I’ve been to a few Sohn conferences over the years, and while a lot of fun & for a good cause, my crazy schedule has led to my pumping the brakes a bit on traveling. I’ve written about hedge funds and their stock picks more than I care to admit on this blog and in my books. Below are a few summaries we’ve included from The Idea Farm (data source: AlphaClone) on how tracking today’s presenters through their public stock picks would have performed since 2000. Not bad!
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I attended a fun evening dinner with my friends from FirstTrust this week. They had a guest speaker who was a political consultant – usually this isn’t my favorite topic – but I joined to have a few glasses of wine then sneak out. Fast forward a few hours later and I was fascinated with the speaker, who was able to weave policy, investing, and economics into a sort of mash-up of House of Cards and George Soros. At one point I was asking about the historical tax rates and Republican versus Democrat hair pulling over the subject. It is interesting to me that taxes as a % of GDP have ranged between 14 and 20% of GDP since 1950. But politicians are not making bold proposals for 50% or 10% of GDP, but rather very very minor alterations. The speaker referenced how Obamacare and Keystone pipelines were likewise very minor components of total spending and supply – but essentially it gives politicians something to fight about. How else will you distinguish yourself from your opponent when you are so similar?
This reminds me of the state of the roboadvisors. Even though I believe asset allocation ETFs are superior to these separate accounts, the development of the roboadvisors has been a big positive for investors (mainly due to fee compression for the managed account space). While most of their innovations have been around for awhile, the ability to wrap them in a beautiful offering that people will use is a great benefit to investors.
I wrote a big about this last month in the piece “What a Great Time to be an Investor!“. I was a little surprised that some of the companies were getting into a catfight over some of the specifics of their offerings, when in my mind they were on the same side of the good fight. What I failed to realize, was that in a world of very, very similar business models, they need to create the appearance of big differences – otherwise how will they be able to distinguish themselves in a world of cutthroat competition?
A nice article was published today from Liz Moyer at the WSJ looking at the very different allocation proposed by the various advisors when she went through the questionnaire. While the allocations look very different (one has 9% in cash, another zero, one has 5% in gold, others zero…you get the drift) how do they perform?
Does it even matter?
Below are the returns and equity curves for the allocations historically back to 1972. (Similar older post here.) As you can see, it is a rounding error what allocation you choose! I mean, a total CAGR difference of 0.22%! I do think that someone eventually will offer tactical roboadvisors instead of everyone just doing MPT, which could seriously stand out from the competition. Also, what’s up with none of the robos tracking their performance through GIPS? In a world of expensive US stocks, when is someone going to include managed futures or liquid alts?
If you want to read some more on the subject, I’m happy to send you a free copy of my new book Global Asset Allocation. Just sign up here and I’ll send you one on Amazon – you just have to promise to write a review when finished!
Click to enlarge below charts
There is a lot of talk about stocks being expensive, but also a lot of people not really doing anything about it. Many simply don’t know how to tackle the problem, and others don’t want to think about it at all. Below, for some perspective, are historical returns to stocks since 1970 and the 10 worst months for the S&P. On average you’re looking at a 11% decline, and that only happens every four years or so (last was Feb 09). Many others have produced charts like this, but I wanted to demonstrate the returns and batting average for typical asset classes when it hits the fan for stocks.
First observation is that when US stocks go down, all stocks go down. It doesn’t matter if you are small cap US, foreign developed or emerging, the high correlation means you all suffer.
Bonds of all flavors do a good job, but you can only count on them a little more than half the time. Good ol’ 10 year US bonds had the highest median return of any asset during stock drops, However, the lower maturities have a higher hit rate, and of course cash is king with a perfect batting average, but doesn’t do much to diversify and zag when stocks zig.
Commodities are a coin flip, but also had a monster -28% month, so also volatile (ditto for gold). REITs, being stocks, don’t help.
One of the best of course is managed futures (hooray for trend!), but FYI pre-1980s this series is hypothetical. I would argue that this is one of the biggest areas investors are under-allocated. I think having trend strategies as a percentage of a stocks/bonds/real assets portfolio is one of the best diversifiers, and anywhere up to 33% allocation is completely reasonable. I’ve said a number of times that a 1/3 each global stocks, global bonds, and managed futures or trend strategy is really hard to beat. (or do 25% each and add in real assets.) Stay tuned for a future post on the subject.
The first figure shows returns of 13 assets when stocks puke. Figure 2 is the same as Figure 1, just sorted by batting average, from good to bad.
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I often say there isn’t a whole lot new in investing. Charles Dow was using trendfollowing approaches over 100 years ago, and Ben Graham was using valuation metrics for security selection as well. Robert Shiller created the CAPE ratio to look at stock market level valuations, and this was based on some of Ben’s work on smoothing earnings over longer periods to reduce the noise.
I had not seen this book before – Templeton’s Way with Money: Strategies and Philosophy of a Legendary Investor – published in 2012 (hat tip to reader KH). The book describes some of the memorandums to clients from Templeton, including a few below on valuation the stock market as a whole (DOW). Funny to see they were using the equivilent of the Shiller CAPE (20), Tobin’s Q, and the Fed-model to value the market and adjust their equity exposure….
Needless to say, he wouldn’t have too much in US stocks these days….now foreign….charts from dShort
I don’t hear nearly as much from the 13F critics anymore. Maybe they have simply lost interest, or perhaps the real time performance of the 13F strategies have converted them into believers, who knows. I’ve been sending out hedge fund profiles each Sunday to The Idea Farm with current holdings and backtests and investors seem to love the updates.
Covered so far:
APPALOOSA, ARIEL, AVENIR, BARROW, BAUPOST, CHIEFTAIN & BRAVE WARRIOR
COBALT, ESL/RBS, EMINENCE, FAIRHOLME, GARDNER RUSSO, GLENVIEW, GREENLIGHT, LSV, MARATHON, PAR, RELATIONAL, RUANE CARDIFF, SPO, THIRD POINT, VALUEACT, YACKTMAN, FUND GROUPS, COLLECTIVE INTELLIGENCE, & THE TIGER CUBS, JAT, PENNANT, SOUTHERN SUN, TETON, ABRAMS, 12WEST, ALTAI, ARLINGTON, MITTLEMAN, KINGDON, EAGLE, JERICHO, KERRISDALE, RAIFF, BRIDGER, JANA, IVORY, PABRAI
If you have any fund suggestions let me know!
I thought it would be fun to look back at the generic “World Beta” clone that I haven’t touched since AlphaClone launched many moons ago. These are not the same funds I would pick today, but hey that’s not a bad list! Top 5 positions from these funds would have beaten the market 6 of last 7 years in real time…If you pick the most popular amongst these funds the results are even better.
I jabber a lot about valuation metrics here, and I mentioned this one on Twitter the other day. Its doesn’t need much explanation – the median stock in the S&P 500 is the most expensive it has even been (for as long as we have data). That’s never a good sign!
If your favorite valuation indicator is not at “the highest ever” , many valuation indicators and now at “the highest ever except 2000″. That’s not good company unless you are a short seller.
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Copyright 2015 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved.
There has been a lot of press lately on the roboadvisors, largely due to the fact that Schwab entered the market this week with their Intelligent Portfolio service that charges a 0% management fee (but invests in their own ETFs). If you haven’t been reading my blog since 2006, I have written many times on their development and in general I am very positive on the emergence of the robos (and the non-robos like Vanguard). I even mentioned a handful of the automated investment services in my new book Global Asset Allocation. There is a lot of misinformation so I thought I would make a few comments below.
I expect the large custodians like Schwab, Vanguard, and Fidelity to dominate this space eventually for a few reasons. They have their own ETFs (a huge cost benefit), and they already have massive scale, distribution, and AUM (anything with a T is pretty big). I likewise expect some of the big ETF shops (like Powershares, WisdomTree, or FirstTrust) to enter the space on their own at some point in some capacity – allocation ETFs or a full robo offering.
Despite the fact I expect the big sponsors to dominate, that doesn’t mean there isn’t room for 5+ automated advisors. Maybe even 10. After all the #5 ETF sponsor manages $50 billion and #30 manages $1 billion. Could there be 30 robos managing over $1b?
Despite the big opportunity for all parties, Schwab and Wealthfront quickly got into a catfight over some various specifics of how they invest and operate. (Wealthfront post here and Schwab’s response here Scott Bell’s comments here and Howard Lindzon’s here.) It is weird and somewhat embarrassing they are fighting so much since they are really on the same side and it should be a rising tide for both. So, in my mind they should be cheering each other on against the high fee crowd, but they’re not, which is a shame. Their concerns were two main (minor in my mind) points in the asset allocation process:
Wealthfront took Schwab to task over their cash allocations in their portfolios. I don’t mind cash as a strategic allocation, but I do agree with Wealthfront that Schwab earning revenues from the money market sweep accounts could bias their decision to include cash. There is just no need to do this – they could have used their short term gov bond ETF at 8 bps and still made the same amount as their money market spread. However, the moral outrage from Wealthfront comparing Schwab to Merrill is a little ridiculous considering Wealthfront used to charge 1.25% for access to “geniuses”. I applaud that they have pivoted to the new low fee structure, but was it simply because the old business model didn’t work, or that all of a sudden they got religion on how they view the investment world and did a 180?
Smart Beta Allocation
Wealthfront also talked about how Schwab uses smart beta investments, and include two quotes that “smart beta products are not smart investments” and “smart beta is stupid”. This is odd since Wealthfront itself does not track the global portfolio and likewise uses smart beta funds like dividend/value. They go as far to state that dividend stocks can be a bond substitute (which is crazy). I applaud Schwab for using smart beta funds – after all almost anything outperforms the market cap weighted portfolio.
So, I agree with Wealthfront on the cash issue and agree with Schwab on the smart beta issue. But again, to me it isn’t really the point – I think they should be cheering each other on. The irony is that the roboadvisors can debate endlessly about their allocations and which is superior, but in reality their asset allocations will likely be very similar and perform similarly as well. Our new book demonstrates that almost all allocations cluster quite closely, and the backtested returns of Wealthfront and Betterment are likewise pretty darn close.
So if the asset allocation is a commodity, then you should pay as little as possible for that. Lost in the debate is that there has never been a better time to be in control of your own investments and both offerings are killer. The competition between roboadvisors will create downward pressure on fees that will massively benefit the end investor.
We forget that the average mutual fund charges 1.25% and the average advisor 1.0%. The top quintile charges over 2% for both!! While Schwab and Wealthfront argue over basis points, there are shops that still manage many billions like The Mutual Fund Store, Edelman, and Fidelity Portfolio Advisory that charge over 1.5%…And not too long ago we lived in a world that was much, much more expensive than even that. Remember front-end loads and 12b-1 fees? They still exist.
And while most roboadvisors are solid on the fee front, there is an even better choice. A 0% management fee ETF is superior to all of the roboadvisors for three or perhaps four reasons. (There is only one of those in existence currently but I expect someone to copy our model within the next 6-12 months.) Below is why:
1. The ETF at 0.29% likely has the lowest total expense ratio versus the roboadvisors (Schwab is potentially the only competitor but not if you add in cash revenue from the money market sweep).
2. The ETF has superior tax treatment to the roboadisors. Both can tax harvest, but the ETF structure is unique in that it benefits from the creation/redemption structure.
3. The ETF can engage in short lending, and return all of the revenue to the fund. Vanguard does this and effectively offers ETFs that are expense ratio negative, meaning they pay you to own them. Think about that for a second – you are getting paid to own an ETF! Could the robos eventually do short lending? Maybe, but it is operationally challenging and not sure this works across separate accounts. (But they should look into it.)
4. You can track the audited exchange traded performance of the ETF, whereas none of the roboadvisors are GIPS certified or audited (to my knowledge). It is near impossible to find published performance since inception. (Again, they should look into it.)
I still think any of these automated options (asset allocation ETFs or robos) are great choices for the buy and hold crowd. Frankly the fees will be rounding errors compared to any of the behavioral mistakes people make. (Tactical is another solution but not the point of the post. Those that know me also know I am a trendfollower at heart, and publish my portfolio every year.)
Assuming you now have the allocation put to bed, what is the big value add of a roboadvisor outside of that? The argument starts to break down, especially when we get another big fat bear and you want someone to talk to.
And that is where the advisor comes in, and there are many thousands of great traditional advisors to choose from around the US. As far as online ones, only two major players come to mind and those are Vanguard (0.3%) and Personal Capital (closer to .9% in fees). Either the roboadvisors or low/no fee asset allocation ETFs allow advisors (and investors) to be freed up to do what they do best – service the client and not worry about the asset allocation. So an investor (individual or pro) can allocate to a core, 0% management fee ETF and move on to more important things.
1. It is a a great time to be an investor!
2. The emergence of the roboadvisors and low cost cyberadvisors (advisor powered automated solutions like Vanguard) are a huge positive for investors and advisors alike.
3. While the roboadvisors scrap over basis points, they should be on the same side and focus their energy on the high fee competition.
4. Despite the positive benefits of a roboadvisor, they can’t compete with an asset allocation ETF.
5. Investors, and advisors can focus their attention on more important things now that a buy and hold allocation is a commodity. Go live and enjoy your life!
This excerpt is from the book Global Asset Allocation now available on Amazon as an eBook. If you promise to write a review, go here and I’ll send you a free copy. It is also available as a printable PDF on Gumroad.
“I think the single most important thing that you can do is diversify your portfolio.”
–Paul Tudor Jones, Founder Tudor Investment Corporation
The next two questions and answers will likely surprise you.
Question 1 – Quick, what is the world’s largest financial asset class? Don’t know?
Answer: Foreign ex-U.S. bonds! This is usually surprising to most investors who assume the answer is U.S. stocks or bonds.
FIGURE 15 – The Largest Asset Class in the World
Question 2: How much of your global stock allocation should be in the United States?
Answer: About half!
U.S. investors usually put around 70% of their stock allocation at home here in the U.S. This is called the “home country bias”, and it occurs everywhere. Most investors around the world invest most of their assets in their own markets. Figure 16 is a chart from Vanguard that details the “home country bias” effect in the U.S., the U.K., Australia, and Canada. The blue bars are how much investors should own of each country according to global weightings, and the red bars are how much they actually own of their own country – way too much!
FIGURE 16 – Home Country Bias
Figure 17 is a chart from the Credit Suisse GIRY update we mentioned earlier. It details the U.S. as a percentage of world market capitalization (52%) in 2014. Given this, while most of us here in the United States invest 70% of our stock allocation in U.S. stocks, in order to be truly representative of the global marketplace it really should only be about half. Note that the U.S. was only 15% of world market cap back in 1899. As a share of global GDP, the U.S. is only 20% (emerging markets are 50% of global GDP, but only 13% of market capitalization).
FIGURE 17 – Stock Market Sizes, 1899 and 2014
Source: Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press 2002, Credit Suisse Global Investment Returns Sourcebook 2015
The point of the two questions at the beginning of the chapter is that we live in a global world. There is no need to build an investment portfolio with just exposure to U.S. stocks and bonds. Figure 18 is another chart of how market cap weightings have changed over time. Notice the large Japanese bubble expansion in the 1980s and the rapid contraction afterward.
FIGURE 18 – Stock Market Sizes, 1900 to 2012
Source: Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press 2002, Credit Suisse Global Investment Returns Sourcebook
The key question for investors to ask, then, is, “What would our allocation look like if we expanded the 60/40 portfolio to include foreign stocks and bonds? Would that help improve our returns or reduce our risk?”
The Global 60-40 Portfolio
The next portfolio we will examine is the 60/40 portfolio, only now we are using global indices rather than just U.S. ones. We split the stock allocation into half domestic and half foreign developed stocks (MSCI EAFE), and split the bond allocation into half domestic and half foreign 10-year government bonds.
Going global in this illustration doesn’t change the end result too much, though it does increase returns, reduce volatility, and improve the Sharpe ratio (all good things). The global portfolio also did better during the inflationary 1973-1981 period, as Figure 19 shows.
FIGURE 19 – Various Assets and Strategies, Real Returns, 1973-2013
Source: Global Financial Data
Source: Global Financial Data
There is no reason, however for investors to focus exclusively on stocks and bonds. Would increasing amounts of granularity with additional asset classes help when looking at building a diversified portfolio? In this book, we are going to examine 13 assets and their returns since 1973. They are found in Figure 20 below with a column denoting what broad category of assets they fall under.
FIGURE 20 – Asset Classes
Are there other asset classes? Of course. However, many asset classes (or sub-asset classes) do not have sufficient histories to analyze, such as emerging market bonds. For those unfamiliar, REITS are publicly traded real estate investment trusts, and TIPS are U.S. Treasury inflation protected bonds.
We also exclude active approaches to investing even though we discuss some of these “tilts” in other white papers and books like Shareholder Yield. So while an active strategy like managed futures is one of my favorite investment strategies, we don’t include it in the building blocks section. (I like to call trendfollowing my “desert island” strategy if I had to pick one method to manage money for the rest of my life. While not the topic of this book, we have written a great deal about trend strategies on the blog as well as in the white paper “A Quantitative Approach to Tactical Asset Allocation.”)
Figure 21 presents a chart of the asset classes we examine in the following chapters.
FIGURE 21 – Various Assets, Real Returns, 1973-2013
Source: Global Financial Data
We didn’t label the asset classes in the chart on purpose simply to demonstrate that while the indexes traveled different routes from start to finish, all of the asset classes finished with positive real returns over the time period. The fact that bonds were even close in absolute performance to the other equity-like asset classes reflects the greater than thirty-year bull market that took yields from double-digit levels to near 2% today. The below charts demonstrate the returns and risk characteristics of the various asset classes.
FIGURE 22 – Asset Class Nominal Returns, 1973-2013
Source: Global Financial Data
While these are some pretty nice returns for these asset classes historically, they suffered through some large drawdowns.
Like we discussed before, nominal returns are illusory. You can’t spend or eat nominal returns. Below in Figure 23 are the same building blocks but with real returns. Stocks were in the ballpark of 5-7%, bonds 0-5%, and real assets 3-5%. (Corporate bonds share equity-like characteristics, so we characterize them as 50% stocks and 50% bonds for purposes later in the paper.)
FIGURE 23 – Asset Class Real Returns, 1973-2013
Source: Global Financial Data
If an investor were to take the data back further, or use daily data observations, those drawdowns only get bigger. It is a sad fact that as an investor, you are either at an all-time high with your portfolio or in a drawdown – there is no middle ground – and the largest absolute drawdown will always be in your future as the number can only grow larger. (Unless you went bankrupt of course as then the amount is a total loss. Sadly, Brazil’s richest man experienced this event when he lost over $30 billion – here is a good article on the topic with lots of lessons for individuals as well.)
One of the biggest challenges of investing is that any asset can have a long period of underperformance relative to other assets – or even outright negative returns and losses. Cliff Asness, co-founder of AQR Capital Management, has a fun piece out on his blog titled “Efficient Frontier “Theory” for the Long Run”, where he talks about five-year periods in stocks, bonds, and commodities and basically how anything can happen over short periods of time. (Although for many investors, five years can feel like a lifetime.)
Using the data in Figure 24, we examine returns during two periods, inflationary 1973-1981 and falling inflation/disinflation 1982-2013. We also look at asset returns by decade. The final line in the table is the volatility of decade returns. While there are only five observations its helps to demonstrate the decade level consistency.
What can we learn from these tables? All of our assets had positive real returns, which is what you want from investing in any asset.
Real returns were much harder to come by in the inflationary 1970s. Eight out of 13 asset classes had negative real returns in the 1970s. Gold, commodities, and emerging market stocks had the best performance. Everything was up big in the 1982-2013 timeframe, but gold and cash lagged the most as the transition from high interest rates and inflation led to growth, lower inflation, and lower still interest rates. The only asset classes that had positive performance in every decade were emerging markets and TIPS, although the TIPS category is not a completely fair comparison since they were only introduced in 1997 and therefore this is a synthetic series that investors could not have allocated to at the time.
FIGURE 24 – Asset Class Returns, 1973-2013
Source: Global Financial Data
While there are certainly hundreds of different portfolios one can construct from our 13 assets, we are going to focus on just a handful of allocations below. (More “lazy portfolio” ideas here.)
These allocations have been proposed by some of the most famous money managers in the world, collectively managing hundreds of billions of dollars. We included a few other portfolios worthy of mention in the Appendix, but excluded them from the body of the text to keep things simple. Otherwise this book could have easily been 300 pages and the goal is not to put you to sleep but rather let you finish in one sitting and get on with your life.
The flow of the chapters will range from the portfolios that allocate the most to bonds to the ones that allocate the least.
Let’s get started!