September 2018
Part 1: The Markowitz Contradiction
Here is a common message: “Core investments are overvalued. In the following graph, the orange line is all the wealth that has been created in the U.S. (nominal GDP), and the blue line is all the wealth Americans think they own (U.S. household net worth) – both normalized in 1951. How can our wealth grow faster than the total wealth that we create? We may be fooling ourselves. It may be a bubble.”
Part 2: Fooled by the Wrapper I: Many long/short alternative strategies are just expensive beta
This is the first entry in what will be a recurring theme: a lot of so-called alternative investments really just provide core stock and bond exposure in an alternative wrapper. By “wrapper,” we mean the category, the name, the investment vehicle, etc. Unlike the wrapper, it is the behavior of an investment that determines its effect on investor outcomes – don’t be fooled by the wrapper. Throughout this series on portfolio construction, we will unwrap several of these so-called alternatives to expose simple core behavior driving their results.
Part 3: Performance rankings have generally proven worthless
Morningstar and others have developed an industry around categorizing and ranking funds. However, the endeavor is not as useful as most people think. The data indicate that the statement “past performance does not guarantee future results” should be amended to “past performance has very little to do with future results.” Funds that have been highly rated have been scattered throughout the rankings in subsequent time periods.
Part 4: Measuring and budgeting risk
Most investors reject the notion of “market timing,” even though many of those same investors time the market but just call it “keeping dry powder” or “moving into defensive sectors.” At the end of the day, does it really matter what label is given to a particular investment behavior, so long as it works? This installment will explain how, over the past 70 years, measuring the amount of RISK in an investment has been much more effective than just measuring the amount of MONEY in an investment. And the key measure of risk is volatility.
Part 5: Fooled by the Wrapper II: Your “Market Neutral” alternative may be just SPY and TLT
In the second installment of this series on portfolio construction, we showed how some long/short equity alternative strategies have provided little more than expensive beta. In this installment, we will continue this theme by stripping away the wrapper on some market neutral alternative investments to expose the core stock and bond exposures dominating their returns. By wrapper, we mean the category, the name, the investment vehicle, etc. Unlike the wrapper, it is the behavior of an investment that determines its effect on investor outcomes – don’t be fooled by the wrapper.
Part 6: Expenses should be risk-adjusted, just like returns
Which of the following two liquid alternative investments is better? Assume anything not specified here is exactly the same. Investment 1: 5% annualized return (gross of expenses), 10% annualized volatility, 0.10% total expense ratio. Investment 2: 10% annualized return (gross of expenses), 20% annualized volatility, 2.00% total expense ratio. Most investors think the answer is Investment 1 because it is safer and cheaper. Congratulations to readers who correctly picked Investment 2. It’s not a matter of opinion or style or preference or investment targets; it’s just simple arithmetic. And this wasn’t a trick question; the second one is better even in a zero interest rate environment. That’s not a typo; the second one is better, even though the first one has a Sharpe ratio of 0.49, and the second one has a Sharpe ratio of 0.40, with a risk-free rate of 0%.
Part 7: If you are properly diversified, you will always hate at least one of your investments
If every investment in a portfolio wins at the same time, then there is a reasonable chance every investment will lose at the same time too. Proper diversification means something is losing, or significantly underperforming, most of the time. That’s not a sign of a problem or an investment that needs to be jettisoned; it is a sign of proper portfolio construction. The alternative is performance chasing, moving into whatever has been winning, generally over the past 1-, 3-, 5-, or 10-year period. Performance chasing isn’t just useless; it may be harmful.
Part 8: Fooled by the Wrapper III: Real estate has behaved a lot like the equity market
Real estate investments have behaved very much like the equity market. Let’s consider why this may make sense. Companies, whether they are publicly traded corporations or private real estate investment companies, have property: intellectual property, employee time and effort, factories, office buildings, farmland, etc. Those companies generate cash flows from their property. The net present values of all of the expected future cash flows of those companies have been affected similarly by economic outlooks and interest rates. Economic outlooks affect how large those cash flows may be, and interest rates affect how the cash flows are discounted to present value. That has been true whether the cash flows were generated by licensing intellectual property or by collecting rent on an office building. In other words, changes in the fundamental prices of stocks and real estate investments share significant drivers.
Part 9: The Active vs. Passive debate is a red herring
Despite the endless TV time and column inches devoted to this lively debate, it is at best a waste of time. Everyone is active. It’s a question of how much, not if. Every portfolio has been actively managed. Furthermore, the frameworks and benchmarks of portfolios are often actively managed. Finally, the components of portfolios are actively managed.
Part 10: Timing capital gains taxes is the same as timing the market
With nothing but respect for Tax Professionals, we must admit that it isn’t easy to make this topic interesting, so we did the next best thing and kept this installment short. It may still be worth a read for those who have considered tax loss “harvesting” or who aren’t invested in what they consider to be an ideal portfolio in order to avoid realizing gains and paying taxes. There is one quick caveat before continuing: this installment deals only with investment timing decisions, given a fixed tax rate, not with the potential consequences of anything that might alter the effective tax rate.
Part 11: Fooled by the Wrapper IV: Option collar overlay strategies may be worse than just selling stock
Option collar overlay managers have a great sounding pitch: “Purchasing a put option defines and limits downside risk. Selling a call option finances the purchase of the put option. That way, a long stock position can have defined, limited downside risk as a long-term investment strategy.” These pitches usually come with good looking payout-at-option-expiration diagrams.
Part 12: Fooled by the Wrapper V: Private Equity and Direct Lending have mostly just been Leveraged Stocks and Bonds
Some investors favor private equity and direct lending over, or as diversification for, public equity and more liquid bond issuances. The reasons tend to include perceived diversification, reduced volatility, and an illiquidity premium. However, many private equity and direct lending strategies are not marked to market daily, so the perceived diversification and reduced volatility were mostly an illusion arising from infrequent pricing. Simply put, the perception of stability was often just the result of stale pricing. In other words, as an extreme example, it doesn’t make sense to assume a privately held company that was worth $100 million at a valuation event on June 30, 2007 is still worth $100 million on December 31, 2008 just because it hadn’t had another valuation event. It doesn’t make any more sense than using the price of the S&P 500 on June 30, 2007 to value a portfolio in the depths of the Financial Crisis.
Part 13: How a low beta can mask a high correlation
A low beta has become a key indicator for selecting alternative investments. However, a low beta can come from one, or both, of two sources: a low correlation or a low volatility. As we illustrate in the “low correlation” section below, a low beta due to a low correlation has been very useful. However, we show in the “high correlation” section that a low beta due to a combination of a high correlation with low volatility has been detrimental to portfolios. Therefore, it is important to look past a low beta and identify the reason for it.
Part 14: Fooled by the Wrapper VI: Convertible bonds have mostly just provided core exposure
Convertible bonds may sound pretty good. If equity prices drop, investors have the security of a bond. If equity prices rally, that bond can be converted into equity, allowing investors to participate in the rally. The supposed ability to participate only in the upside of equity rallies is found in other instruments as well, especially equity “call” options. In other words, a convertible bond is part bond and part equity call option, and it is priced as such.
Part 15: Everyone is a long-term investor, until volatility hits
A worthwhile goal in portfolio construction is seeking to maximize the reward for each dollar put at risk. Return is widely agreed upon as the best measurement of portfolio reward (and it’s true, of course), so we won’t spend any more time on it. However, some investors object to the use of volatility as the measurement of portfolio risk.
Part 16: The discretionary vs. systematic debate
There are numerous ways to evaluate discretionary vs. systematic investing. What follows is a brief survey of some of the more interesting data, organized into two sections: Discretionary decisions (Security selection, Market timing) and Systematic decisions (Security selection, Market timing). Generally speaking, systematic decisions have had the potential to improve results while discretionary decisions have hurt results, sometimes quite significantly. No method of addressing this debate is perfect, and legitimate criticisms have been leveled at all of them, including some of the data we present below. We do not delve into the criticisms in this brief survey. Although some of them are legitimate, in our view they are not sufficient to overcome the lopsidedness of the data and swing the conclusion away from systematic decision-making.
Part 17: Fooled by the Wrapper VII: Many long/short credit strategies have effectively just been long-only bond allocations
Many long/short credit strategies have been driven primarily by their net long exposure. As a result of primarily providing a net long exposure, these long/short credit “alternatives” have behaved much like simple long bond exposure. In other words, many long/short credit “alternatives” have mostly just provided expensive core exposure. In this way, they are analogous to many long/short equity strategies, which have mostly just provided simple long equity exposure, covered in installment 2.
Part 18: Superficial diversification may hide concentrated equity bets
In 2009, Warren Buffett famously made “an all-in wager on the economic future of the United States. “In 2019, many investors don’t realize they are making the same wager, but after the recovery and after 10 years of abnormally high equity returns.”
Part 19: Maximizing reward for every dollar put at risk
Modern Portfolio Theory (MPT) has come under criticism in some circles for not providing the expected diversification, especially in crises. However, installment 18 demonstrated that the problem is largely the addition of cash and equity behavior to portfolio components that were meant to be different from equity behavior. In other words, it was largely a problem of implementation, not theory. This installment will explain the basic concepts and implement the theory properly using just equity behavior and interest rate behavior and compare it to the 60/40 (give or take) portfolio used by many investors.
Part 20: The Value of Alternative Investments
This installment builds on installment 19 by constructing portfolios with the addition of two more behaviors to the equity behavior (“SPY”) and interest rate behavior (“TLT”) of installment 19. We will test several possible complementary investments. The test is simple. Because their purpose will be to complement the equity behavior dominating most portfolios, we will look for investments with low correlations to equity behavior. The test is correlation, not beta, in line with installment 13.
Part 21: Leverage has been a poor measure of risk but a useful tool for setting risk
This installment begins briefly with some comments on leverage as a poor measure of risk, and then it uses real-world sources of leverage (including their costs) as a tool to set risk.
Part 22: Garbage in, garbage out
Thus far in this series on portfolio construction, the portfolios have been constructed with the benefit of hindsight. Preparing for the future adds elements of uncertainty. If the past has nothing to do with the future, then using the past as an input to guide allocations for the future may not help. That’s essentially what is meant by “garbage in, garbage out.” However, that potential problem exists with any method of investing and should not discourage this one. After all, over time, true diversification has worked better than concentrated bets in whatever has performed well over the past few years. In other words, everyone is using the past to predict the future, but not everyone is doing it wisely. Fortunately, the discussion doesn’t have to end there. There are some lessons that can be learned from consideration of the known knowns, the known unknowns, and the unknown unknowns.
Part 23: Alpha and various other MPT stats are often used to rationalize performance chasing
In the previous installments, we have constructed portfolios which were significantly better than “60/40.” What is noteworthy for this installment is that it was done with just 4 benchmark behaviors. These were not the best performing versions of strategies, with significant alpha and improved risk features. They were fairly commonly available benchmarks. In fact, nothing whatsoever in this series has used alpha at all. There’s a reason for that. At most, it barely matters. Alpha may not exist, and, even if it does exist, it may be too hard to identify reliably. Diversification, on the other hand, has been identifiable and extremely helpful.
Part 24: Results, Rebuttals, and Closing Summary
Installments 19-23 explored a simple approach to a better method of portfolio construction that was first published over half a century ago: 1. Maximize the reward for every dollar put at risk in a portfolio. 2. Scale all allocations up or down to target a desired level of overall risk.
