needs higher “normal” rates as well as a much better taxation system (a national sales tax and get rid of the deductions for borrowing money) to truly stabilize and revitalize our economy in the long-run. But, you won’t get to better long-term policies without short-term pain . . . and we seem to be (as a country) in the pain-minimization mode at present.
Do you believe that President Trump will appoint a Federal Reserve Chair that will focus on the long-term health of the “real” economy, or just another Alan Greenspan groupie, who cares more about the level of the S&P than GDP? – Joel
I think that Trump wants to have his cake and eat it, too, meaning that he needs both higher short-term rates AND a steepening yield curve (i.e., higher long-term rates) to support a reflation narrative for the 2018 and 2020 campaigns, and he thinks that a reflation narrative will keep the S&P chugging along (in particular, supportive of financials as part of a rotation away from growth and into value). That would be the narrative accompanying, say, Gary Cohn taking the FOMC reins — that the Fed is raising short-term rates and shrinking the balance sheet for the right reasons, thus steepening the yield curve. And you know that the Street would absolutely eat this narrative up, even though everyone also knows it’s just another Big Lie. Wait, did I just say that out loud? Scratch that. What I meant to say is that I, for one, welcome our new Goldman Sachs overlords!
A lot of forces want to see Trump fail. Are the current Fed and Chair carrying that same agenda? Seems like they could be a lot more powerful than the politicians and the press’ infatuation with Russia, Russia, Russia. Is there a bigger motive at work here when the Fed aggressively raises rates? “Politics Always Trumps Economics”? how about “Fed Always Trumps House/Senate Investigations?
Are there examples in the past when a Fed/Chair was working to hurt the economy to make the President look bad? – James
Back in 1960, Richard Nixon blamed his loss to JFK in large part on the Fed’s tight monetary policy, claiming that William McChesney Martin — a Truman appointee — had deliberately sabotaged the economy to damage his incumbent candidacy (Nixon ran as Eisenhower’s VP in 1960). So when Nixon won the presidency in 1968, he got rid of Martin as soon as he could and appointed Arthur Burns, who was basically Nixon’s lapdog. Nixon famously told Burns to keep interest rates low leading into the 1972 re-election campaign, and when Burns resisted, Nixon planted negative stories about him in the press until he finally gave in. So yes, politics have always been a big part of Fed policy, and I think the Yellen Fed would be perfectly happy to hang a recession around the Donald’s neck, so long as it didn’t damage their post-Fed earning potential … err, I mean, their credibility and gravitas as prudent bankers.
Of course, what’s new today and is the biggest difference-in-degree-but-not-in-kind between Trump and Nixon is that Trump plants negative stories about everyone, including the Justice Department, which is just about the most depressing thing I can write. I’ve said it before [“Virtue Signaling, or … Why Clinton is in Trouble”] and I’ll say it again: Trump breaks us, not because of his policy specifics, but because he transforms every game we play as a country — from our domestic social games to our international security games — from a Coordination Game to a Competition Game.
I travel a LOT, speaking with investor groups all over the country, of every political persuasion. Plus I have dual citizenship, having grown up in Red America and now living in Blue America, so I speak both Good Ole Boy and Team Elite fluently and without an accent. My observation from this perch is that we are utterly divided as a country, that the polarization is getting worse, and that political entrepreneurs (including the one in the White House and a whole host of smaller players on the Democratic side) are doing what political entrepreneurs always do — they’re embracing and accelerating this sea change in our social behaviors and institutions, and they’re using Fiat News to do it.
Your conclusion is very clear, but I’m confused by the path you get there. You suggest that Yellen’s response function has flipped since the Trump election (implying that she is being politically partisan?), and yet you also seem to suggest that she is being consistent with the long term real job of a central banker, which is to maintain the power of capital and so prioritizing the suppression of wage inflation. Is it just co-incidental that the job market is becoming “unstable” after Trump’s election, or has that been there, ignored, for a while, and Yellen is picking it up now as an excuse to damage Trump? – Guy
Lots of letters about the Fed wanting to damage Trump. I really don’t think there’s an animus here as much as there’s an intense desire to declare institutional victory and cement a legacy. If that legacy means a headache for the Donald … well, so be it, but that’s not the primary motivation. This has been brewing for a while. I wrote a note about this last September, called “Essence of Decision.”
Yesterday I was listening to Neil Howe’s presentation at the Mauldin Strategic Investment Conference last month, during which he suggested that a recession/downturn is exactly what Trump needs to make progress on his agenda. That is, because the economy is doing so well and stocks continue to rise, no one in DC or NY has any incentive to compromise. However, should things start to go into reverse – and Fed tightening has been the trigger for almost every recession – that’s when he can really get stuff done. Thus, in the current bizarro world we live in, malice toward Trump by the Fed could actually end up helping him. – David
Too clever by half. I once had an analyst tell me that he wished that a stock we owned would go down so that we could buy more. Ummm … no. Neither life in markets nor life in politics works that way. Buying more may be the right reaction to an unlucky beat, but show me a PM who wants to lose today in order to win more bigly tomorrow, and I’ll show you a PM who’s not long for this world. Ditto for presidents.
Would I say there will never, ever be another financial crisis? You know probably that would be going too far, but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be. – Janet
I dunno, Janet, that’s a statement that might not age well, the sort of thing that ends up as a rueful tagline on an otherwise distinguished career. Just ask Chuck Prince about dancing until the music stops. George W. about “Mission Accomplished”. Statements like this are rewardless risk. You know, kinda like negative interest rate bonds.
Good to hear Devin’s thoughts [podcast with Devin Anderson, “Does It Fly, Really?”], and that I wasn’t the only one who enjoyed McCullough’s take on Orville and Wilbur’s empirical method. Kill Devil Hills is sacred ground. When you talk about American Makers …. I’ve flown and kitesurfed that area frequently, keeping aware that I’m standing on the shoulders of giants.
Two great books: David McCullough’s The Wright Brothers (2015) and Richard Neustadt and Ernest May’s Thinking in Time (1986). Thucydides wrote a great book, too. I’ve taught a course on it. But Brendan is right. The Peloponnesian War was 2,500 years ago. The U.S. ain’t Athens and China ain’t Sparta (much less the other way around, which would be a lot more accurate to the power dynamics that Thucydides actually described). So give it a rest, all you war hawks on both the left and the right. Just stop it with the “lessons from history” that you cherry pick. Want a lesson from Thucydides about war and conflict? Go read about the Syracuse campaign and then get back to me.
I was particularly struck by the below claim in your note [“Tell My Horse”]. I tried unsuccessfully to find a source on google, so I was wondering if you could help by pointing me in the direction of the data that supports this? “ETFs and index products — of which there are now more such aggregated securities listed on U.S. markets than the company stocks which comprise them!” – Matthew
My background is science; I am/was a forestor. The late great Stephen Jay Gould was also a master of telling one story by telling the tale of another more common event. I read everything he wrote.
So you talk about diversification being the ‘bird’ for all seasons. Not as flashy as the Goldfinch [“The Goldfinch in Winter”], but more reliable. I’d like to offer a viewpoint from an ecologists POV about your field and birds.
I would offer that portfolio diversification is more like your field and surrounding forests than the occasional flock of birds that visit. Because you make the effort to knock back the growth in that field you get new plants and new plant growth, which attract flocks of birds. Even to the extent of keeping them around through the year. From an ecologists POV this is called ‘robustness’; an environment that has a greater number of species co-existing has a greater chance of maintaining a greater number of species through a greater variation of conditions.
So, you keep clearing out that field occasionally and clean out the underbrush near the edge of the forest (the interface between forest & field is where the greatest local biological diversity will occur) and you will continue to be rewarded with occasional delights of all god’s creatures. I dare say you might be visited by the Fox or even the Owl in winter.
There really is a parable for investors here. – Kimpton
In my client reviews, I like to leave them with something thoughtful or philosophical, and many of those nuggets start in Epsilon.
One original one I wanted to share, which has likely been thought of in a different way. “it is not often that both US stocks and bonds are at all time highs at the same time – those are the things we are thinking about while managing your money”.
Have you done any research about what that means for diversification? – Vince
Your recent posting regarding the Fed’s decision to unwind its massive securities portfolio contained the following comment:
“Or just ride your 60/40 vanilla stock/bond allocation through the cycle, which is the whole point of the 60/40 thing (even, though, of course, you’re really running a 95/5 portfolio from a risk perspective).”
Is it possible to provide a brief explanation of what you meant by “95/5 portfolio from a risk perspective?” I’m a small investor, admittedly currently following a Vanguard-inspired “vanilla” strategy. – Jim
Nothing wrong with vanilla, Jim, and to Vince’s question, yes, the Salient Brain Trust has done a tremendous amount of work on what all this means for diversification. A couple of points before I suggest further reading.
Allocations like 60/40 are talking about the dollar amounts you have invested in different asset classes, in this case 60% of your dollars allocated to stocks and 40% of your dollars allocated to bonds. But a dollar invested in stocks has a different amount of risk associated with it than a dollar invested in bonds; i.e., the historical volatility of the stock market is a lot higher than the historical volatility of the bond market. So from a risk “budget” perspective as opposed to a dollar budget, a 60/40 stocks-to-bonds portfolio is really more like a 95/5 stocks-to-bonds portfolio.
Even if stocks and bonds are positively correlated, as they have been on the way up over the past eight years and as they may be on the way down (if there’s ever a down), a diversified portfolio should still own plenty of bonds. Period.
When we’re thinking about diversification, it’s useful to consider dimensions beyond just stocks vs. bonds. That includes the risk/volatility dimension. That includes the asset class dimension (commodities, real assets, corporate credit as distinct from government bonds, etc.) That includes the geography dimension. That includes the classic Fama/French dimensions. That includes behavioral dimensions such as momentum. Markets radiate information on many different wavelengths, not all of which are naturally visible to the human eye, but all of which are important to take into account in a well-balanced portfolio.
After reading all of these, I continue to have one question: how does one set expectations for returns? Assuming a solidly built (nothing is perfect), diversified portfolio and 10(?) years, what is the curve of return with the horizontal axis being vol tolerance… – Matt
While your logic seems counterintuitive at first, on second thought, I get that there could be a zone where rates are still low enough that raising them is inflationary not deflationary as the world is not so black and white as the investing masses assume (i.e. too much brain damage to think in greyscale). Do you have the data to support the thesis (either in our market or a similar market … am guessing we won’t have a lot of statistical significance)? – Felix
We’ve got eight years of data on the original premise of QE — that more central bank printing of money and buying of financial assets would lead to greater amounts of money getting into the real economy to spur more real economic activity — and the inescapable conclusion is that it doesn’t happen. Money goes into bank reserves but it doesn’t get out, in a classic example of a roach motel … err, I mean a liquidity trap. That fact, which was clear to all by 2012, led to a bit of a schism in the High Church of Monetary Policy, with one Pope saying that QE 1 was a good idea, but that subsequent printing and buying sprees were a wash at best, and we should stop doing more of this. That Pope’s name, believe it or not, is Ben Bernanke, which is why the U.S. denomination of the High Church is way ahead of the other denominations in unwinding their QE experiment.
Unfortunately but unsurprisingly, the other Popes weren’t convinced when Bernanke started saying that QE doesn’t really work that well in the real economy, particularly when they saw how well it could work to prop up financial asset prices and deliver political stability. As a result, the other Popes have generally been of the mind that the answer wasn’t to do something else, but to do MOAR! than the U.S. Church ever thought possible. Hence we got negative rates and efforts to outlaw cash and direct central bank buying of equities and all the other madness of the past three years in Europe and Japan. But MOAR! didn’t work in those real economies, either, although it sure did cripple the banks, which is why Pope Draghi is now coming around to Pope Bernanke’s view.
On the reverse argument — that as central banks now start to tighten monetary policy through both traditional interest rate hikes and nontraditional balance sheet contraction, inflation and loan growth will actually start to pick up — we have zero historical evidence that this will be the case because we’ve never been in this situation before.
What we do have, however, is both a supply and a demand argument for why this will happen. On the supply side, central banks pay commercial banks interest on the reserves they hold. As the Fed raises rates, they pay the banks more interest, which — given the massive reserves in the system — is a non-trivial boost to the capital position of the banks on a present value basis. Boosting the capital ratios of the banks should make them more willing to take risk and put money out. Couple that with a steeper yield curve (see my earlier response regarding the forthcoming Gary Cohn narrative) to generate higher net interest margins on these loans, and you should see the velocity of money really pick up as banks reduce lending standards and push, push, push on getting those loans out the door.
The demand argument isn’t talked about as much, because it’s not under the direct control of the regulatory mandarins of the Fed and the ECB. Central banks control all the levers on the supply side. To repeat, they literally make The Money. And they control its distribution. But they don’t control who asks for a loan or what that loan is used for. They don’t make the demand. They can influence the demand by making the price of The Money cheaper (lower interest rates), but even there they only have direct control over the price of short-term money.
My opinion is that when the price of money gets exceptionally low AND you’ve got a massive buyer of financial assets waiting in the wings, it tilts the risk and reward of debt-taking away from making stuff and towards investing in stuff, towards what’s commonly called “financialization.” I think we see this tilt everywhere in the modern economy, particularly in the largest corporations with essentially unlimited access to capital. Why take the chance of building a new factory or launching a new growth initiative when you can generate a highly predictable and substantial earnings growth rate or return on equity through a buyback or dividend program? If you don’t have unlimited access to capital — and most small businesses don’t — then you’re limited to the avoidance of making stuff without the ability to embrace financialization. So you just stall. It’s not terrible. You’re getting by. But you’re just getting by.
So what diminishes the demand for “financialization” loans and increases the demand for “productive” loans? I promise you that it’s not cutting the price of money by another 50 basis points. On the contrary, the price of money has to go UP and the reward of markets DOWN before the risk-reward calculus of debt-taking shifts back to making stuff in the real economy.
Whew! That was a long-winded explication. Here are some letters that say it more pithily than me …
That’s just crazy enough to be totally dead on.
Your idea will also accelerate the velocity of money in the great American bingo parlor of life. – John
The current Fed policy effectively injects liquidity into the financial system through raising the IOER rate — printing money to make interest payments on reserves banks hold on deposit at the Fed. This compares to the traditional monetary where the Fed drains reserves from the financial system to drive the Fed Funds rate higher. We are years off to getting back to traditional monetary policy. Maybe not in our lifetime.
No wonder markets are going bonkers. We believe this is why the Fed has quickened its pace to start shrinking their balance sheet. Rather than being forced to overshoot interest rates, which could adversely affect the economy, the Fed will start draining reserves through balance sheet reduction hoping to introduce some risk aversion and sense back into the giddy global markets. – Gary
You are describing [“Gradually and Then Suddenly”] a self-reinforcing positive feedback loop whch can be described mathematically as a geometric or exponential function, until it reaches a maximum.
Has the “barge” already left the dock, or will it have done so only upon the fact of FED balance sheet run-off commencing? The jawboning this week was only a damper, contemporaneous as it was with weak data. Last month’s Draghi comments whch lifted the global sovereign yield curves, I believe, was the barge tooting its horn as it departed its mooring at the dock.
Buy DUST and hold it through the FED’s asset sales.
Interesting, apparently crazy, and probably dangerous times, indeed. Good speculation and investing. Thanks for your writing. – Robert
So you are talking about the unintended consequences of policy-driven interest rates. Hmm. John Locke talked to the parliament about the exact same thing in 1691 (sic!). Then one and a half century later came Bastiat with “That which is seen, and that which is not seen” addressing similar concept. I’d guess Adam Smith’s “invisible hand” is related to (positive) unintended consequences as well.
That’s some of the biggest names of libertarianism 🙂
Today’s short letter was so empowering and enlightening, I almost didn’t miss your beekeeper stories or movie quotes. – Johan
The counter argument would be that each country that has tried QE, has seen their economies slip back into recession when they finally took the QE punch bowl away.
This has been true in the past in the US, Europe, Japan, and China (sort of) – so could we have a recession AND inflation? – West Coast Investor
You mean stagflation? I kinda doubt it, because it generates an unstable political equilibrium, but it’s absolutely possible. Market gives this less than zero odds, of course, which is … interesting, from a macro trading perspective.
That said, it’s smaller businesses, those without access to the financialization goodies of the modern monetary policy system, that are already suffering from a form of stagflation-lite. And on that note …
I suspect another, and perhaps more direct, answer to your question is that while we do not have wage inflation, we have compensation inflation (compensation = wages + benefits). For example (and this may be the key driver) medical costs continue to rise much faster than overall inflation and someone is paying that. To put numbers to my example: if a company is spending $4k a year on benefits on a $40k a year employee and the cost of those benefits goes up 10% then there is 1% compensation inflation. Add that to 2.5% wage inflation and you have 3.5% compensation inflation.
I have not seen anyone write about this and that may be due to the fact that there is a scarcity of good data on the subject. I am aware of this only because I have been a small company CEO. – David
By the way and for what it’s worth, wages in the construction industry are already off to the races. We are paying our professionals/ semi-professionals and experienced people probably 30% more than 2-3 years ago. At a meeting yesterday with one of the large Gen Contractors, they told me young guys are heading straight into field jobs out of the construction management schools (Auburn, Clemson, Ga Tech, etc) where they can make a lot more than they could coming in to an office as a trainee. This ship has turned fast in our business. I guess the difference is that we (as non-public entrepreneurs) ARE investing significantly. Just a data point thought you might want to hear. – Alan
You don’t have to wonder, we are at 4.3% unemployment and were not seeing acceleration yet, so clearly NAIRU has been structurally lower this cycle. The other thing that is clear we will get there and it is not years away, but more likely months.
If you look at states where unemployment is lower, like NH and ME, you have wages moving up in the 4-5% Y/Y range currently so we know the concept is sound. After all we are talking about the most basic principle of economics here – supply and demand.
Companies we talk to are baffled by the government numbers, they see it and are worried about maintaining margins (raising prices). There is a fair amount of anchoring and it is important to keep in mind that each crisis occurs because people are worried about the last crisis. In this case fighting the psychology of deflation.
So yes, NAIRU is lower, but it is also likely to be a coiled spring. That realization, along with a positive correlation between stocks and bonds, will sow the seeds of the next collapse. – Alan
In exactly the same way that almost every financial advisor I speak with feels “stuck”, so does almost every small to medium business owner I speak with. There’s a trickle-down wealth effect from their personal accounts, which is all well and good, but they’re not feeling the love from the last eight years of QE in their businesses because they can’t access the financialization wonder drug of public markets. At best they get it second hand if they can find an LBO buyer. But the LBO buyers are all mega shops today, so juiced up on the financialization steroid themselves that they don’t have time to mess around with the small to medium guys.
It’s just another manifestation of the central truth of life in 2017, on every level of aggregation and scale — if you’re in the Club, life is good. If you’re not, life is very very anxious.
Ben, I just read the piece that you sent out yesterday [“Gradually and Then Suddenly”] and I have a question for you regarding productivity. Other authors that I have read have put forth the theory that productivity growth is low because we are measuring productivity in a manner that doesn’t fit the new economy. In other words, measuring widgets produced per hour is not the accurate measure of productivity in the digital economy. They admitted that we don’t know yet how to measure productivity in the digital economy but that we would be well served to think about it.
I would very much like to hear your thoughts about their theory. – Ann
I got a lot of good letters on the Great Productivity Debate, too many to address directly in what is already an overly long Mailbag. I’ve reposted a handful below, because they do a good job of covering the waterfront. The topic deserves a full-fledged Epsilon Theory note of its own, so that’s what I’ll do next week in a new Note From the Field. I’ve already got the title picked out: “Horsepower.”
Political hamstringing of entrepreneurs, yes. Focus on stock price not business, yes. But a simpler causation is that cheap money and open borders help suppress real wages (and, via govt spending and consumer credit, both, make up for them ) and THEREFORE mean less need to substitute with invested capital, in turning keeping marginal gain to labour low-added and so reacting back on itself. – Sean
Can you address the role of globalization on your theory of inflation going up with monetary tightening? I believe the world is awash in industrial capacity brought on mostly by Chinese overbuilding in numerous industries. I know the Chinese can’t subsidize forever, but right now they seem to be cranking out product they have no idea where it will go. Solar panels is a great example. Look what happened to the price of solar panels since January? They are selling with a negative gross margin! Every other competitor is going out of business. I think the same may be true for steel and other industrial commodities. Why invest in more capacity when you can’t compete with a Mercantilist. – John
My theory Ben is social networking is what’s keeping Prod Growth from happening. People are spending way too much time on FB and the like snapping selfies in front of fountains, inputting jokes and nonsense and not working!.. They’re not even driving their cars properly but stuck with their darn face in front of a nonsense networking device…my 0.02 – Steve
I can point to one other potential reason we aren’t seeing inflation and lower productivity – at least in engineering and construction. There are a whole lot of boomers retiring and taking with them both their experience and higher pay. The new folks are coming on at much lower pay but are also much less productive. The good news, if I’m right, is that we will start to see increasing productivity as these folks are assimilated into the work place. Assuming of course we don’t have a downturn first. – Brian
Perhaps one of the reasons productivity gains are so low is that the latest wave of the “New Economy” are companies like Uber, Door Dash and EZ Home. They provide personal services which are pretty low productivity and even with the .com overlay, there are limits to what one worker can do. For example, Uber drivers can only carry a few people around at one time, and probably only generate $60,000/yr in gross revenue working full time. The corporate organization leverages this into a high productivity and growth story on their level, but it is built on a large low productivity business. I’m sure they all have plans (fantasies?) of someday replacing all their field workers with robots, in which case productivity might soar, but that is a ways down the road.
I live in Menlo Park, Ca and the local economy (and perhaps productivity) is growing at a fast pace because companies like Uber are headquartered here. I suspect that other parts of the country are growing much more slowly or not at all because they have the low productivity economic activity that supports Uber and the like but don’t benefit from the corporate leverage. – Keith
Thanks for your stimulating articles! I never took econ but was a bad math major. To me econ theory seems to rest on two axiomatic relationships: supply and demand, unemployment and wages. In the 1980’s, we bought well-made solid wood shiny brown furniture for thousands of dollars apiece. There has been no physical depreciation, and yet those pieces today go for hundreds of dollars. Similarly for oriental rugs, sterling silver, china, etc. Only those pieces deemed worthy by the ultra-rich seem to ‘hold’ their value. Meanwhile, the overall ‘quality’ is going down (this means regular replacement of shovels, software, hardware, and phones). That combined with atrocious service (except for the ultra-rich) and regular discovery that what one just bought is actually a ‘second’ inevitably leads to consumer demand malaise, except for consumables. It is no wonder then that the children of the boomers aren’t buying material possessions, except for baby stuff. Famous economists call this area ‘aggregate demand’, and when they have to consider NIRP to stimulate aggregate demand, you know the goose is cooked. Spending on consumables, vacations, and experiences would increase; savings would decrease, and so on. The above four axiomatic econ words just do not mean much in today’s fast food, landfill economy. They are glittering generalizations of an economy that once was. I don’t know what the replacement terminology should be, but I know it’s out there somewhere. – John
You have missed the boat on unemployment and wage inflation. As long as more people enter the work force and have the proper skills then wages do not have to increase. There are other factors but job automation and people entering the work force seem to be the current keys. – Jam
How is the productivity improvement of the rise of Uber or Google search or online shopping on Amazon captured by the gov’t? They are not.
There are hundreds of examples like this. They don’t improve some form of production, they change how we run our personal lives by vastly improving our non working efficiency. Some technology, like smart phones, have revolutionized our personal lives and have a bleed over effect in productivity but that is minor in comparison to the non working efficiency. Since people use their smart phones at work for personal reasons you might even conclude they reduce efficiency. – Art
I’ve never thought to link the fact that the current low growth in productivity seems to rule out the concept that technological advancements aren’t the driving force behind low wage growth.
In saying that, can you not see a case whereby technology is driving people out of once productive jobs (manufacturing etc) and into poorly productive and lower paying jobs (retail, hospitality, etc) where they work a similar amount of hours? In this case we still have the same amount of production (with machines/new tech doing the bulk of the work) AND the same amount of hours worked, but with the % of hours worked in poorly productive sectors now representing a much greater % of the overall total?
In other words, both the numerator and denominator stay the same, thus it appears productivity has slowed to stall speed, but the real story is the change in distribution as to who benefits from productivity advances AND what is happening to those displaced by technology, i.e you move from working 8hrs/day on a factory line contributing $100k/pa to GDP, to driving for a cab/Uber 8hrs/day and contributing $40k/pa?
This also explains the growth in inequality, with those who own the technology/plant benefiting from the increased productivity of their business, while “labour” suffers with stagnating/declining wages. Seems to all fit in with the secular stagnation and growth in under employment themes too. – Sam
Good letters all. To be continued next week.
I also got a lot of good letters pointing out that “it’s the debt, stupid”. In other words, that it’s going to be deflation and economic weakness just as far as the eye can see. Here are a few …
The biggest question I have about this analysis comes from the fact that all these companies that have been buying back stock this entire decade are now up to their eyeballs in debt, and (depending on how this debt is structured) rising rates are going to crush earnings and free cash flow sooner or later. This will lead to crushing the broad market and the wealth effect it has created. Inflation offers a way out, but will inflation pick up fast enough to outrun the monster of corporate debt service? – Ian
Isn’t the Fed (or shouldn’t they be) more concerned with the demographically-induced effects on consumption than they are with potential inflation? Haven’t we seen this movie before, with the biggest demographic disaster in the formerly second largest economy sucking wind for 20 years + of ZIRP? Then again, maybe Japan only had to start raising rates ca 1995 to reach escape velocity, according to your logic herein.
Isn’t the real issue the shifting of consumption and production away from the developed world to the emerging economies? Millions every day joining the global economy, urbanizing, getting credit cards and bank accounts? Isn’t the more apt analogy the one to 20th century Europe as America thrived? In previous notes, you have discussed the possible effects of nationalist/populist leaders, both here and abroad. The real question I’m curious about: would a trade/immigration war be inflationary or deflationary? – John
Ben, on most things we see eye to eye. However, on this one I’ll take the under. I don’t think wage inflation is or is going to be a problem at all. The 4.3% UE rate is an utter fiction. Low paying service jobs are the only ones driving any labor “growth”, and the largest segment of the population securing these jobs is people over 55 years of age. Further, I think that any Fed “tightening” will be whitewashed by other global CBs continuing to prime the pump to the tune of > $2.5TR per year. There can be no credit contraction without GDP cratering and equities falling off a cliff, and equities can’t be allowed to fall off a cliff as then the faux “recovery” narrative will be exposed and untold amounts of debt will be subject to default. Fed and all CBs are stuck. More of the same coming. – Bill
Thanks for sending this. It is obviously appealing intuitively, because it is so counter-intuitive. It makes sense, within its own parameters. The question is will this scenario play out, and I fear that no-one knows, because no-one has ever been in this position before.
He doesn’t seem interested in the problem of the quantity of debt — public corporate and household – that are now burdening economies. But for many people, including myself, that is the primary issue.
What if the reason why corporates are not investing is because there is no final demand out there to satisfy? That the current final demand is debt-driven and not real. That demand is in secular decline, for demographic reasons (ie Harry Dent approach).
Bottom line: I don’t think he is drilling deep enough to get to the bottom of the mysteries he is discussing. – P.
I’m actually very sympathetic to this view, that the massive debt of the world hangs like a millstone around our collective neck, preventing any sustained resurgence in growth, and you can find plenty of Epsilon Theory notes expressing that. But my views have “evolved”, to steal a line from our new White House Communications Director. I think that in the land of the blind, the one-eyed man is king. I think that 2.5% to 3% real economic growth is absolutely attainable here in the U.S., massive debt or no massive debt, and that will feel like 4-5% growth back in the day. I think that there’s enough entrepreneurialism and desire still left in the American tank that changing the debt-taking risk/reward calculus from investing in stuff (financialization, if you can get it) to making stuff can absolutely drive 2.5 – 3% real growth in this country. Will changing the risk/reward calculus be painless for markets and the real economy? No. Is it worth it? Yes
And now for a big Mailbag finish …
On the side, I write financial poems. Here’s my latest on our fabled Fed:
Chaperoning the Dance Arrive at the Spring Fling, not a soul on the dance floor. For you and other teachers, watching over’s a chore. You encourage some kids. None budge and desperation ensues. Eventually, spike the punch and pray for the effects of the booze. For some of the kids, all it takes is a couple of sips. They are the brave few who start shaking their hips. Slowly but surely, others get the urge to join in. Satisfied by your work, success brings on your grin. Unthinkable just a few hours ago, some ruckus is brewing. To your horror, most students are now tobacco chewing. We’ve much surpassed the time to encourage more fun. You try and sneak away the punch bowl to curb this run. Despite prospect for future hangovers, the students protest. Your actions make you the villain, the one to detest. Controlling the party is a thankless task. Be careful with the power. Ration that flask! – Tim
Actually not half bad.
It may be that you lived in an alternate universe in which Fess Parker had a different role [“Notes From the Field”], but when I wore my coonskin cap, I sang about Davy Crocket, not Daniel Boone. – Kit
Fess Parker played both Daniel Boone AND Davy Crockett in the respective TV shows! The Daniel Boone show ran for five or six years while Davy Crockett only aired a few times as a special series on The Wonderful World of Disney. Yep, that was my Sunday night ritual — Mutual of Omaha’s Wild Kingdom, followed by whatever was showing on The Wonderful World of Disney. Simpler times, for good and for ill.
And then there’s this: scientists have embedded 5 frames of the “Horse in Motion” into the DNA of bacteria. And people think memes are far-fetched.
Deep Thought: Yes. Though I don’t think you’re going to like it.
Fook: Doesn’t matter! We must know it!
Deep Thought: You’re really not going to like it!
Fook: Tell us!
Deep Thought: Alright. The answer to the ultimate question…of Life, the Universe, and Everything…is… “42”. I checked it thoroughly. It would have been simpler, of course, to have known what the actual question was.
— Douglas Adams, Hitchhiker’s Guide to the Galaxy
As investors, our process is usually to start from the answer and work our way back to the question. Unfortunately, the answers we are provided are usually pre-baked products, vehicle types or persistent industry conventions, which means that the answers we get when we actually focus on the questions that matter may be counterintuitive and jarring. The entire point of developing a personal code for investing is knowing which questions matter and ought to be asked first, before a single product, vehicle or style box gets thrown into the mix.
The purpose you undertake is dangerous.’ Why, that’s certain. ‘Tis dangerous to take a cold, to sleep, to drink; but I tell you, my lord fool, out of this nettle, danger, we pluck this flower, safety.
― William Shakespeare, Henry IV, Part 1, Act 2, Scene 3, Hotspur
Thomasina: When you stir your rice pudding, Septimus, the spoonful of jam spreads itself round making red trails like the picture of a meteor in my astronomical atlas. But if you stir backwards, the jam will not come together again. Indeed, the pudding does not notice and continues to turn pink just as before. Do you think this is odd?
Thomasina: Well, I do. You cannot stir things apart.
Septimus: No more you can, time must needs run backward, and since it will not, we must stir our way onward mixing as we go, disorder out of disorder into disorder until pink is complete, unchanging and unchangeable, and we are done with it forever. This is known as free will or self-determination.
Thomasina: Septimus, do you think God is a Newtonian?
Septimus: An Etonian? Almost certainly, I’m afraid. We must ask your brother to make it his first enquiry.
Thomasina: No, Septimus, a Newtonian. Septimus! Am I the first person to have thought of this?
Thomasina: I have not said yet.
Septimus: “If everything from the furthest planet to the smallest atom of our brain acts according to Newton’s law of motion, what becomes of free will?”
Septimus: God’s will.
Thomasina (derisively): No!
Septimus: Very well.
Thomasina: If you could stop every atom in its position and direction, and if your mind could comprehend all the actions thus suspended, then if you were really, really good at algebra you could write the formula for all the future; and although nobody can be so clever as to do it, the formula must exist just as if one could.
Septimus (after a pause): Yes. Yes, as far as I know, you are the first person to have thought of this.
— Tom Stoppard, Arcadia, (1993)
On this most important question of risk, we and our advisors often default to approaches which rely on the expectation that the past and present give us profound and utterly reliable insights into what we ought to expect going forward. As a result, we end up with portfolios and, more importantly, portfolio construction frameworks which don’t respect the way in which capital actually grows over time and can’t adapt to changing environments. That’s not good enough.
Most of these notes tend to stand on their own, but this one (being a Part 2) borrows a lot from the thinking in Part 1. If you’re going to get the most out of this note, I recommend you start there. But if you’re pressed for time or just lazy, I wanted you to take away two basic ideas:
That the risk decision dominates all other decisions you make.
That the risk decision is not exactly the same as the asset class decision.
Children of a Lazier God
Before I dive into the weeds on those ideas, however, I want to tell you about a dream I have. It’s a recurring dream. In this dream, I have discovered the secret to making the most possible money with the least possible effort.
Hey, I never said it was a unique dream.
It is, however, a unique investing case. Imagine for a moment that we had perfect omniscience into returns, but also that we were profoundly lazy – a sort of Jeffersonian version of God. We live in a world of stocks, bonds and commodities, and we want to set a fixed proportion of our wealth to invest in each of those assets. We want to hold that portfolio for 50+ years, sit on a beach watching dolphins or whatever it is people do on beach vacations, and maximize our returns. What do we hold? The portfolio only needs to satisfy one explicit and one implicit objective. The explicit objective is to maximize how much money we have at the end of the period. The implicit objective is the small matter of not going bankrupt in the process.
This rather curious portfolio is noteworthy for another reason, too: it is a static and rather cheeky case of an optimal portfolio under the Kelly Criterion. Named after John Kelly, Jr., a Bell Labs researcher in the 1950s, the eponymous criterion was formally proposed in 1956 before being expanded and given its name by Edward O. Thorp in the 1960s. As applied by Thorp and many others, the Kelly Criterion is a mechanism for translating assessments about risk and edge into both trading and betting decisions.
Thorp himself has written several must-reads for any investor. Beat the Dealer, Beat the Market and A Man for All Markets are all on my team’s mandatory reading list. His story and that of the Kelly Criterion were updated and expanded in William Poundstone’s similarly excellent 2005 book, Fortune’s Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street. The criterion itself has long been part of the parlance of the professional and would-be professional gambler, and has also been the subject of various finance papers for the better part of 60 years. For the less prone to the twin vices of gambling and authoring finance papers, Kelly translates those assessments about risk and edge into position sizes. In other words, it’s a guide to sizing bets. The objective is to maximize the geometric growth rate of your bankroll — or the expected value of your final bankroll — but with zero probability of going broke along the way. It is popular because it is simple and because, when applied to games with known payoffs, it works.
When we moonlight as non-deities and seek to determine how much we ought to bet/invest, Kelly requires knowing only three facts: the size of your bankroll, your odds of winning and the payout of a winning and losing bet. For the simplest kind of friendly bet, where a wager of $1 wins $1, the calculation is simple: Kelly says that you should bet the difference between your odds of winning and your odds of losing. If you have a 55-to-45 edge against your friend, you should bet 10% of your bankroll. Your expected compounded return of doing so is provably optimal once you have bet against him enough to prove out the stated edge — although should you manage to reach this point, you are a provably suboptimal friend.
Most of the finance papers that apply this thinking to markets have focused on individual trades that look more or less like bets we’d make at a casino. These are usually things with at least a kinda-sorta knowable payoff and a discrete event where that payoff is determined: a single hand of blackjack, an exercise of an option, or a predicted corporate action taking place (or not taking place). It’s a lot harder to get your head around what “bet” we’re making and what “edge” we have when we, say, buy an S&P 500 ETF instead of holding cash. Unless you really are omniscient or carry around a copy of Grays Sports Almanac, you’re going to find estimating the range of potential outcomes for an investment or portfolio of investments pretty tricky. Not that it stops anyone from trying.
Since I don’t want to assume that any of us is quite so good at algebra as to write the formula for all the future, at a minimum what I’m trying to do is get us to think about risk unanchored to the arbitrarily determined characteristics and traits of asset classes. In other words, I want to establish an outside bound on the amount of risk a person could theoretically take in a portfolio if his only goal was maximizing return. Doing that requires us to think in geometric space, which is just a fancy way of saying that we want to know how the realization of returns over time ends up differing from a more abstract return assumption. It’s easy enough to get a feel for this yourself by opening Excel and calculating what the return would be if your portfolio went up 5% in one year and down 5% in the next (works for any such pair of numbers). Your simple average will always be zero, but your geometric mean will always be less than zero, by an increasing amount as the volatility increases.
So, if we knew exactly what stocks, bond and commodities would do between 1961 and 2016, what portfolio would we have bought? The blend of assets if we went Full Kelly would have looked like this:
Source: Salient 2017. For illustrative purposes only.
Only there’s a catch. Yes, we would have bought this portfolio, but we would have bought it more than six times. With perfect information about odds and payoffs, the optimal bet would have been to buy a portfolio with 634% (!) exposure, consisting of $2.00 in stocks, $3.21 in bonds and $1.13 in commodities for every dollar in capital we had. After all was said and done, if we looked back on the annualized volatility of this portfolio over those 50 years, what would we have found? What was the answer to life, the universe and everything?
44. Sorry, Deep Thought, you were off by two.
Perhaps the only characteristic of this portfolio more prominent than its rather remarkable level of exposure and leverage, is its hale and hearty annualized volatility of 44.1%. This result means if all you cared about was having the most money over a 50+ year period that ended last year, you would have bought a portfolio of stocks, bonds and commodities that had annualized volatility of 44.1%, roughly three times the long-term average for most equity markets, and probably five times that of the typical HNW investor’s portfolio.
And before you go running off to tell my lovely, charming, well-dressed and distressingly unsusceptible-to-flattery compliance officer that I told you to buy a 44% volatility super-portfolio, allow me to acknowledge that this requires some… uh… qualification. Most of these qualifications are pretty self-explanatory, since the whole exercise isn’t intended to tell you what you should buy going forward, or even the right amount of risk for you. This portfolio, this leverage and that level of risk worked over the last 50 years. Would they be optimal over the next 50?
Of course not. In real life, we’re not omniscient. Whereas a skilled card counter can estimate his mathematical edge fairly readily, it’s a lot harder for those of us in markets who are deciding what our asset allocation ought to look like. Largely for this reason, even Thorp himself advised betting “half-Kelly” or less, whether at the blackjack table or in the market. When asked why, Thorp told Jack Schwager in Hedge Fund Market Wizards, “We are not able to calculate exact probabilities… there are things that are going on that are not part of one’s knowledge at the time that affect the probabilities. So you need to scale back to a certain extent.”
Said another way, going Full Kelly on a presumption of precise certainty about outcomes in markets is a surefire way to over-bet, potentially leading to a complete loss of capital. Now, scaling back is easy if we are starting from an explicit calculation of our edge as in a game of blackjack. It’s not as easy to think about scaling down to, say, a Half Kelly portfolio. There is, however, another fascinating (but intuitive) feature of the Kelly Optimal Portfolio that allows us to scale back this portfolio in a way that may be more familiar: the Kelly Optimal Portfolio can be generalized as the highest return case of a set of portfolios generating geometric returns that are most efficient relative to the risk they take.
This may sound familiar. In a way, it’s very much like a presentation of Markowitz’s efficient frontier. Markowitz plots the portfolios that generate the most return for a given unit of risk, but his is a single-period calculation. It isn’t a geometric approach like Kelly, but rather reflects a return expectation that doesn’t incorporate how volatility and non-linearities impact the path and the resulting compound return. There have been a variety of academic pieces over the years covering the application of geometric returns to this framework, but most have focused on either identifying a single optimal geometric portfolio or on utility. Bernstein and Wilkinson went a bit further, developing a geometric efficient frontier.
All of these analyses are instructive and useful to the investor who wants to take path into account, but because the efficient frontier is heavily constrained by the assumed constraint on leverage, it’s not as useful for us. What we want is to take the most efficient portfolio in geometric terms, and take up or down the risk of that portfolio to reflect our tolerance for capital loss. In other words, we want a geometric capital market line. The intuitive outcome of doing this is that we can plot the highest point on this line as the Full Kelly portfolio. The second, and perhaps more satisfying outcome, is that we can retrospectively identify that scaling back from Full Kelly just looks like delevering on this geometric capital market line.
The below figure plots each of these items, including a Half Kelly portfolio that defines ruin as any scenario in the path in which losses exceed 50%, rather than full bankruptcy. The Half Kelly portfolio delivers the highest total return over this period without ever experiencing a drawdown of 50%.
Source: Salient, as of December 31, 2016. For illustrative purposes only.
When we de-lever from the Full Kelly to Half Kelly portfolio, we drop from a terrifying 44% annualized volatility number (which experiences an 80% drawdown at one point) to 18.5%, closer to but still materially higher in risk than most aggressive portfolios available from financial advisors or institutional investors.
This can be thought of in drawdown space as well for investors or advisors who have difficulty thinking in more arcane volatility terms. The below exhibit maps annualized volatility to maximum loss of capital over the analysis period. As mentioned, the 50% maximum drawdown portfolio historically looks like about 18.5% in volatility units.
Source: Salient, as of December 31, 2016. For illustrative purposes only.
For many investors, their true risk tolerance and investment horizon makes this whole discussion irrelevant. Traditional methods of thinking about risk and return are probably serving more conservative investors quite well. And there are some realities that anyone thinking about taking more risk needs to come to terms with, a lot of which I’m going to talk about in a moment — there’s a reason we wanted to talk about this in geometric terms, and it’s all about risk. But for those with a 30, 40 or 50-year horizon, for the permanent institutions with limited cash flow needs, it’s reasonable to ask the question: is the amount of risk in the S&P 500 Index or in a blend of that with the Bloomberg Barclays Aggregate Bond Index the right amount of risk to take? Or can we be taking more? Should we be taking more?
Did you think that was rhetorical? Nope.
Many investors can – and if they are acting as fiduciaries probably ought to — take more risk.
If every hedge fund manager jumped off a bridge…
This may not be a message you hear every day, but I’m not telling you anything novel. Don’t just listen to what your advisors, fund managers and institutional peers are telling you. They’re as motivated and influenced by career risk concerns as the rest of us. Instead, look at what they’re doing.
The next time you have a conversation with a sophisticated money manager you work with, ask them where they typically put their money. Yes, many of them will invest alongside you because that is right and appropriate (and also expected of them). But many more, when they are being honest, will tell you that they have a personal account or an internal-only strategy operated for staff, that operates at a significantly higher level of risk than almost anything they offer to clients. Vehicles with 20%, 25% or even 30% volatility are not uncommon. Yes, some of this is hubris, but some of it is also the realization on the part of professional investors that maximizing portfolio returns — if that is indeed your objective — can only be done if we strip back the conventions that tell us that the natural amount of risk in an unlevered investment in broad asset classes is always the right amount of risk.
Same thing with the widely admired investors, entrepreneurs and business operators. The individual stocks that represent their wealth are risky in a way that dwarfs most of what we would be willing to tolerate in individual portfolios. We explain it away with the notion that they are very skilled, or that they have control over the outcomes of the company — which may be true in doses — but in reality, they are typically equally subject to many of the uncontrollable whims that drive broader macroeconomic and financial market outcomes.
Then observe your institutional peers who are increasing their allocations to private equity and private real estate. They’re not just increasing because hedge funds have had lower absolute returns in a strong equity environment, although that is one very stupid reason why this is happening. It’s also happening because institutions are increasingly aware that they have limited alternatives to meet their target returns. While few will admit it explicitly, they use private equity because it’s the easiest way to lever their portfolios in a way that won’t look like leverage. In a true sense of uncertainty or portfolio level risk, when the risk of private portfolios is appropriately accounted for, I believe many pools of institutional capital are taking risk well beyond that of traditional equity benchmarks.
Many of the investors we all respect the most are already taking more risk than they let on, but explain it away because it’s not considered “right thinking.”
To Whom Much is Given
When we make the decision to take more risk, however, our tools and frameworks for managing uncertainty must occupy more of the stage. This isn’t only about our inability to build accurate forecasts, or even our inability to build mostly accurate stochastic frameworks based on return and volatility, like the Monte Carlo simulations many of us build for clients to simulate their growth in wealth over time. It’s also because the kinds of portfolios that a Full Kelly framework will lead you to are usually pretty risky. Their risk constraint is avoiding complete bankruptcy, and that’s not a very high bar. The things we have to do to capture such a high level of risk and return also usually disproportionately increase our exposure to big, unpredictable events. If you increase the risk of a portfolio by 20%, most of the ways you would do so will increase the exposure to these kinds of events by a lot morethan 20%.
Taken together, all these things create that famous gap between our realized experience and what we expected going in. This is a because most financial and economic models assume that the world is ergodic. And it ain’t. I know that’s a ten-dollar word, but it’s important. My favorite explanation of ergodicity comes from Nassim Nicholas Taleb, who claims to have stolen it from mathematician Yakov Sinai, who in turns claims to have stolen it from Israel Gelfand:
Suppose you want to buy a pair of shoes and you live in a house that has a shoe store. There are two different strategies: one is that you go to the store in your house every day to check out the shoes and eventually you find the best pair; another is to take your car and to spend a whole day searching for footwear all over town to find a place where they have the best shoes and you buy them immediately. The system is ergodic if the result of these two strategies is the same.
There are infinite examples of investors making this mistake. My mind wanders to the fund manager who offers up the fashionable but not-very-practical “permanent loss of capital” definition of risk, a stupid definition that is the last refuge of the fund manager with lousy long-term performance. “Sure, it’s down 65%, but that’s a non-permanent impairment!” Invariably, the PM will grumble and call this a 7-standard deviation event because he assumed a world of ergodicity. Because of the impact of a loss like this on the path of our wealth, we’ll now have to vastly exceed the average expected return we put in our scenario models in Excel just to break even on it.
“It’s not a permanent impairment of capital!”
It matters what path our portfolios follow through time. It matters that our big gains and losses may come all at once. It matters to how we should bet and it matters to how we invest. You cannot stir things apart!
So if you’ve decided to take risk as an investor, how we do avoid this pitfall? Consider again the case of the entrepreneur.
The entrepreneur’s portfolio is concentrated, which means that much of his risk has not been diversified away. A lot of that is going to be reflected in the risk and return measures we would use if we were to plot him on the efficient frontier. That doesn’t necessarily mean his risk of ruin will appear high, and his analysis might, in fact, inform the entrepreneur that he ought to borrow and hold this business as his sole investment. He’s done the work, performed business plan SWOT analyses, competitor analyses, etc., and concluded that he has a pretty good grasp of what his range of outcomes and risks look like.
In an ergodic world, this makes us feel all warm and fuzzy, and we give ourselves due diligence gold stars for asking all the right questions. In a non-ergodic world, the guy dies using his own product. A competitor comes out of nowhere with a product that immediately invalidates his business model. A bigger player in a related industry decides they want to dominate his industry, too. And these are just your usual tail events, not even caused the complexity of a system we can’t understand but by sheer happenstance. For the entrepreneur, all sorts of non-tail events over time may materially and permanently change any probabilistic assessment going forward. How do we address this?
The first line of defense as we take more risk must be diversification. After all, there is a reason why the Kelly Portfolios distribute the risk fairly evenly across the constituent asset classes.
Even that isn’t enough. Consider also the case of the leveraged investor in multiple investments with some measure of diversification, for example a risk parity investor, Berkshire Hathaway, or the guy who went Full Kelly per our earlier example, but without the whole perfect information thing. This investor has taken the opposite approach, which is to diversify heavily across different asset classes and/or company investments. His return expectation is driven not so much by his ability to create an outcome but by the exploitation of diversification. As he increases his leverage, his sensitivity to the correctness of his point-in-time probabilistic estimates of risk, return and correlations between his holdings will increase as well. In an ergodic world, this is fine and dandy. In a non-ergodic world, while he has largely mitigated the risk of idiosyncratic tails, he is relying on relationships which are based on a complex system and human behaviors that can change rapidly.
Thus, the second line of defense as we take more risk must be adaptive investing. Sometimes the only answer to a complex system is not to play the game, or at least to play less of it. Frameworks which adapt to changing relationships between markets and changing levels of risk are critical. But even they can only do so much.
Liquidity, leverage and concentration limits are your rearguard. These three things are also the only three ways you’ll be able to take more risk than asset classes give you. They are also the three horsemen of the apocalypse. They must be monitored and tightly managed if you want to have an investment program that takes more risk.
It’s not my intent to end on a fearful note, because that isn’t the point at all. More than asset class selection, more than diversification, more than fees, more than any source of alpha you believe in, nothing will matter to your portfolio and the returns it generates more than risk. And the more you take, the more it must occupy your attention. That doesn’t mean that we as investors ought to cower in fear.
On the contrary, my friends, fortune favors the bold.
 Back in 1989, Grauer and Hakansson undertook a somewhat similar analysis on a finite, pre-determined set of weightings among different assets with directionally similar results. Over most windows the optimal backward-looking levered portfolio tends to come out with a mid-30s level of annualized volatility.
 For this and the other exhibits and simulations presented here, I’m very grateful to my brilliant colleague and our head of quantitative strategies at Salient, Dr. Roberto Croce.
 And that reason isn’t just “we’re at the end of a 30-year bond rally,” if you’re thinking about being that guy.
 One suspects Mr. Buffett would be less than thrilled by the company we’re assigning him, but to misquote Milton Friedman, we are all levered derivatives users now.
I’ve learned that people will forget what you said, people will forget what you did, but people will never forget how you made them feel.
― Maya Angelou (1928 – 2014), author of I Know Why the Caged Bird Sings
And in our business, people will forget what price targets you set, people will forget what funds you managed, but people will never forget how you impacted their personal account.
Longer summer means longer winter.
― traditional Westerosi saying
We’ve got a five acre field that I brush hog once a year if I’m feeling particularly industrious, and one day I suppose we may do something with it.
In late summer this fallow field of thistle and hay is one of my favorite spots, particularly in the early morning and late afternoon, because of the flocks of goldfinches that swoop in and around the field. The goldfinch is exactly as the name implies — a small bird with a bright yellow, almost tropical, plumage — and it looks out of place in the Northeast, like maybe it’s an escapee from a gilded cage in Greenwich. But they love these Connecticut summers, and it’s not uncommon for me to count 30 or more flying around in a swarm that at times seems to be the animal itself.
The flocks are never as big as the far more famous murmurations of starlings, which is a good thing, of course, but they generate that same sense of awe in that there is clearly some sort of order and method to the flowing chaos of all these birds moving together. Most unlike the starlings, however, is that the goldfinch flocks are absolutely beautiful. The glints of yellows and gold moving through the air like a living liquid, the morning sun piercing the flock … it’s a natural poetry that has no good reason to exist, but does all the same.
I’m as much a dilletante birdwatcher as I am a dilletante farmer, so when the beautiful yellow birds stopped making their appearances over the field every fall, I just assumed that they were like the robin, flown south for the winter. I assumed this was the case for years, And in fact some goldfinches do migrate south every year, particularly the ones who set their breeding nests up in southern Canada.
But not our goldfinches. No, our field and its thistles, together with the nearby woods and the river that runs through it, is just too good of a home base to leave even for a season (I agree!). So they don’t fly south. They don’t go anywhere at all. They stay the whole winter, there in the field and the scrub and the forest all along.
Why didn’t I see them in the winter? Because they change color, or at least the males do, exchanging their flashy yellow feathers for a quite pedestrian dull brown. Just an ordinary little bird, one you’d never give a second glance at, even if now you remember seeing so many at the bird feeders you set out when the snows come.
Yes, the goldfinches were there all along. I just didn’t know where to look.
What’s the investing lesson here?
Goldfinches are like Value investing. Or Growth investing or Momentum investing or whatever your investment style might be. They have a season where they seize the stage, blistering in their radiance. And then they recede. They don’t go away. They just fade into the background and become a pedestrian little bird, until their appointed season returns — it always does! — and they seize the stage once more, zipping around in a glorious flock with some sort of fractalish order-in-chaos.
Unfortunately for us investors, though, the seasonality of investment styles is more like Westeros on Game of Thrones than Connecticut here on Earth. “Winter is here” on Game of Thrones today, but it took a long time coming … summer lasted a good nine years this time around, and legends tell of a winter back in the day that lasted for an entire generation. The winter currently being experienced by Value investors only seems like it’s lasted for a generation.
Not surprisingly, then, investors are always asking the same question: is there a bird for all seasons? Is there an investment style or process that can be more than just a pedestrian performer come winter, spring, summer, or fall, and no matter how long or how deep those seasons might be?
The answer, I think, is yes. The answer, I think, is diversification. There’s your bird for all seasons.
Diversification isn’t a pretty bird. Diversification doesn’t make my heart skip a beat like a flock of goldfinches in July. Diversification, by design, is going to have winners and losers simultaneously. Diversification, by design, is never going to look pretty doing its job, because if your portfolio is all working in unison, swooping through the market in a beautiful glint of gold … well, you may be making money, but you sure aren’t diversified. Diversification is undeniably effective, but it’s effective like a rat is effective, wonderfully adapted to do pretty well in pretty much any possible environment without calling too much attention to itself. That’s actually one of the rat’s primary survival mechanisms. It’s not flashy. It’s not pretty. It’s a freakin’ rat.
Diversification doesn’t make us feel good like a winning value or growth investment makes us feel good, and as Maya Angelou so brilliantly said, how you make people feel is ALL they remember.
I don’t have an answer for the simple fact that diversification doesn’t sing. I can’t make a financial advisor’s client feel good about diversification. I wish I could, because I would be … umm … a very rich man. But what I do know is that it’s a mistake to gussie up diversification as something that it isn’t. You can’t sell diversification as a beautiful song bird. You have to be honest about what diversification can and can’t do, not just for a portfolio’s performance, but also for a portfolio’s experience. The more years I spend in this business, the more I am convinced that how one lives with a portfolio, how one experiences its ups and downs over time, is more important for business success and business staying power than that portfolio’s performance. And I’m not just talking about volatility, which is usually how we think about the path of a portfolio and its ups and downs. No, I’m talking about how a portfolio makes us feel. Most of us need those goldfinch moments of wonder and awe, even if they just last for a season, to feel good about our portfolios, and those are moments that diversification has a really hard time delivering.
To every thing there is a season, and a time to every purpose under heaven. That holds for portfolio construction, too.
Herald: I bring a message from your master, Marcus Licinius Crassus, commander of Italy. By common of His Most Merciful Excellency, your lives are to be spared! Slaves you were, and slaves you remain. But the terrible penalty of crucifixion has been set aside on the single condition that you identify the body or the living person of the slave called Spartacus.
Antoninus (Tony Curtis): I am Spartacus!
Other Slaves: I’m Spartacus!
— Spartacus (1960)
We are all active managers, friends. The sooner the better that we realize this and start focusing on the when and why it makes sense for investors, instead of wishcasting “good environments for active management” that don’t exist. While we may not be obscuring each other’s identities, it’s probably time for more of us to stand up and say, “I am an active manager!” Although, I suppose it is worth mentioning that shortly after this scene, Spartacus is forced to kill his best friend before being crucified.
“Active management is a zero-sum game before cost, and the winners have to win at the expense of the losers.”
— Eugene Fama, Ph.D., Investment News, October 7, 2013
Walter Sobchak: Am I wrong?
The Dude: No, you’re not wrong.
Walter: Am I wrong?
The Dude: You’re not wrong, Walter. You’re just an asshole.
Walter: All right then.
— The Big Lebowski (1998)
“You heard about it? Yeah you had to.
Mm hmm I know you changed your mind,
You ain’t the only one with bad news.
I know that it made you feel strange, huh?
You was right in the middle complainin’
and forgot what you was cryin’ about.”
— Mystikal, “Bouncin’ Back” (2001)
Ahchoo: Look, Robin, you don’t have to do this. I mean, this ain’t exactly the Mississippi. I’m on one side. I’m on the other side. I’m on the east bank, I’m on the west bank. It’s not that critical.
Robin: It’s the principle of the thing.
— Robin Hood: Men in Tights (1993)
It seems like every few years the debate on active vs. passive management comes back in full force — not that any of this is new, of course. DFA, Vanguard, and brilliant investors and writers like Charlie Ellis have been shouting from the mountaintop about what a waste of time active management is for decades now. So why the breathless excitement from the financial press on the topic this time? Mostly because they haven’t the faintest idea what they’re talking about.
Don’t mistake me: Charlie Ellis isn’t wrong. Jack Bogle isn’t wrong. Gene Fama isn’t wrong. But the basis for the broader active vs. passive debate is misleading at best, and outright fraud at worst. Let’s get a few objective, unequivocal facts out of the way about active management:
There is no such thing as a “good” or “bad” environment for active management.
Everyone — including you, dear reader — is an active investor.
Costs matter. The rest of this debate is a waste of time.
This is why the debate over active vs. passive is #1 on my list of Things that Don’t Matter.
The myth of the good or bad environment for active management
Most investors have at least a passing familiarity with the notion of the zero-sum game. It is an academic and logically sound construct which says that if one investor is overweight or long a particular security relative to its market capitalization weighted share of that market, it stands to reason that another investor must necessarily be underweight or short.
This is true to the point of tautology, and there’s no disputing it. It’s true, and it’s used as the fundamental, deterministic argument for why active management can neverwork. If every winner is offset with a loser and everyone is paying fees, over time the house is going to win. It’s also why Dr. Fama has famously and accurately said that if the data shows that active management is working, then the data is wrong.
But if this is the case, how it is possible that there are “good” or “bad” environments for active managers or stock pickers? Wouldn’t every environment just be equally bad to the tune of the drag from fees and expenses? If so, why are we talking about this historically bad period for fund managers?
The reason we are talking about it is that practically every study, allocator, advisor, researcher and article covering this topic considers passive management in context of a particular benchmark or index. However, not every pool of assets benchmarked against an index is necessarily seeking to outperform that index on an absolute basis. Even more to the point, these pools certainly don’t confine their investments to constituents of that index.
If you weighted each of the benchmarks used by investors, funds and institutions by the value of each of those pools of capital, you would end up with something that looked very different from the market capitalization of the world’s financial assets. By way of the most obvious example, I suspect that the total value of pools of capital that benchmark themselves formally against the S&P 500 Index (“S&P 500”) vastly exceeds the market capitalization of the S&P 500 itself. The value that does so informally is probably many multiples of that.
The way that this plays out in practice is surprisingly consistent. Consider a U.S. large-cap strategy. There are four biases that are ubiquitous — uniform might be nearer the mark — among both actively managed mutual funds and institutional separate accounts:
investments in small- and mid-cap stocks
investments in higher volatility / higher beta stocks
investments in international stocks
In other words, there is no good or bad environment for active management. There are good or bad environments for the relatively static biases that are almost universal among the pools of capital that benchmark themselves to various indices.
If you are an allocator, financial advisor or individual investor, you may have heard from your large-cap fund managers during the first half of 2016 how bad an environment it was for active management. Maybe they said that the market is ignoring fundamentals or that everything is moving together or that the market is adopting a short-term view.
That’s about 50% story-telling and 50% confirmation bias. It’s also 0% useful.
In an overwhelming majority of cases, that environment is simply one in which either small-caps underperformed or high beta / high-risk stocks did.
From the same investor vantage point, the second half of 2016 probably looked different. We often say that we don’t have a crystal ball, but I have a very reliable prediction about your annual reviews with your U.S. large-cap managers. They may inform you that “fundamentals started mattering again” in the second half of the year. The market started paying attention to earnings quality and management decisions and [insert generalization that will fill up the allotted time for the meeting here].
No they didn’t.
Small-cap and high-beta or high volatility stocks bounced back really hard. When you do your review with your active small-cap managers, you may be surprised when they, on the other hand, are doing so poorly relative to their benchmarks. Why? Because small-cap managers manage portfolios that are typically above the market cap of the Russell 2000 Index (“Russell 2000”) and nearly uniformly underperform when small-cap is trouncing large-cap.
Let’s take a look at how and why this is. The chart below splits up every month from January 2001 through January 2017 by the spread between the return of the Russell 2000 and the S&P 500. The chart plots the average excess return of each of the funds in the Morningstar Large Blend category against the S&P 500 by how pronounced the difference between small- and large-caps was for the period. In other words, what we’re looking at is whether large-cap funds have done better or worse vs. the S&P when large-caps are outperforming small-caps in general.
The results are stark. In the bottom decile of months for the large vs. small spread (i.e., the 10% of months where small-caps do the BEST), large-cap blend managers outperform the S&P by an annualized rate of just over 4%. By contrast, in the top decile for large-cap vs. small-cap, they underperform by an annualized rate of nearly 5%!
Those bad environments for stock picking your fund managers are so fond of telling you about? They’re only bad because almost all of your active managers are picking riskier stocks and putting small- and mid-caps in your large-cap fund.
Sources: Bloomberg, Ken French U.S. Research Returns, Morningstar as of 01/31/17. For illustrative purposes only. Past performance is no guarantee of future results.
Unfortunately for those of you who breathed a sigh of relief in August and September of 2016 because your active managers were ‘working’ again, this doesn’t necessarily mean your fund manager had a flash of brilliance from the patio of his Southampton rental. Low beta just spat up all the excess returns it generated in the first half of the year.
These kinds of biases are not confined to large-cap U.S. equity managers, of course. As mentioned, your small-cap managers are usually going to get smoked when small-caps are roaring. Your international equity managers are all buying emerging markets stocks around the edges of their portfolios (that’s why they were geniuses until the last three years or so, and now we think they’re stupid). Your fixed income guys are often just about all doing “core plus” even if they don’t say so on the wrapper. Your long/short equity and event funds have persistent sectoral biases.
Every category of active management has its own peculiar but fairly persistent bias against its benchmark.
OK, so active managers have consistent biases. So what? It still rolls up to the same zero-sum game, right? Yes, but it’s useful to think about and understand what’s going on underneath the hood. Namely, since we know that actively managed large-cap mutual funds and institutional separate accounts are usually underweight mega-caps, large-caps and lower risk stocks relative to the passive universe, we must fill in the gap: who is overweight these stocks to offset?
The answer is, well, strategies other than large-cap strategies, or ones that are not benchmarked to the S&P 500 or Russell 1000 Index (“Russell 1000”). That can include a wide variety of vehicles, but at the margin it includes (1) hedge funds, (2) individual or corporate holders of ‘un-benchmarked’ securities portfolios and (3) portfolios that are targeting a sub-set or variant of the large-cap universe. Clearly it also includes all sorts of strategies benchmarked to other markets entirely, one of the most common examples being multi-asset portfolios. As illustrated in the exhibit below, the S&P 500 is very obviously not completely owned by pools of capital that are benchmarked to the S&P 500.
For illustrative purposes only.
Hedge funds provide us with the most exaggerated example of one of the ways this happens. Let’s presume that large-cap mutual funds are underweight low volatility mega-cap stocks to the tune of $50 billion.
Now let’s examine two cases — in the first case, $25 billion in hedge fund capital is deployed to buy all $50 billion of that on a levered long basis. In the second case, $100 billion of hedge fund capital is used, meaning that the funds chose to hold 50% cash and spent the remaining 50% on the mega-cap stocks.
If the S&P 500 is up and a particular publication wants to talk about hedge fund returns, they’re going to talk about the first scenario as a heroic period of returns for hedge funds. In the second scenario, hedge funds are a scam run to prop up the richest 1%. Neither is true, of course — well, not on this basis alone, at least — because the benchmark isn’t capturing the risk posture that an investor is using as part of its asset allocation scheme to select that investment — in this case a long/short hedge fund.
Consider as well that many of the strategies that are ‘filling in’ for active large-cap managers’ underweights to Johnson & Johnson and ExxonMobil do so in tactical or multi-asset portfolios, many of which are going to be compared against different benchmarks entirely. Still, others may be executed under minimum volatility or income equity mandates. When you consider that the utility functions of investors in these strategies may be different, and that one investor may reasonably emphasize risk-adjusted returns rather than total returns, or that two investors might have meaningfully different needs for income in context of their overall financial situation, the argument starts to get very cloudy indeed.
There is no such thing as a passive investor
So when faced with an income objective like the example above, the response of many in the passive management camp is typically some form of, “Well, just buy more of a passive income equity fund, or move more money to bonds.”
It is this kind of argument that exemplifies why this active vs. passive debate feels so phony, so contrived. As it is too often applied, the mantra of passive management emphasizes avoiding funds that make decisions that many those allocators/advisors/investors will then make themselves and charge/pay for under the guise of asset allocation.
If a fund manager rotates between diversified portfolios of stocks, bonds, credit and other assets based on changing risks or income characteristics, he gets a Scarlet A for the vile, dastardly active manager he is. If an investor or allocator does the same thing by allocating between passively managed funds in each of those categories, he posts about it on Reddit and gets 200 up-votes.
If a fund manager invests in a portfolio of futures (lower cost passive exposure than ETFs, by the way) to reach a target level of risk and diversification without trying to pick individual securities at all, just go ahead and tattoo the “A” on their deserving forehead in permanent ink. If an investor or allocator does the same thing to build a portfolio that is equally or more distinct from a global cap-weighted benchmark using more expensive ETFs, we can only celebrate them and hope they pen a scathing white paper on the systemic risks embedded in risk-targeted investment strategies.
Everyone is often doing the same things — and usually paying for it — in different ways. To paraphrase Ahchoo (bless you), some of you are on the east bank and some of you are on the west bank. But this ain’t exactly the Mississippi. It’s not. That. Critical.
What IS critical is understanding why this debate occupies such an august (notorious?) spot on this list of Things that Don’t Matter. And here it is: I am fully confident that not a single passive investor owns a portfolio of global financial assets in the respective weights of their total value or market capitalization. Instead, they allocate away from the cap-weighted global financial assets standard based on (1) their risk appetite, (2) in order to better diversify and (3) to satisfy certain personal goals around income and taxes.
Let’s put some figures on this. Using a basic methodology from public sources (while acknowledging without having access to his letters that Paul Singer has adopted a similar approach) as of the end of 2015 or 2016 — we’re talking big numbers here, so the timeliness isn’t that important — global investable assets look something like the pie chart below.
Sources: BIS, Savillis, World Bank. For illustrative purposes only.
Yes, there’s overlap here. Yes, if you added in capital raised to invest in private companies it would add another 1.2% to equities, and including insider holdings in private companies would expand this more (although debatably). It also doesn’t include a range of commodities or commodities reserves because of the (generally) transitive nature of the former and indeterminate nature of the latter. But it’s good enough for our purposes. So does your portfolio look like this? If not, let me be the first to initiate you into the club of active managers.
Every investor is an active investor when it comes down to the major dimensions of asset allocation: risk, diversification, income and liquidity. Eliminating strategies as “Active” because they seek to manage risk, improve diversification, increase income or take advantage of greater (or lesser) liquidity is wrong-headed at best and hypocritical at worst. Most of all, it harms investors.
The S&P 500 example is not universally applicable, of course. Public large capitalization stocks are well-covered by indices, and so index funds that track the S&P 500 or Russell 1000 are generally sound examples of vehicles seeking to avoid the pitfalls of the zero-sum game. That is not always the case, however.
One example of this I like to use is the Alerian MLP Index. It is a perfectly acceptable representation of the energy MLP market, and deserves credit for being the first to track this growing asset class. It tracks 50 key constituents with around $300 billion in total market cap. The overall universe of listed midstream energy companies, however, is closer to 140-150 and sports a market cap of nearly $750 billion. There are several index funds and ETFs that track the index, and dozens of so-called actively managed funds that include a higher number of securities that look rather more like the cap-weighted market for energy infrastructure!
A more mainstream example of this might be the Dow Jones Industrial Index, famous for being used by CNBC every day and by a professional investor for the last time in the mid-1950s. This index of 30 stocks covers only a fraction of the breadth of listed stocks in the U.S. with meaningfully different characteristics on a dozen dimensions, and is tracked by a “passive” ETF with roughly $12 billion in assets. Meanwhile, lower cost large-cap mutual funds and accounts with 120 holdings built to deliver higher than typical income at a lower volatility than the market are “actively managed.” To make matters more complicated, many asset classes that are a meaningful — and diversifying — part of the cap-weighted global market simply do not have passive alternatives.
There is a wonderful local convenience store chain called Wawa where I went to college. I had a…uh…friend whose laziness was so well-developed that his diet was entirely driven by what was available at Wawa. If they didn’t have it, he didn’t eat it. Now, there are all sorts of delightful things to be had there, so don’t get me wrong. But if you’ve got something other than hot dogs, ham sandwiches or Tastykake Krimpets on your mind, you’re out of luck.
I’m sorry to say that the Index Fund Wawa is fresh out of vehicles owning securities issued by private companies, listed securities in certain niches of the markets (e.g., preferred securities in real estate) with meaningful diversification and income benefits, less liquid instruments and others unable to be held in daily or continuous liquidity vehicles. Many of these strategies have significant diversification potential and roles within portfolios. Many are often highly effective tools for adding income, efficient risk mitigation or other characteristics to portfolios. Many may even have higher expected returns or risk-adjusted returns. But you’ll have to leave the Wawa to get them.
None of this even begins to venture into hedge funds and other alternative strategies, and how they ought to be considered in context of the overall debate. To be sure, the answer is probably to observe that the same criticisms and defenses that can be brought to bear against (or on behalf of) active management apply to strategies like this as well.
But to a great extent for hedge funds (and to a lesser one for traditional strategies), there are potential sources of return that may be consistently exploited that have nearly the same empirical and fundamental underpinnings of market exposure as a source of potential return. At their core — and consistent with how we discuss them in Epsilon Theory — they are almost universally an expression of human behavior. Whether expressed through premia to value, momentum or carry premia, or else biases investors have toward quality, lottery payoffs, liquidity and the like, the great irony is that the most successful actively managed strategies are those that exploit the fact that many investors are often drawn to the appeal of active management under the guise of ‘beating the market.’
For this reason, it is somewhat baffling to see the disdain with which passionate passive investors treat many alternative strategies. If we believe that active management can persistently lead investors to predictable bad outcomes driven by understandable behavioral biases and responses to information, why would we be averse to approaches that seek to exploit this? Most investors can, however, see the forest for the trees on this issue. That is the reason why, despite the contraction in actively managed strategies more broadly, most projections for the market for liquid alternatives posit a doubling of assets in the space between 2015 and 20201.
1Both PWC and McKinsey’s work on this topic comes highly recommended.
Costs matter (and the rest of this debate is a waste of time)
Now admittedly, I have waited quite a long time to talk about one of the principal concerns around many actively managed strategies: cost.
In coming around to this critical consideration, it is worth circling back to the indisputable fact that Bogle, Fama and Ellis are right. Trying to beat the market in most markets by being overweight the right stocks and underweight the right stocks is a loser’s game. Doing that and paying fees for it makes it an expensive loser’s game. The reality is that investors need to put the pitchforks away and ask themselves a set of simple questions when considering actively managed funds:
Portfolio Outcomes: For a fund that is making active decisions that I would be responsible for in my asset allocation, like risk targeting, biasing toward income and yield or improving portfolio diversification, do the benefits justify the cost?
Incomplete or Non-Existent Indexes: When an active fund provides better diversification or coverage of an opportunity set, or covers an investment universe that is not investable through passive solutions, do the benefits justify the cost?
Exploiting Bad Behaviors: When investing to exploit the behaviors of other investors who are trying to beat the market to increase returns or improve risk-adjusted returns of my portfolio, do the benefits justify the cost?
It shouldn’t be any surprise that this will often lead you to the same conclusion as a passive management zealot, because adding value that justifies the cost on the above dimensions is still really hard. Active management should be evaluated with the same critical eye and cost/benefit analysis every one of us use when we make active decisions in our portfolio design and asset allocation. But because it won’t always be the case, the process matters, and the code you follow to draw your investment conclusions matters.
The active vs. passive debate, on the other hand, does not. Enough.
Lots more where this came from on you-had-one-job.com. Of course I think these pix and this meme are hilarious. But then I start to think about whether or not alternative investment strategies have done their job. I start to think about what that job is. And I go hmmm …
Whenever you are about to find fault with someone, ask yourself the following question: What fault of mine most nearly resembles the one I am about to criticize?
― Marcus Aurelius, “Meditations” (180 AD)
Cesar Millan, dog whisperer. The show can be silly, but I’m a fan. If you want to boil his advice down into one phrase, it’s this: every dog needs a job.
It’s true for the pack, and it’s true for the portfolio. I know he doesn’t look like much, but Karnak is the most powerful superhero of them all. His ability? To see the flaw in all things. That includes death and philosophies. That includes himself. When he’s not begrudgingly saving the world, Karnak spends most of his time staring at blocks of stone.
One of Karnak’s flaws is that he can’t lead. No one follows a man who sees exactly what’s wrong with you. But he’d make a great short-seller.
Again. Sadder than was. Again. Saddest of all. Again.
― William Faulkner, “The Sound and the Fury” (1929)
How often have I lain beneath rain on a strange roof, thinking of home.
― William Faulkner, “As I Lay Dying” (1930)
Memory believes before knowing remembers.
― William Faulkner, “Light in August” (1932)
The past is never dead. It’s not even past.
― William Faulkner, “Requiem for a Nun” (1951)
A Great Rabbi stands, teaching in the marketplace. It happens that a husband finds proof that morning of his wife’s adultery, and a mob carries her to the marketplace to stone her to death.
There is a familiar version of this story, but a friend of mine — a Speaker for the Dead — has told me of two other Rabbis that faced the same situation. Those are the ones I’m going to tell you.
The Rabbi walks forward and stands beside the woman. Out of respect for him the mob forbears and waits with the stones heavy in their hands. ‘Is there any man here,’ he says to them, ‘who has not desired another man’s wife, another woman’s husband?’
They murmur and say, ‘We all know the desire, but Rabbi none of us has acted on it.’
The Rabbi says, ‘Then kneel down and give thanks that God has made you strong.’ He takes the woman by the hand and leads her out of the market. Just before he lets her go, he whispers to her, ‘Tell the Lord Magistrate who saved his mistress, then he’ll know I am his loyal servant.’
So the woman lives because the community is too corrupt to protect itself from disorder.
Another Rabbi. Another city. He goes to her and stops the mob as in the other story and says, ‘Which of you is without sin? Let him cast the first stone.’
The people are abashed, and they forget their unity of purpose in the memory of their own individual sins. ‘Someday,’ they think, ‘I may be like this woman. And I’ll hope for forgiveness and another chance. I should treat her as I wish to be treated.’
As they opened their hands and let their stones fall to the ground, the Rabbi picks up one of the fallen stones, lifts it high over the woman’s head and throws it straight down with all his might. It crushes her skull and dashes her brain among the cobblestones. ‘Nor am I without sins,’ he says to the people, ‘but if we allow only perfect people to enforce the law, the law will soon be dead — and our city with it.’
So the woman died because her community was too rigid to endure her deviance.
The famous version of this story is noteworthy because it is so startlingly rare in our experience. Most communities lurch between decay and rigor mortis and when they veer too far they die. Only one Rabbi dared to expect of us such a perfect balance that we could preserve the law and still forgive the deviation.
So of course, we killed him.
– San Angelo, “Letters to an Incipient Heretic”
― Orson Scott Card, “Speaker for the Dead” (1986)
It takes a village to manage a portfolio. Or a country. Discipline to maintain process. Flexibility to tolerate deviance … err, I mean tracking error. We need better Rabbis. Who we don’t kill.
In all cases, not only in the two which we have analyzed, recovery came of itself. But this is not all: our analysis leads us to believe that recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another crisis ahead. Particularly, our story provides a presumption against remedial measures which work through money and credit. For the trouble is fundamentally not with money and credit, and policies of this class are particularly apt to keep up, and add to, maladjustment, and to produce additional trouble in the future.
― Joseph Schumpeter, “Depressions: Can we learn from past experience” (1934)
Schumpeter famously wrote that his personal goals were to be the smartest economist in Europe, the finest horseman in Austria, and the most accomplished lover in Vienna. He judged these to be equally difficult and equally praiseworthy achievements. I think he overrated the whole economist thing.
The thing is, Butch, right now you got ability. But painful as it may be, ability don’t last. And your days are just about over. Now that’s a hard motherfn’ fact of life, but that’s a fact of life you’re gonna have to get realistic about. See, this business is filled to the brim with unrealistic motherf’rs. Motherf’rs who thought their ass would age like wine. If you mean it turns to vinegar, it does. If you mean it gets better with age, it don’t. Besides, Butch, how many fights do you think you got in you anyhow? Two? Boxers don’t have an Old Timers Place. You came close but you never made it. And if you were gonna make it, you would have made it before now. [holds out the envelope of cash just out of Butch’s reach] You’re mine, dig?
It certainly appears so.
―“Pulp Fiction” (1994)
Like boxing and organized crime, our business is filled to the brim with unrealistic motherf’rs.
This is the line that haunts me: if you were gonna make it, you would have made it before now.
The Hunt family has three dogs, each with a distinct job. The German Shephard’s job is to protect. The Sheltie’s job is to herd. The Golden’s job is to love. Each dog is very good at its job, sometimes in an annoying way (particularly the Sheltie), but they’re oh-so happy with what they do well, and it fits our entire family dynamic. There are sacrifices we make for having this particular pack, like we can’t have any other dogs drop in for a visit or else the German Shephard might eat them, but the positives far outweigh the negatives. We’re a solid pack, and there’s nothing quite like that feeling of knowing that the dogs are there for you and you for them, and that the entire Hunt family — human and dog alike — is stronger not just in fact but in spirit for giving ourselves over to the pack.
It’s the same with investment portfolios. Every dog needs a job, and every investment does, too. No single dog can be all things to all people, and neither can a single investment. Nor can any pack of dogs accomplish anything and everything you like. The biggest mistake people make when they get a dog is trying to make the dog fit into the life they wish they led, rather than the life they actually lead. You better know thyself before you get a dog, much less a couple of dogs, and it’s exactly the same thing with making an investment. But if you get it right … man, there’s nothing better. Like a confident pack, a confident portfolio provides both strength in fact, as well as — and this is the part I bet you’re missing right now and the focus of this note — strength in spirit.
In my experience, most people don’t particularly like their portfolios, much less get a lift from them. They tolerate their portfolios. They may be pleased enough with the performance, but they don’t get a psychic boost from their portfolios. They don’t enjoy the confidence and strength of spirit that a solid pack or a solid portfolio can provide. And before you say that this really doesn’t matter to you, that so long as your portfolio performs up to a certain standard you couldn’t really care less whether it provides any “psychic strength” or any such mumbo-jumbo hogwash, let me stop you to say that you’re not just wrong, you’re completely wrong. In truth, the only thing that matters to you about your portfolio is its psychic reward, the positive way it makes you feel.
Now don’t misunderstand me. Performance is part of that psychic reward, usually the biggest part. But in the same way that the Economic Machine is part of a larger social phenomenon that I call the Narrative Machine, in the same way that Newtonian physics is part of a larger set of natural laws called Einsteinian physics, in the same way that Game Theory is part of a larger intellectual construct called Information Theory, so is “performance enjoyment” part of a larger behavioral attitude toward our portfolios. I first wrote about all this in Epsilon Theory with “It’s Not About the Nail” and “It’s (Still) Not About the Nail”, and it’s high time I picked up on this thread as part of the current “Anthem!” series.
The place where I see the greatest dissatisfaction or lack of spirit in most portfolios is in the allocation to alternative strategies. Most model portfolios that come down from on high at the big wealth management firms suggest that alternative strategies should be anywhere from 10-20% of a portfolio. But in fact most actual portfolios for actual clients have a small fraction of the recommended allocation, say 3-4% at most. Why the disconnect?
To answer that question, let me start by telling you what the answer is not. The answer is NOT that financial advisors or professional investors need more “education” about the virtues of an alternatives-heavy portfolio. I think that this focus on “education” is the single most tone-deaf and semi-condescending aspect of the business of modern investment management, which I suppose is a pretty bold statement given the sheer number of tone-deaf and semi-condescending things in our line of work. But there you go. I see it every day. Another email, another webinar, another white paper, another earnest effort to “educate” financial advisors about alternatives, with, let’s be honest, the unspoken implication that you are kinda stupid if you don’t have a heaping plate of alternatives in your portfolio.
It’s not that any of these “educational” efforts are wrong. They speak the truth, albeit a bloodless, overly scientificized truth. But the truth is also that financial advisors have had a poor experience with alternative investment strategies, and once burned twice shy. Why burned? Because A) they’ve been pushed onto financial advisors as some sort of wonder dog that can be all things to all portfolios, and B) they’ve been pulled into portfolios by financial advisors who were thinking more about the portfolio and clients that they wish they had rather than the portfolio and clients that they actually have.
I’m not going to spend a lot of time on point A because it’s obviously egregious and I see this changing for the better in my conversations with financial advisors. They are still inundated with semi-condescending “educational” materials from every possible source, but at least the content of those materials today is a lot more even-handed about the specific job that alternative strategies can perform in a portfolio, as opposed to promising the investment equivalent of Scrappy Doo, Scooby’s far more competent crime-fighting nephew. Pro tip: if you’re offered a walking, talking dog to fill out your pack, you should hold onto your wallet.
Its point B that I think is a bit less obvious and one that needs more explication. Basically I think what’s happened is that a lot of financial advisors and serious investors believe they know the job that alternatives can help provide for a portfolio — diversification — and they really want that for their portfolio. But they set themselves up for failure, where the alternative strategies in their portfolio don’t FEEL satisfying even if the performance is okay, in two important ways.
First, they’re mistaking a quality of the portfolio — diversification — for a job of an individual investment. Asking an investment to provide diversification is like asking a dog to provide pack stability. It’s just not within their power to do this. Portfolio diversification and pack stability emerge from the proper organization and job assignment of the individual members of the portfolio or pack, not the other way around. If someone tells you that their alternative strategy is “a diversifier”, your question should be “Relative to what?” if you’re in a generous mood, something a little more snippy if you’re not. The question you need answered is what job does the strategy perform in your portfolio. How should I expect it to behave under what conditions? Then you can decide for yourself how that job fits with the other jobs your other investments are doing. Then you can evaluate this potential new member of your pack in a non-alienated fashion, focusing on its fit within the whole rather than its standalone attributes.
Second, they’re judging this alternative strategy versus that alternative strategy on the basis of standalone historical performance, alienatedfrom the psychological meaning that the overall portfolio composition — the pack — plays in their client’s or their own life. Alternative strategies in this conception are a line item in the portfolio, a tasty-looking dish that one orders from a 10-page diner menu, a beautiful exotic dog breed that one reads about in TheNew York Times Style Magazine.
Odds are that you’ll be disappointed with that exotic dog, through no fault of the dog and actually, through no fault of yours. Odds are that you’ll be disappointed with that fancy alternative strategy, similarly through no fault of the strategy or you. Why? Because human rationality is based on Bayesian decision-making, a $10 phrase that means we make up our minds as we go along and new information comes our way. Maybe that dog is, in truth, perfect for you and your life. But maybe it’s not. I mean, you got all excited about the breed from an article you read in the NYT Style Magazine. Are you crazy? Maybe that alternative strategy is a perfect diversifying complement for your portfolio. But maybe it’s not. I mean, you got all excited about the fund because the manager sounded really smart. Really? Did you really make THAT mistake again?
My point is that we start any standalone investment from a position of self-doubt, and from a Bayesian perspective it takes a lot of evidence before we come to any conclusion as to whether we made a good original decision or not. Even then our conclusions are never final or definitive in a Bayesian approach, because there’s always a chance that new information will come to light that shifts our opinion. Moreover, the qualities of portfolio diversification and pack stability take quite a bit of time to emerge. If you think you see these qualities right off the bat, or conversely you think you see something that shows this is a disaster, you’re usually mistaken. In fact, with both dogs and alternative investment strategies, by the time you’ve received enough information to judge for sure whether or not you’ve actually got a “good one” or a “bad one”, it’s almost always too late to make a switch or do anything differently about it. Put it all together, and we stay in this position of self-doubt on an effectively permanent basis.
It’s what I call The Curse of (Some) Talent, and it’s one of the most pernicious aspects not only of investing, but of the human condition. It’s embodied in Butch, the Bruce Willis character in Pulp Fiction, a boxer who’s a pretty good fighter but is now getting a little long in the tooth. As Marsellus Wallace, the crime boss who bribes Butch to take a dive, says, “if you were gonna make it, you would have made it before now.” Butch has (some) talent, enough to become a professional fighter. But he doesn’t have enough talent to really succeed, to really make it big. I recognize Butch in myself, which is what makes this scene so haunting. Here I am, 52 years old, sitting in a hotel room far away from home on another business trip, writing this note. If I was gonna make it, wouldn’t I have made it before now? I recognize Butch in all the really smart portfolio managers I know, each of whom runs what seems like a really interesting strategy that for whatever reason hasn’t made them a Master of the Universe. If they were gonna make it, wouldn’t they have made it before now? Clearly they have (some) talent. Do they have enough to be an individual star? And if that’s what I need from them or if that’s how I’m evaluating them, then how in the world do I muster up the confidence to take the chance that they do? How in the world do I maintain the confidence to keep them in my portfolio when the winds of chance blow against me or them, something that will always happen at some point?
I think that most financial advisors or serious investors know exactly what I’m talking about here, and this is why most of them are waaaay under-allocated to what investment “science” and their model portfolios and their own voices inside their heads tell them should be their “proper” allocation to alternative strategies. If we’re evaluating these strategies on a standalone, line-item basis, plagued by the self-doubt inherent in Bayesian decision-making and the other-doubt inherent in the Curse of (Some) Talent, then the mystery isn’t why current allocations to alternatives are so low at 3-4%, but why they’re so high!
So here’s what I think is a better way to think about portfolio construction, one that puts not only alternative strategies but ALL strategies in their proper place, which is in service to the pack. That’s your responsibility, too, by the way. The pack always comes first.
Step One. Every investment in the portfolio must have a job, meaning that we expect each investment to do certain things under certain circumstances. This means that we have to imagine what those future circumstances might be. Here are two scenarios that I think we should wrestle with.
The Long Gray Slog: a continuation of the current investment status quo, where central banks continue to squelch the volatility out of markets in their continuing efforts to turn markets and the entire macro-economy into political utilities. Business cycles and bear markets are effectively outlawed, but the imposition of a floor also imposes a ceiling. It’s 1% GDP growth and zero on your savings and flat to slightly up markets just as far as the eye can see.
Fire & Ice: a political event that sets the global economy on a new deflationary leg down, which in turn creates a global credit freeze and liquidity concerns at systemically important European banks. This is Ice. But central banks of the modern ilk refuse to back down, unleashing a wave of bank nationalizations, negative interest rates, and helicopter money drops of various sorts, all designed to force asset prices higher by sheer dint of printing and distributing vast quantities of fiat currencies. This is Fire. You don’t get the Fire without the Ice, and I need strategies that can survive both.
Step Two: Now that we’ve identified the scenarios we think we might face, we need to figure out what sort of portfolio can survive or thrive under these circumstances. How do we do that? By immersing ourselves in the stories of investors who survived and thrived during Long Gray Slogs or Fire & Ice scenarios of the past. By developing a sense of empathy for what it felt like to invest during, say, the 1930s or the 1970s or (for the younger crowd) the 2000s. This is how we figure out what sort of pack supports the life we want to live when confronted by these circumstances. This is how we figure out what strategies — in complement with each other — can create that pack with strength of spirit as well as strength of performance.
We gain this sense of empathy in two ways. We talk to old-timers (for much of my audience, that’s anyone older than 40), and we read. We read a lot. We read biographies. We read memoirs. We read old newspapers and old magazines, as much primary material as we can. We read and we talk, not in the modern cynical way of gotcha and tsk-tsk and eye-roll, but in older ways of trying to understand the WHY and the FEEL, not just the WHAT and the FACT. It’s a Faulknerian effort of trying to understand the past on a visceral level, such that it’s part of the living us and not “the past” at all. Empathy means putting yourself in someone else’s shoes, and it’s one of the hardest, least taught skills in the modern age of narcissism and self-absorption. But it’s also one of the most important. I hire history majors.
What strategies have I found that perform specific, useful jobs in these scenarios? Keep in mind that this is for a portfolio that works for me and my family and the life we’ve chosen. We’re not like everyone. We live out in the woods in Fairfield County, CT. We homeschool our kids. We have sheep and goats and horses. Your kids will have a blast when they visit, but if you bring over your dog, it might be killed by our dogs. Just kidding on that last one. Kind of.
On the Long Gray Slog side, for me it’s basically what’s worked for the last several years, strategies that either harvest global betas in a cheap, efficient, preferably volatility-controlled way, or strategies that “play the player” in a trend-following or discretionary way. Especially the discretionary stuff, but then again I’m a discretionary global macro kind of guy. That’s who I am. Also, in a more or less permanently low growth world, any sort of secular growth and real cash flows from real economic activity is something to be treasured. See my “Hobson’s Choice” and “Cat’s Cradle” notes for more.
The Fire & Ice scenario is perhaps a little more contentious, but only because we’ve been living so completely in the Long Gray Slog for the past few years. My take on Fire & Ice is pretty simple. I want as close to direct ownership as possible of real assets with real cash flows. My definition of real assets is pretty broad, including not just the obvious choices like infrastructure and real estate, but also intellectual property and gold. Yes, I know that gold doesn’t have intrinsic cash flows. Neither does an insurance policy (which is what gold is against central bank error), and I like insurance. A lot of people are fans of Bitcoin and other cryptocurrencies for a Fire & Ice scenario. I’m not (you can read my views here). Basically I’m looking for maximum resiliency, what Nassim Taleb would call antifragile, in the jobs I want my portfolio holdings to perform in a Fire & Ice scenario. And remember, in my scenario, Fire comes last and it can go on and on. Bond holders beware. This is where the right discretionary calls on global macro, particularly on the short side where you get the timing right on long-volatility bets, can make a career. This is when you want Karnak on your team.
As an aside … well, not so much of an aside, because it’s central to the Epsilon Theory effort … this embrace of empathy and the true lessons of the past is exactly what our central bankers are NOT doing. I put a long quote by Joseph Schumpeter at the start of the note just to show that there have been some other really smart people in the past who suffered through really similar macro-economic situations and looked carefully at empirical evidence and came to diametrically opposed conclusions on what monetary policy should and shouldn’t do as a response. What we are told today is the Truth with a capital T in regards to monetary policy is nothing of the sort. It’s a particular sort of truth, an ex cathedra pronouncement by cultists like Ben Bernanke and his academic acolytes, cherrypicking historical data about the U.S. in the ‘30s or Japan in the ‘90s that fits their tautological world view and rejecting the rest, brooking no dissent. It’s a mongrel pack of policies that provides neither strength in fact nor strength in spirit to the citizens it’s supposed to support and protect. That’s a lot of mixed metaphors, but you get my point. And my disgust. Just remember that Greenspan used to be lauded as a hero, too. Today not so much. Today he’s the man who knew, as in the man who knew better. Okay, rant concluded for today.
Step Three: So I know what sort of portfolio I want for the sort of future scenarios I might encounter. I know what jobs I need filled in that portfolio and I’ve got a sense of the strategies that can best do those jobs. Now how do I choose between specific strategies or managers or what have you? How do I avoid that whole Curse of (Some) Talent thing? Here’s what I’m not doing. I’m not evaluating historical track records, projecting those into the future in some sort of crystal ball, capital markets return prediction effort, and then rolling those individual calculations up into some aggregate portfolio projection. I think that’s nuts. Instead, I’m asking whether the manager has a clear idea of what makes the strategy work (or not). What is the job that the manager performs and under what conditions does he or she perform it? Then I evaluate those claims in a Bayesian way. The most important evidence: did the manager do this job before? As advertised and for realz, not in a backtest. What was the investor experience within that prior job performance? How did it feel? Almost as important from a Bayesian perspective, does the manager have a stable, visible process? Does the process impose a discipline of sticking to the principles of the strategy come hell or high water, while also handling uncertainty and deviation in a calm and intellectually rigorous way? That’s how I judge real talent, the talent that ultimately matters most, in others and in myself. Fortune is fickle, even for the most talented. Experience and process never is.
The hardest part about Step Three is saying no to a talented manager, a good Rabbi for the strategy he administers, because the strategy doesn’t do the required job for the portfolio you actually have, as opposed to the portfolio you wish you had. In truth, that’s the hardest part about this entire process, the monomaniacal focus on what’s best for the portfolio as a whole, given the challenges it might face in the future. But in the same way that we require (or should require) discipline in our managers, we should absolutely require that discipline in ourselves as financial advisors or serious investors. It’s what creates a confident client/advisor relationship, it’s what creates a confident investor/manager relationship, it’s what turns any collection of individuals, man or beast, into a well-functioning pack.
Ultimately, that’s what we’re after here. The protection of the pack. It’s been the human animal’s source of strength, in both fact and spirit, for a couple of hundred thousand years now. I think we’re going to need it over the next few years, too.
Reader reaction to the March 31 Epsilon Theory note, “It’s Not About the Nail”, was probably the strongest and most positive for any note to date. The message in a nutshell: financial advisors of all stripes and sizes would be well-served to do more than serve up old-school diversification platitudes in this Brave New World of a bull market that everyone hates, and the behavioral insights of regret minimization are an effective framework for making that adaptation.
This is a message that bears repeating, and thanks to Institutional Investor that’s what’s happening. A condensed version of “It’s Not About the Nail” can be found on the Institutional Investor website here, that piece will appear in the print magazine later this month in their “Unconventional Wisdom” column, and I’ve appended it below.
I think the reason this message strikes a chord is that it not only puts into words what a lot of people are feeling in an inchoate fashion, but also suggests a toolkit for improving the strained dialog between advisors and investors. It’s possible to take our tried and tested (but tired) notions of portfolio construction and energize them with the tools of game theory and behavioral economics, so that we get to the meaning of words like “diversification” and “de-risking”.
In the note I presented one way of thinking about all this in simple graphical terms, by taking the historical risk and reward of a portfolio or a subset of a portfolio and just seeing what the impact of a diversifying strategy would actually have been as seen in risk/reward space.
The goal here is to move the original portfolio (the gold ball) up and to the left into the green triangle that marries both the traditional meaning of diversification (maximization of reward per unit of risk) and the behavioral meaning of de-risking in a bull market (minimization of the risk of underperformance). There ARE strategies that accomplish this goal, but the trick is finding the strategies that do this for the actual portfolio you have today, not some hypothetical portfolio or index.
We’ve built a set of tools at Salient within our systematic strategies group to analyze the historical impact of a wide range of diversifying strategies from a wide range of asset managers on actual portfolios, and then to map the impact of various diversifying strategies in risk/reward space. It’s not rocket science, and I’m sure any number of Epsilon Theory readers could develop a similar toolkit, but we’ve found it to be a very useful process for not only evaluating, but also communicating how diversifying strategies can make an existing portfolio better for an investor’s needs. Sometimes Salient strategies show up well in this analysis; sometimes they don’t. If you’re familiar with the Progressive Car Insurance commercials with Flo, you get the idea. If you’re an investment professional and/or financial advisor with a portfolio you’d like to have analyzed in this manner, reply to this email or drop me a note at firstname.lastname@example.org , and I’d be delighted to set it up for you.
As with all things Epsilon Theory-related, there’s no fee or obligation associated with this analysis. Thanks again to my partners and colleagues here at Salient for their commitment to releasing useful intellectual property into the wild. I think it’s a smart, non-myopic view of what it means to be an asset manager in the modern age, but a rare bird nonetheless.
There’s a massive disconnect between advisors and investors today, and it’s reflected in both declining investment activity as well as a general fatigue with the consultant-client conversation. Consultants continue to preach the faith of diversification, and their clients continue to genuflect in its general direction. But diversification as it’s currently preached is perhaps the most oversold concept in financial advisor-dom, and the sermon isn’t connecting. Fortunately, behavioral economics offers a fresh perspective on portfolio construction, one that lends itself to what we call Adaptive Investing.
Investors aren’t asking for diversification, which isn’t that surprising after six years of a bull market. Investors only ask for diversification after the fire, as a door-closing exercise when the horse has already left the burning barn. What’s surprising is that investors are asking for de-risking, similar in some respects to diversification but different in crucial ways. What’s also surprising is that investors are asking for de-risking rather than re-risking, which is what you’d typically expect at this stage of such a powerful bull market.
Why is this the most mistrusted bull market in recorded history? Because no one thinks it’s real. Everyone believes that it’s a by-product of outrageously extraordinary monetary policy actions rather than the by-product of fundamental economic growth and productivity — and what the Fed giveth, the Fed can taketh away.
This is a big problem for the Federal Reserve, as its efforts to force greater risk-taking in markets through large-scale asset purchases and quantitative easing have failed to take hold in investor hearts and minds. Yes, we’re fully invested, but just because we have to be. To paraphrase the old saying about beauty, risk-taking is only skin deep for today’s investor, but risk-aversion goes clear to the bone.
It’s also the root of our current adviser-investor malaise. How so? Because de-risking a bull market is a very different animal than de-risking a bear market. As seen through the lens of behavioral economics, de-risking is based on regret minimization (not risk–reward maximization like diversification), and the simple fact is that regret minimization is driven by peer comparisons in a bull market. In a bear market your primary regret — the thing you must avoid at all costs — is ruin, and that provokes a very direct physical reaction. You can’t sleep. And that’s why de-risking Rule No. 1 in a bear market is so simple: Sell until you can sleep at night. Go to cash.
In a bull market, your primary regret is looking or feeling stupid, and that provokes a very conflicted, very psychological reaction. You want to de-risk because you don’t understand this market, and you’re scared of what will happen when the policy ground shifts. But you’re equally scared of being tagged “a panicker” and missing “the greatest bull market of this or any other generation.” And so you do nothing. You avoid making a decision, which means you also avoid the consultant-client conversation. Ultimately everyone — advisor and investor alike — looks to blame someone else for their own feelings of unease. No one’s happy, even as the good times roll.
So what’s to be done? Is it possible to both de-risk a portfolio and satisfy the regret minimization calculus of a bull market?
In fact, our old friend diversification is the answer, but not in its traditional presentation as a cure-all bromide. Diversification can certainly de-risk a portfolio by turning down the volatility, and it’s well suited for a bull market because it can reduce volatility without reducing market exposure. The problem is that diversification can take a long time to prove itself, and that’s rarely acceptable to investors who are seeking the immediate portfolio impact of de-risking, whether it’s the bear market or bull market variety.
What we need are diversification strategies that can react quickly. That brings me back to adaptive investing, which has two relevant points for de-risking in a bull market.
First, your portfolio should include allocations to strategies that can go short. If you’re de-risking a bull market, you need to make money when you’re right, not just lose less money. Losing less money pays off over the long haul, but the path can be bumpy.
Second, your portfolio should include allocations to trend-following strategies, which keep you in assets that are working and get you out of those that aren’t. The market is always right, and that’s never been more true — or more difficult to remember — than now in the Golden Age of the Central Banker.
– Yoda, “Star Wars: Episode V – The Empire Strikes Back” (1980)
I see it all perfectly; there are two possible situations – one can either do this or that. My honest opinion and my friendly advice is this: do it or do not do it – you will regret both. – Soren Kierkegaard, “Either/Or: A Fragment of Life” (1843)
The only victories which leave no regret are those which are gained over ignorance. – Napoleon Bonaparte (1769 – 1821)
Maybe all one can do is hope to end up with the right regrets. – Arthur Miller, “The Ride Down Mt. Morgan” (1991)
Of all the words of mice and men, the saddest are, “It might have been.” – Kurt Vonnegut, “Cat’s Cradle” (1963)
One can’t reason away regret – it’s a bit like falling in love, fall into regret. – Graham Greene, “The Human Factor” (1978)
I bet there’s rich folks eatin’
In a fancy dining car.
They’re probably drinkin’ coffee
And smokin’ big cigars.
Well I know I had it comin’.
I know I can’t be free.
But those people keep-a-movin’
And that’s what tortures me.
– Johnny Cash, “Folsom Prison Blues” (1955)
Regrets…I’ve had a few.
But then again, too few to mention.
– Paul Anka, Frank Sinatra “My Way” (1969)
The Moving Finger writes; and, having writ, Moves on: nor all thy Piety nor Wit Shall lure it back to cancel half a Line, Nor all thy Tears wash out a Word of it. – Omar Khayyam, “Rubaiyat” (1048 – 1141)
You can tell it any way you want but that’s the way it is. I should of done it and I didn’t. And some part of me has never quit wishin’ I could go back. And I can’t. I didn’t know you could steal your own life. And I didn’t know that it would bring you no more benefit than about anything else you might steal. I think I done the best with it I knew how but it still wasn’t mine. It never has been.” – Cormac McCarthy, “No Country for Old Men” (2005)
Yeah, right, well, great. So listen, so here’s the deal. This is what we should do. You should get off the train with me here in Vienna, and come check out the capital.
Come on. It’ll be fun. Come on.
What would we do?
Umm, I don’t know. All I know is I have to catch an Austrian Airlines flight tomorrow morning at 9:30 and I don’t really have enough money for a hotel, so I was just going to walk around, and it would be a lot more fun if you came with me. And if I turn out to be some kind of psycho, you know, you just get on the next train.
Alright, alright. Think of it like this: jump ahead, ten, twenty years, okay, and you’re married. Only your marriage doesn’t have that same energy that it used to have, y’know. You start to blame your husband. You start to think about all those guys you’ve met in your life and what might have happened if you’d picked up with one of them, right? Well, I’m one of those guys. That’s me, y’know, so think of this as time travel, from then, to now, to find out what you’re missing out on. See, what this really could be is a gigantic favor to both you and your future husband to find out that you’re not missing out on anything. I’m just as big a loser as he is, totally unmotivated, totally boring, and, uh, you made the right choice, and you’re really happy.
Let me get my bag.
– Richard Linklater, “Before Sunrise” (1995)
For it falls out That what we have we prize not to the worth Whiles we enjoy it, but being lacked and lost, Why, then we rack the value, then we find The virtue that possession would not show us While it was ours. – William Shakespeare, “Much Ado About Nothing” (1612)
When to the sessions of sweet silent thought I summon up remembrance of things past, I sigh the lack of many a thing I sought, And with old woes new wail my dear time’s waste: – William Shakespeare, “Sonnet 30” (1609)
No, I don’t have a gun.
– Nirvana, “Come As You Are” (1992)
I spend a lot of my time speaking with investors and financial advisors of all stripes and sizes, and here’s what I’m hearing, loud and clear. There’s a massive disconnect between advisors and investors today, and it’s reflected in both declining investment activity as well as a general fatigue with the advisor-investor conversation. I mean “advisor-investor conversation” in the broadest possible context, a context that should be recognizable to everyone reading this note. It’s the conversation of a financial advisor with an individual investor client. It’s the conversation of a consultant with an institutional investor client. It’s the conversation of a CIO with a Board of Directors. It’s the conversation of many of us with ourselves. The wariness and weariness associated with this conversation runs in both directions, by the way.
Advisors continue to preach the faith of diversification, and investors continue to genuflect in its general direction. But the sermon isn’t connecting. Investors continue to express their nervousness with the market and dissatisfaction with their portfolio performance, and advisors continue to nod their heads and say they understand. It reminds me of Jason Headley’s brilliant short film, “It’s Not About the Nail”, with the advisor reprising Headley’s role. Yes, the advisor is listening. But most find it impossible to get past what they believe is the obvious answer to the obvious problem. Got a headache? Take the nail out of your head. Nervous about the market? Diversify your portfolio. But there are headaches and then there are headaches. There is nervousness and then there is nervousness. It’s not about the nail, and the sooner advisors realize this, the sooner they will find a way to reconnect with their clients. Even if it’s just a conversation with yourself.
Investors aren’t asking for diversification, which isn’t that surprising after 6 years of a bull market. Investors never ask for diversification after 6 years of a bull market. They only ask for it after the Fall, as a door-closing exercise when the horse has already left the burning barn. What’s surprising is that investors are asking for de-risking, similar in some respects to diversification but different in crucial ways. What’s surprising is that investors are asking for de-risking rather than re-risking, which is what you’d typically expect at this stage of such a powerful bull market.
Investors are asking for de-risking because this is the most mistrusted bull market in recorded history, a market that seemingly everyone wants to fade rather than press. Why? Because no one thinks this market is real. Everyone believes that it’s a by-product of outrageously extraordinary monetary policy actions rather than the by-product of fundamental economic growth and productivity, and what the Fed giveth … the Fed can taketh away.
This is a big problem for the Fed, as their efforts to force greater risk-taking in markets through LSAP and QE (and thus more productive risk-taking, or at least inflation, in the real economy) have failed to take hold in investor hearts and minds. Yes, we’re fully invested, but only because we have to be. To paraphrase the old saying about beauty, risk-taking is only skin deep for today’s investor, but risk-aversion goes clear to the bone.
It’s also the root of our current advisor-investor malaise. De-risking a bull market is a very different animal than de-risking a bear market. And neither is the same as diversification.
Let’s take that second point first.
Here’s a simple representation of what diversification looks like, from a risk/reward perspective.
For illustrative purposes only.
The gold ball is whatever your portfolio looks like today from a historical risk/reward perspective, and the goal of diversification is to move your portfolio up and to the left of the risk/reward trade-off line that runs diagonally through the current portfolio position. Diversification is all about increasing the risk/reward balance, about getting more reward per unit of risk in your portfolio, and the goodness or poorness of your diversification effort is defined by how far you move your portfolio away from that diagonal line. In fact, as the graph below shows, each of the Good Diversification outcomes are equally good from a risk/reward balance perspective because they are equally distant from the original risk/reward balance line, and vice versa for the Poor Diversification outcomes.
For illustrative purposes only.
Diversification does NOT mean getting more reward out of your portfolio per se, which means that some Poor Diversification changes to your portfolio will outperform some Good Diversification changes to your portfolio over time (albeit with a much bumpier ride).
For illustrative purposes only.
It’s an absolute myth to say that any well-diversified portfolio will outperform all poorly diversified portfolios over time. But it’s an absolute truth to say that any well-diversified portfolio will outperform all poorly diversified portfolios over time on a risk-adjusted basis. If an investor is thinking predominantly in terms of risk and reward, then greater diversification is the slam-dunk portfolio recommendation. This is the central insight of Harry Markowitz and his modern portfolio theory contemporaries, and I’m sure I don’t need to belabor that for anyone reading this note.
The problem is that investors are not only risk/reward maximizers, they are also regret minimizers (see Epsilon Theory notes “Why Take a Chance” and “The Koan of Donald Rumsfeld” for more, or read anything by Daniel Kahneman). The meaning of “risk” must be understood as not only as the other side of the reward coin, but also as the co-pilot of behavioral regret. That’s a mixed metaphor, and it’s intentional. The human animal holds two very different meanings for risk in its brain simultaneously. One notion of risk, as part and parcel of expected investment returns and the path those returns are likely to take, is captured well by the concept of volatility and the toolkit of modern economic theory. The other, as part and parcel of the psychological utility associated with both realized and foregone investment returns, is captured well by the concepts of evolutionary biology and the toolkit of modern game theory.
The problem is that diversification can only be understood as an exercise in risk/reward maximization, has next to nothing to say about regret minimization, and thus fails to connect with investors who are consumed by concerns of regret minimization. This fundamental miscommunication is almost always present in any advisor-investor conversation, but it is particularly pernicious during periods of global debt deleveraging as we saw in the 1870’s, the 1930’s, and today. Why? Because the political consequences of that deleveraging create investment uncertainty in the technical, game theoretic sense, an uncertainty which is reflected in reduced investor confidence in the efficacy of fundamental market and macroeconomic factors to drive market outcomes. In other words, the rules of the investment game change when politicians attempt to maintain the status quo – i.e., their power – when caught in the hurricane of a global debt crisis. That’s what happened in the 1870’s. That’s what happened in the 1930’s. And it’s darn sure happening today. We all feel it. We all feel like we’ve entered some Brave New World where the old market moorings make little sense, and that’s what’s driving the acute anxiety expressed today by investors both large and small. Recommending old-school diversification techniques as a cure-all for this psychological pain isn’t necessarily wrong. It probably won’t do any harm. But it’s not doing anyone much good, either. It’s not about the nail.
On the other hand, the concept of de-risking has a lot of meaning within the context of regret minimization, which makes it a good framework for exploring a more psychologically satisfactory set of portfolio allocation recommendations. But to develop that framework, we need to ask what drives investment regret. And just as we talk about different notions of volatility-based portfolio constructions under different market regimes, so do we need to talk about different notions of regret-based portfolio constructions under different market regimes.
Okay, that last paragraph was a bit of a mouthful. Let me skip the academic-ese and get straight to the point. In a bear market, regret minimization is driven by existential concerns. In a bull market, regret minimization is driven by peer comparisons.
In a bear market your primary regret – the thing you must avoid at all costs – is ruin, and that provokes a very direct, very physical reaction. You can’t sleep. And that’s why Rule #1 of de-risking in a bear market is so simple: sell until you can sleep at night. Go to cash. Here’s what de-risking in a bear market looks like, as drawn in risk/reward space.
For illustrative purposes only.
Again, the gold ball is whatever your portfolio looks like today from a historical risk/reward perspective. De-risking means moving your portfolio to the left, i.e. a lower degree of risk. The question is how much reward you are forced to sacrifice for that move to the left. Perfect De-Risking sacrifices zero performance. Good luck with that if you are reducing your gross exposure. Average De-Risking is typically accomplished by selling down your portfolio in a pro rata fashion across all of your holdings, and that’s a simple, effective strategy. Good De-Risking and Poor De-Risking are the result of active choices in selling down some portion of your portfolio more than another portion of your portfolio, or – if you don’t want to go to cash – replacing something in your portfolio that’s relatively volatile with something that’s relatively less volatile.
In a bull market, on the other hand, your primary regret is looking or feeling stupid, and that provokes a very conflicted, very psychological reaction. You want to de-risk because you don’t understand this market, and you’re scared of what will happen when the policy ground shifts. But you’re equally scared of being tagged with the worst possible insults you can suffer in our business: “you’re a panicker” … “you missed the greatest bull market of this or any other generation”. Again, maybe this is a conversation you’re having with yourself (frankly, that’s the most difficult and conflicted conversation most of us will ever have). And so you do nothing. You avoid making a decision, which means you also avoid the advisor-investor conversation. Ultimately everyone, advisor and investor alike, looks to blame someone else for their own feelings of unease. No one’s happy, even as the good times roll.
So what’s to be done? Is it possible to both de-risk a portfolio and satisfy the regret minimization calculus of a bull market?
Through the lens of regret minimization, here’s what de-risking in a bull market looks like, again as depicted in risk/reward space:
For illustrative purposes only.
Essentially you’ve taken all of the bear market de-risking arrows and moved them 45 degrees clockwise. What would be Perfect De-Risking in a bear market is only perceived as average in a bull market, and many outcomes that would be considered Good Diversification in pure risk/reward terms are seen as Poor De-Risking. I submit that this latter condition, what I’ve marked with an asterisk in the graph above, is exactly what poisons so many advisor-investor conversations today. It’s a portfolio adjustment that’s up and to the left from the diagonal risk/reward balance line, so you’re getting better risk-adjusted returns and Good Diversification – but it’s utterly disappointing in a bull market as peer comparison regret minimization takes hold. It doesn’t even serve as a Good De-Risking outcome as it would in a bear market.
Now here’s the good news. There are diversification outcomes that overlap with the bull market Good De-Risking outcomes, as shown in the graph below. In fact, it’s ONLY diversification strategies that can get you into the bull market Good De-Risking area. That is, typical de-risking strategies look to cut exposure, not replace it with equivalent but uncorrelated exposure as diversification strategies do, and you’re highly unlikely to improve the reward profile of your portfolio (moving up vertically from the horizontal line going through the gold ball) by reducing gross exposure. The trick to satisfying investors in a bull market is to increase reward AND reduce volatility. I never said this was easy.
For illustrative purposes only.
The question is … what diversification strategies can move your portfolio into this promised land? Also (as if this weren’t a challenging enough task already), what diversification strategies can work quickly enough to satisfy a de-risking calculus? Diversification can take a long time to prove itself, and that’s rarely acceptable to investors who are seeking the immediate portfolio impact of de-risking, whether it’s the bear market or bull market variety.
What we need are diversification strategies that can act quickly. More to the point, we need strategies that can react quickly, all while maintaining a full head of steam with their gross exposure to non-correlated or negatively-correlated return streams. This is at the heart of what I’ve been calling Adaptive Investing.
Epsilon Theory isn’t the right venue to make specific investment recommendations. But I’ll make three general points.
First, I’d suggest looking at strategies that can go short. If you’re de-risking a bull market, you need to make money when you’re right, not just lose less money. Losing less money pays off over the long haul, but the long haul is problematic from a regret-based perspective, which tends to be quite path-sensitive. Short positions are, by definition, negatively correlated to the thing that they’re short. They have a lot more oomph than the non-correlated or weakly-correlated exposures that are at the heart of most old-school diversification strategies, and that’s really powerful in this framework. Of course, you’ve got to be right about your shorts for this to work, which is why I’m suggesting a look at strategies that CAN go short as an adaptation to changing circumstances, not necessarily strategies that ARE short as a matter of habit or requirement.
Second, and relatedly, I’d suggest looking at trend-following strategies, which keep you in assets that are working and get you out of assets that aren’t (or better yet, allow you to go short the assets that aren’t working). Trend-following strategies are inherently behaviorally-based, which is near and dear to the Epsilon Theory heart, and more importantly they embody the profound agnosticism that I think is absolutely critical to maintain when uncertainty rules the day and fundamental “rules” change on political whim. Trend-following strategies are driven by the maxim that the market is always right, and that’s never been more true – or more difficult to remember – than here in the Golden Age of the Central Banker.
Third, these graphs of portfolio adjustments in risk/reward space are not hypothetical exercises. Take the historical risk/reward of your current portfolio, or some portion of that portfolio such as the real assets allocation, and just see what the impact of including one or more liquid alternative strategies would be over the past few years. Check out what the impact on your portfolio would be since the Fed and the ECB embarked on divergent monetary policy courses late last summer, creating an entirely different macroeconomic regime. Seriously, it’s not a difficult exercise, and I think you’ll be surprised at what, for example, a relatively small trend-following allocation can do to de-risk a portfolio while still preserving the regret-based logic of managing a portfolio in a bull market. For both advisors and investors, this is the time to engage in a conversation about de-risking and diversification, properly understood as creatures of regret minimization as well as risk/reward maximization, rather than to avoid the conversation. As the old saying goes, risk happens fast. Well … so does regret.