December 2019
Part 1: Introduction: Concerned about the Possible Stagnation of U.S. markets?
Over the 30-year period from 1989 to 2018, Japan’s Nikkei 225 stock index was down 33.6% (-1.4% annualized, not including dividends). We are not predicting those numbers in the U.S. over the next 30 years, but we are simply noting that extended disappointments are possible in developed-economy stock markets. This introduction is the first installment in a short series on some possibilities that investors, who have lowered their expectations to realistic outlooks for stocks and bonds over the next decade, may want to consider for partial equity replacement.
Part 2: Short Volatility
Many pensions and large institutions are ahead of the curve on this one. They have been using short volatility exposure as an equity replacement for some time, as it has often produced a similar return profile to equities while tying up less capital than an equity investment sized to similar risk levels. However, shorting volatility has had the potential to deliver an additional source of return, in addition to some inherent equity-like exposure. Over time, the price of volatility instruments (called “implied volatility”) has generally exceeded the payout of volatility instruments (called “realized volatility”). These inflated prices, compared to payouts, have created an opportunity to win over the long-term from shorting volatility instruments. Some short volatility strategies layer this potential source of return on top of equity-like exposure, for the possibility of outperforming equities in some market environments.
Part 3: High Yield Bonds
Proponents of high yield bonds often suggest they make good long-term equity replacements because they have offered equity-like return profiles with reduced swings. We disagree, when it comes to the long-term. Equity-like return profiles with reduced swings in both directions have mostly just meant that more capital had to be tied up in high yield bonds to achieve the same result for a portfolio than had to be tied up in equities. However, for investors expecting ~3% returns from equities, that longterm critique may not apply to the next decade. Currently, high yield bonds have about 5% yields, possibly making them worthy of consideration as replacements for part of a portfolio’s equity exposure.
Part 4: International Equities
The Shiller CAPE ratio in the U.S. (specifically on the S&P 500) is historically high, but that doesn’t mean it is high around the world. International equities have generally performed worse than U.S. equities over the past few years, and that is partially due to the fact that international equities have generally not grown as expensive as U.S. equities over that same time frame. A glance at CAPE ratios around the world shows figures of 8 and up, and indicates the possibility (although CAPE ratios bring no certainty, of course) of better results over the next decade from some international equity markets.
Part 5: Equity Factors
There are a select few equity “factors” which have shown outperformance over long in-sample backtests and also achieved outperformance in out-sample tests and realized results. Investors who are convinced that a factor (or factors) works over the long-term may consider a long-only (or net long) equity factor exposure. The MSCI USA Diversified Multi-Factor Index (M2WODV Index) uses systematic exposure to the value, momentum, quality, and size factors. As with all the other choices in this series, it was selected simply for illustration purposes, in part due to its systematic nature and published methodology, not as any sort of endorsement.
Part 6: Managed Futures
Trend-following managed futures strategies often have the ability to take both long and short positions in various asset classes, typically including equities, fixed income, currencies, and commodities. Those features have given managed futures strategies the potential to generate favorable returns in various (trending) market conditions, including both upward and downward trending equity markets. The Credit Suisse Managed Futures Index (HEDGFUTR Index) is an index composed of various actual managed futures strategies. As with all the other choices in this series, it was selected simply for illustration purposes, not as any sort of endorsement.
Part 7: Long Volatility
In the first installment, we noted that, at the time this series was written, the S&P 500 Shiller cyclicallyadjusted price to earnings ratio (CAPE) was approximately 30 (of course, that can change quickly), and that value has historically indicated a next 10-year annualized return for the S&P 500 of about 3%. The last time the S&P 500 Shiller CAPE was about 30 was near the beginning of 2002. Over the next decade (2002-2011), the S&P 500 annualized return was 2.9%. This installment will focus on the possibility of increasing the equity return by very simply increasing the equity exposure, but while also attempting to mitigate the drawdowns otherwise associated with larger equity exposure.
Part 8: U.S. Treasuries
In the first installment, we noted that, at the time this series was written, the 10-year U.S. Treasury yield was only about 1.5%. We also noted that the 10-year yield has been a decent indicator of the upcoming annualized return over the next 10 years. Should investors even bother with U.S. Treasuries? Should they even bother with any duration risk? It’s tempting to answer no. However, this installment will present the sometimes overlooked counter arguments, the arguments for keeping U.S. Treasuries and duration risk. To be clear, the purpose of this installment is not to argue against any adjustments to treasury exposure. Some adjustments likely make sense. The purpose is just to present the case against completely jettisoning U.S. Treasuries and duration risk.
Part 9: Conclusion
The conclusion can be summed up in one word: diversification. In installments 2-5, we presented several ideas for U.S. equity replacements with the potential to outperform equities in certain market environments, perhaps environments such as decades of low equity returns. These ideas had return profiles generally similar to the return profile of the S&P 500. Then, in installments 6-8, we presented several ideas for allocations which may be well-suited to complement equity allocations. These ideas had return profiles generally quite different from the return profile of the S&P 500
