Making better investment decisions

US Equity Market 9 Years of Advancement

/ Kiwi Investor / 1 Comment

The US equity market recently celebrated 9 years of advancement without a bear market (a Bear market is defined as an equity market decline of greater than 20% from its peak).

This 9 year Bull market is closing in on the historical record of 9 years and five and half months.  The longest post-war Bull market stretched from 11 October 1990 to 24 March 2000.  To break that record the current Bull market will have to continue until the last week of August 2018.

The US equity market experienced a “correction” in February 2018 (a correction is defined as a fall in market value of between 10 and 20%) on inflation and higher interest rate concerns.  I wrote about this in this blog and also put into historical perspective here and here.  

 

Bull markets end with a Bear market.  Bear markets usually coincide with recession.  Very rarely has there been a Bear Equity Market without recession.  Nevertheless, there have been bear markets without a recession.

Fortunately the global economy has good momentum and recession does not look imminent. Most economic forecasts are for economic growth throughout 2018 and into 2019.

Albeit, the current Bull market does face some risks.  Key amongst those risks are:

  • Earnings disappointment in 2019. Earnings momentum is vulnerable this late in the economic cycle
  • Economic data disappoints – global equity markets are priced for continuation of the current “Goldilocks” economic environment, not too hot and not too cold.
  • Inflation data surprises on the upside
  • Policy mistake by a Central Bank given the extraordinary policy positions over the last 10 years of very low interest rates and Quantitative Easing, e.g. US Reserve Bank needs to raise short term interest rates more quickly than currently anticipated
  • Longer term interest rates rise much higher than currently expected

 

Therefore, lots to consider as the year progresses.

 

I enjoyed this quote from Howard Marks “there are two things I would never say (since they require far more certainty than I consider attainable): “get out” and “it’s time.”  It’s rare for the market pendulum to reach such an extreme that views can properly be black-or-white.  Most markets are far too uncertain and nuanced to permit such unequivocal, sweeping statements.”

Well worth thinking about when making portfolio investment decisions.

 

Please see my Disclosure Statement

More Asset Classes Does Not Equal More Diversification

/ Kiwi Investor / 10 Comments

The Failings of Diversification.

Diversification has been the central tenant of portfolio construction since the early 1950s.

Diversification simply explained, you don’t put all your eggs in one basket.

Nevertheless, technically we want to invest in a combination of lowly correlated asset classes. This will lower portfolio volatility.  (Lowly correlated means returns from assets are largely independent of each other – they have largely different risk and return drivers.)

The article highlights that more asset classes does not equal more diversification.

“This is because the investment returns of a range of asset classes are driven by many of the same factors. These can include: economic growth; valuation; inflation; liquidity; credit; political risk; momentum; manager skill; option premium; and demographic shifts.

So while investors have added a range of asset classes to their portfolio (such as property, infrastructure, distressed debt, and commodities) their portfolio risk remains similar at the expense of adding greater complexity and management cost.”

 

These are key messages from earlier blogs, focus on true portfolio diversification so as to ride out the volatility and on Liquid Alternative investment strategies.

 

From the Article

Key Points

  • Diversification is just one risk management tool, not a comprehensive risk management solution.
  • Multiple asset classes won’t lower portfolio risk when the same factors drive each asset classes’ investment returns.
  • Diversification cannot provide protection against systematic risk, such as a global recession, when all major asset classes tend to fall in unison.

Risk comes in many forms but investors are acutely aware of two: the impact of capital losses and extreme bouts of volatility.

Both can have a devastating impact on a portfolio.

Capital losses, such as we saw during the global financial crisis, may never be recouped by some unlucky investors. Meanwhile, volatility can prompt investors to withdraw their money at just the wrong time or quickly erode a lifetime’s savings when an investor is drawing down their capital.

Liquid Alternatives

/ Kiwi Investor / 2 Comments

This is a great article on the benefits of Liquid Alternatives (“Liquid Alternatives Coming of Age”)

One of the big lessons from the Global Financial Crisis (GFC) ten years ago was for investors to seek true portfolio diversification.  Specifically, increase the diversification within portfolios so as to reduce the level of equity risk within them.  Thus reducing the level of portfolio volatility.  This will likely lead to better outcomes for investors in meeting their investment objectives over time.

For investors, increasing the level of true portfolio diversification comes with the added challenge of reducing costs, maintaining high levels of liquidity, and having transparency of the underlying investment strategies.

For these reasons Liquid Alternative strategies have gained increasing acceptance around the world.

The article covers the benefits of Liquid Alternative strategies and a variety of implementation approaches undertaken by a number of Australian Institutional Investors.

Liquid Alternative Investment strategies are a growing allocations across many investment portfolios globally and are an effective means of increasing the true diversification of a multi-asset class (diversified) portfolio.

 

I have written previous Posts on adding Alternatives to Investment Portfolios.

 

Please see my Disclosure Statement

The Buffet Bet

/ Kiwi Investor / 2 Comments

Receiving much attention from the 2017 Berkshire Hathaway shareholder letter has been “The Bet”.

To recap, “The Bet” was with Protégé Partners, who picked five “funds of fund” hedge funds they expected would outperform the S&P 500 over the 10 year period ending December 2017.

The bet was made in December 2007, when the market was reasonably expensive and the Global Financial Crisis (GFC) was just around the corner.

Needless to say, Buffet won.  The S&P 500 easily outperformed the Hedge Fund selection over the 10 year period.

 

I have some sympathy with this well written article.

 

Firstly I’d like to make three points:

  1. I’d never bet against Buffet!
  1. I would also not expect a Funds of Fund hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Fund.

This is not to say Hedged Funds should not form part of a “truly” diversified investment portfolio.  They should.

Nevertheless, I am unconvinced their role is to provide equity plus returns.

  1. Most, if not all, investor’s investment objective(s) is not to beat the S&P 500. Investment Objectives are personal and targeted e.g. Goal Based Investing to meet future retirement income or endowments

 

Albeit, as the article points out (A Rhetorical Oracle?), key investment points are missed by the media’s focus on the drag race over a 10 year period.

Now, I have no barrel to push here, except advocating for the building of robust investment portfolios consistent with meeting your investment objectives. The level of fees also needs to be managed across a portfolio.

 

In this regard and consistent with the points in the article:

  1. Having a well-diversified multi-asset portfolio is paramount.

Being diversified across non-correlated or low correlated investments is important.  Adding low correlated investments to an equities portfolio, combined with a disciplined rebalancing policy, will add value above equities over time.

The investment focus should be on reducing portfolio volatility through true portfolio diversification so that wealth can be accumulate overtime.  If you like, minimising loses results in higher returns over time.  A portfolio that falls 50%, needs to gain 100% to get back to the starting capital.  This means as equity markets take off, as they have over the last 24 months, a well-diversified multi-asset portfolio will not keep up.  Nevertheless, the well diversified portfolio won’t fall as much when the inevitable crash comes along.

It is true that equities are less risky over the longer term.  Nevertheless, not many people can maintain a fully invested equities portfolio, given the wild swings in value (as highlighted by Buffett in his recent Shareholder Letter, Berkshire can fall 50% in value).

100% in equities is often not consistent with meeting ones investment objectives.  Buffet himself has recommended the 60/40 equities/bond allocation, with allocations adjusted around this target based on market valuations.

In fact, I’d never suggest someone to be 100% invested in equities for the very reason of the second point in the article.

 

  1. Investment Behavioural aspects.

How many clients would have held on to a 100% equity position during the high level of volatility experienced over the last 10 years, particularly in the 2008 – 2014 period.  Not many I suspect.

 

A well-diversified portfolio, that lowers portfolio volatility, will assist an investor in staying the course in meeting their investment objectives.

An allocation to alternative strategies, including a well-chosen selection of Hedge Funds, will result in a truly diversified Portfolio, lowering portfolio volatility.  See earlier Post

Staying the course is the biggest battle for most investors.  Therefore, take a longer term view, focus on customised investment objectives, and maintain a truly diversified portfolio.

This will help the psychological battle as much as anything else!

 

I like this analogy of using standard deviation of returns as a measure of risk, average volatility:

“A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 

 

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Are we in a Bubble?

/ Kiwi Investor / 1 Comment

A developing consensus view is that the US sharemarket is overvalued, certainly by measures such as the Shiller PE (Price to earnings ratio).  Future low returns can be expected based on this measure.

Of course there is some debate about whether this is a bubble. Time will tell.

An earlier Post did touch on this. Another Post put the recent level of sharemarket volatility into a historical context.

 

Furthermore, the consensus view is that although overvalued the risk of a US recession is low. Generally a recession is needed to trigger a large drop in the value of sharemarkets.

None of the following forward indicators are flashing the risk of a recession: Leading Economic Indicators, ISM Manufacturing New Orders, Initial Unemployment Insurance claims, Durable Goods Order, shape of the yield curve (e.g. are longer dated interest rates lower than short dated interest rates, which is often a precursor to recession) and level of High Yield Credit Spreads.

The consensus view is that the US economy will continue to expand in 2018, now into its third longest period of economic expansion. Over time capacity constraints within the economy will grow further (e.g. falling unemployment) and the US Central Bank, US Federal Reserve (Fed), will continue to raise interest rates as the threat of or higher inflation emerge.

This will result in a “classical” ending to the economic cycle where higher interest rates will result in a slowing of economic activity, resulting in a pick-up in unemployment, followed closely by recession, say late 2019 early 2020. Unfortunately the recession will be felt more heavily on Wall Street (e.g. large share price declines) than Main Street.

This article outlines a paper written by James Montier of GMO. He outlines 4 different types of bubbles:

  1. Fad or mania e.g. dot-com bubble, Roaring 20s, and US Housing market
  2. Intrinsic Bubble e.g. Financials prior to the GFC had inflated earnings
  3. Near Rational bubble – the greater fool market, cynical, and they can keep going as long as the music is playing.
  4. Information Bubble

 

Montier argues we are in a cynical bubble (3 above), noting many professional investors acknowledge the US market is expensive yet remain fully invested even overweight, based on a BofA Merrill Lynch survey.

He agrees with Jeremy Grantham, many of the psychological hallmarks of a Fad and Mania are absent. Grantham has raised the prospect the US sharemarket may be entering a two year “melt-up” period as the next phase of the current “bubble”.

Time will indeed tell.  Nevertheless, the cynical bubble appears consistent with the consensus view above.

 

Mortimer’s article also has some great quotes from John Maynard Keynes, a great investor in his own right.

 

 Please see my Disclosure Statement

 

Investment Mistakes to avoid

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In an earlier post we talked about the short volatility (VIX) products that had added to the recent global equity market volatility.

 

The experience of these products prompted a good article from Barry Ritholtz, Five Rules to Help Avoid Investing Disaster.

The Inverse Volatility Products will enter history along-side CDO’s. It is likely that 95% of the wealth invested in these Products will be wiped out when they are finally wound up/terminated.  Well worth following developments here.

 

I am somewhat bewildered from an investment strategy perspective why these exposures would end up in Portfolios at this time. It is a prime example of chasing historical returns. It is always a good idea to be guided by value.  The cost of buying volatility protection was very low. Therefore there was no value shorting market volatility, as these Products did. It is also a good idea to have a counter-cyclical bias in your investment approach: when markets are at historical extremes, i.e. historically low volatility, it is a good idea to reduce the exposure to that market extreme. Markets revert from extremes toward averages – often violently as we have recently witnessed.

This is basis of portfolio risk management and consistent with focusing on managing risk rather than trying to time markets and chase historical returns. I think most of the funds management industry was working out how to go long volatility given the over-brought nature of the global equity markets in January, not short it!  Some form of market correction was widely anticipated, the timing was just unknown.

 

Anyway, ………… the rules outlined to avoid making investment mistakes:

  1. Avoid new products – if they are a good investment no need to hurry – e.g. the Buffet rule in relations to Initial Public Offerings (IPOs)
  2. Learn from history – markets are volatile never get complacent – Hubris before the fall
  3. Never buy anything you don’t understand – another Buffet rule
  4. I would say get good investment advice i.e. wholesale products vs retail product comments, in fact considerable value can be added to client portfolios in this area and costs reduced by accessing appropriate investment strategies not readily available
  5. Greater returns always comes with greater risk – this is a fundamental axiom of investing, never forget it.  If it is too good to be true, it probably is.  There are never “easy” sustainable returns in investing.

 

Happy investing.

 

Please see my Disclosure Statement

 

Equity Markets Keep Falling

/ Kiwi Investor / 3 Comments

The equity market volatility from last week continued into this week.

The Dow Jones has experienced its worst week in two years. US equity markets reached “correction” territory (a decline of 10% from the peaks in January).

Concerns over higher longer term interest rates and a more aggressive Federal Reserve Fed Funds Rate tightening path than expected are the backdrop to the recent downturn in markets.

It also appears that the short VIX (volatility) products significantly added to market volatility. A good explanation of how these inverse volatility products impacted on market volatility can be found at $XIV Volpocalypse – A Sea of Disinformation and Misunderstanding

The US inflation number on February 14th has taken on heightened importance and will be the focus of markets this week i.e. a likely source of volatility

What has changed? Not much.

As expected prior to the “market melt-down” volatility was expected to pick up from historical lows and that interest rates would rise over coming months. Albeit the volatility has occurred more abruptly and violently than anticipated (as it often does).

US longer dated interest rates have reached 4 year highs but remain near historically low levels.

The global economy is characterised by synchronised economic growth. It is expected that all 45 of the larger economies monitored by the OECD will experience growth in 2017 and 2018. It has been a while since this has occurred. In the US unemployment remains at near historical lows and financial conditions remain supportive of ongoing economic activity. US equity markets are still up over 10% for the last 12 months.

It is a good idea to go back to what was being said prior to a large market event.

The comments by Mohamed El-Erain, the chief economic advisor at Allianz, at the Inside ETFs conference 23 January 2018 are a good reference point for the current market situation.

El-Erain told the conference we are not in an asset bubble but that we should expect a higher level of market volatility in 2018. Mohamed El-Erain: We’re Not in a Bubble

His comments focussed on the fact that the US Federal Reserve (Fed) would continue to normalise monetary Policy in 2018 e.g. lift interest rates over the year to more normal levels while also reducing the size of the Fed’s Balance Sheet.

El-Erain noted 3 key risks for 2018:

  1. Geopolitics e.g. Korea and the Middle East
  2. What happens if the four major Central Banks try to normalise monetary at the same time i.e. Fed, China, Japan, and Europe
  3. A market accident e.g. a liquidity event in say an ETF given an over promise to deliver

The last risk is very insightful given the events of the inverse volatility products over the last 10 days. I am quite sure El-Erain did not expect that risk to materialise so quickly!

 

So if things change, you change your mind, to badly paraphrase Keynes. Not sure that things have changed that much but maybe a realisation interest rates are actually heading higher and the very low level of market volatility experienced cannot last for ever. The US equity market is still trading on high valuations.

Whatever you do don’t panic. The Topic of my next post.

 

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Cryptocurrencies to Hit Zero

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Not that I am one to make market projections, this article caught my eye.

 https://www.bloomberg.com/news/articles/2018-02-07/get-ready-for-most-cryptocurrencies-to-hit-zero-goldman-says

 

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Adding Alternatives to an Investment Portfolio – Part 3; Investing Like an Endowment Fund

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Part 3 of a series of articles about adding / increasing Alternatives in a Portfolio.

The attached article is a recently published article via the CAIA: Investing Like the Harvard and Yale Endowment Funds.

My previous Posts have outlined the potential benefits of adding Alternatives to a portfolio. This article provides some evidence of the benefits of adding alternatives to a portfolio.

The Endowment Fund success has come from having more than just absolute return funds i.e. hedge fund alternative strategies, but also exposure to real assets have played a part, including a Private Equity exposure. Many Australian Super Funds have benefited from their exposure to unlisted infrastructure and Property.

New Zealand Portfolios generally lack exposure to real assets, private equity, absolute return funds, and alternative strategies.

The Top performing Endowment Funds have benefited from “true diversification”, they have benefited from their allocation to alternative asset classes.

“Their long term investment strategy has prevailed to the extent that long term total and risk adjusted returns remain superior to those of traditional portfolios.”

 

CAIA Investing like an endowment

 

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Adding Alternatives to an Investment Portfolio – Part 2

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Following on from an earlier post on adding alternatives to a portfolio the attached document is a short and precise commentary on the case for adding alternatives to a traditional portfolio.  See link below.

The Title: “It’s an evolution, not a revolution” sums it up very well.

The article notes that the evolution in portfolio construction has moved away from the old way of style boxes, market expectations, and benchmarks, to a greater focus on the investors (clients) liabilities, risk tolerances, and an investors actual objectives – most likely funding requirements in retirement.

The article references the behavioural finance that people “feel the pain of losses far more they do the benefits of gains”. As they say, Investors want to minimise loses, and focus on outcomes rather than returns.

The article is then nicely concluded referencing one of Warren Buffet’s key influences, Benjamin Graham, quote “the essence of investment management is the management of risks, not the management of returns.”  This is so true.

I agree with their concluding remark, “better to lose less and compound more than to reach for excess returns and fail to reach your objectives”. Alternative strategies can play an important role in compounding returns / wealth over time.

P.S. This article is an editorial that appeared in the Chief Investment Officer magazine.

Evolution not revolution

 

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