September 2021
High allocation to equities
Insider trading should remain illegal, especially for Congress
There’s always reason for concern
Maybe I’ll dress up as Investing for Halloween
What The Rolling Stones can teach us all about investing
Traditional active management is not performing
How’s this for an indictment of the traditional active management industry?
Investors have been speaking and continue to speak with their feet in switching from active management to passive indexing. These investors prefer settling for merely matching the higher returns of broad-based indexes rather than paying active managers for net-of-fees underperformance. The promise of active managers has not delivered.
Of course, traditional active managers make all kinds of arguments to explain away this trend, including:
“We offer risk-adjusted returns - we are not trying to beat the S&P 500 Index.”
“We offer positive returns in both up and down markets.”
“Just wait until the next recession when we will outperform.”
I don’t know, man. These arguments seem unconvincing and readily rebutted:
Claim: “We offer risk-adjusted returns - we are not trying to beat the S&P 500 Index.”
Rebuttal: You know they would promote beating the S&P 500 Index if in fact their returns outperformed.
Framed another way: Can you imagine a manager saying “I beat the S&P 500 Index but that was unintended. Risk-adjusted returns should underperform the S&P 500 Index and I got it wrong. Sorry about that.”
2. Claim: “We offer positive returns in both up and down markets.”
Rebuttal: For many investors, small positive returns in down markets don’t offer adequate compensation for positive but significantly lagging performance in up markets. Yun Li of CNBC offers evidence in Hedge funds could be staging a comeback as short bets post best month since 2010. Consider the annual returns of hedge funds via the Hedge Fund Research Inc.’s Fund Weighted Composite Index (HFRI FWCI) versus the S&P 500 Index over the past decade:
Source: Hedge Fund Research, CNBC
Risk aversion is real - losses feel approximately twice as painful as equivalent gains feel pleasurable (Kahneman, Daniel. Thinking, Fast and Slow). Nobody likes losing money… but loss aversion is costly itself. In 2018 when the S&P 500 TR lost -4.38% and the HFRI FWCI lost a little less, sure, on average there was a marginal advantage to hedge fund management. But look at every other year! 2013, 2014, 2015, 2016, 2017, 2019, 2020, and 2021 YTD all show HFRI FWCI underperforming the S&P 500 Index. And with the exception of the S&P 500’s only slight beat in 2015, the S&P 500’s outperformance not only dwarfed the HFRI FWCI in every other year, but also more than compensated passive investors for the slight HFRI FWCI advantage in 2018.
Loss aversion is costly. The claim that managers can offer positive performance in both up and down markets can sometimes be defended. But positive returns that still significantly underperform low-cost S&P 500 Index funds is a tough sell, given the S&P 500 Index’s long-term record of significantly higher returns.
3. Claim: “Just wait until the next recession when we will outperform.
Rebuttal: Outperforming for a relatively short period during infrequent recessions may not be worth underperforming during longer and more frequent non-recessions.
In their article Dalio’s Hedge Fund Risks Being Dumped by Pension on Weak Returns, Katherine Burton and Melissa Karsh of Bloomberg recently spoke to the consequences of when this claim does not pan out.
“A California county’s $21 billion pension is considering whether to drop Ray Dalio’s hedge fund after it underperformed for most of the past 16 years.”
“The Orange County Employees Retirement System’s investment in Bridgewater Associates’s Pure Alpha fund has returned an annualized 4.5% since 2005, about 2.5 percentage points less than its benchmark, according to a memo seen by Bloomberg from Meketa Investment Group, the pension’s consultant. The strategy has topped OCERS’s target only once in the past five years and has trailed on a seven- and 10-year time horizon.”
**The benchmark was Treasury Bill rates plus 5%, since June 2010.
…
“Bridgewater has come under scrutiny from Meketa consultants before. In January 2019, the firm was jettisoned by San Joaquin County, California’s pension, which cited high fees and low returns for the Pure Alpha II hedge fund. The county’s consultant, Pension Consulting Alliance, first recommended putting the $81 million investment with Bridgewater under review in November 2017.”
But then… here’s Thomas Griffiths, Head of Product at software firm Cassini Systems:
“A lot of hedge funds’ returns over the past few years have been lower than expected due to volatile markets,” he says [emphasis mine]. “They have had to fight very hard to outperform passive investments that are available to investors through ETFs in particular. As a result, hedge funds have been much more focused on costs than previously. They can’t afford for any cost drag on their portfolio performance.”
Wait, I thought hedge funds are supposed to outperform during higher volatility?!! That promise is behind the claim “Just wait until the next recession when we will outperform.” Finding out during a downturn that most hedge funds still underperform during downturns is a lousy time to learn their net-of-fees performance history.
For those who are not yet convinced, here is Morningstar’s Ben Johnson Busting the Myth That Active Funds Do Better in Bear Markets. Spoiler alert: Active Funds still underperform in bear markets.
Let’s close with Ted Seides’s infamous bet with Warren Buffett that a basket of hedge funds would net-of-fees outperform a low-cost S&P 500 Index fund over 10 years. That bet, from January 2008 through December 2017, ended with Seides losing quite badly. The hedge fund basket returned about 24% total (2.2% annualized gain) versus the S&P 500 index fund’s return of 99% total (7.1% annualized gain). 24% versus 99%, not even close. Seides resigned in May 2017, didn’t even bother waiting until the end of 2017.
Digging into the internals, Buffett’s bet got off to perhaps the worst possible start! Did I mention the bet started in January 2008, just in time for the Global Financial Crisis? From Investopedia’s Buffett's Bet with the Hedge Funds: And the Winner Is …:
Not long after the wager started on January 1, 2008, the market tanked, and the hedge funds were able to show off their strong suit: hedging. Buffett's index fund lost 37.0% of its value, compared to the hedge funds' 23.9%. Buffett then beat Protégé in every year from 2009 through 2014, but it took four years to pull ahead of the hedge funds in terms of cumulative return.
As detailed above, history validates the Likelyhood that any performance edge captured by traditional active management during down markets will be dwarfed by the even-larger returns of low-cost S&P 500 Index funds during the longer and more frequent up markets.
For further reading:
Seides gives reasons (excuses) why he lost the bet.
Seides thinks it is unlikely that his losing bet would repeat.
Insuring Vacuums, Blackjacks, Life, and Volatility
The professor in my Theory of Interest class challenged us to explain mathematically why most people should not buy insurance for their vacuums. The discussion centered around several themes common to investment management including probability, uncertainty, loss aversion, and risk tolerance.
People have a variety of reasons for buying insurance. The typical and perhaps most defensible purpose of insurance is to protect against significant losses that would greatly impact one’s livelihood. Most vacuum owners have enough disposable income to cover the cost of repairing or replacing the vacuum if it breaks, and that expense would not significantly harm their overall livelihood. If repairing or replacing a vacuum would cause significant financial distress, they probably shouldn’t be buying vacuums ahead of other more important priorities. Thus most people should not insure their vacuum. For most homeowners, however, losing their house in a fire or other such event would significantly impact their financial lives, and therefore home insurance makes sense. Joe the Plumber should insure his home, but Elon Musk can afford not to.
Interestingly, there are (admittedly rare) cases when insurance can be profitable to the policyholder…
Casinos typically offer a 2:1 payout for players who want to “insure” themselves against a dealer’s Blackjack. Occasionally the probability of a dealer’s Blackjack swings positively in the player’s favor depending on the density of 10s and Aces remaining in the shoe. Adept card counters can count this density and strategically buy insurance when the expected value swings in their favor.
I spent a summer working at a life settlement company. Occasionally there are life insurance policies on people sufficiently close to their life expectancy, with sufficient cash values in the policies, sufficiently low premiums, and sufficiently large death benefits, among other factors, that it made sense for our company to “buy” the policy from the policyholder, pay them a lump sum to enjoy while they are living, draw down any cash value and take on the premium payments until death, then collect the death benefit when the person passed away.
We have discussed insuring vacuums, Blackjacks, and lives. That leaves insuring volatility. Several themes apply equally to vacuums, Blackjacks, lives, and volatility. First, in the long run those providing insurance make money. Policyholders usually pay more in premiums than they receive in benefits and thus subsidize the policyholders who receive more in payouts than premiums paid. While in some contexts it is possible to isolate the cases when insurance is profitable for the policyholder, these cases require an informational advantage (eg. card counting) that is elusive - and perhaps impossible - in highly liquid and highly analyzed financial markets.
So when active managers promise market-matching (or even market-beating) performance with reduced volatility, the reality is that investors are paying for insurance and the costs of which systematically drag down performance. If investors cannot tolerate volatile swings in their portfolio, then like vacuums they probably shouldn’t be investing those monies in the first place.
The proverbial, um, hamster?
For some reason that I will never understand, people are fascinated with animals picking winners of sporting events. This story is not new, but it certainly gained worldwide attention in the 2010 World Cup when Paul the Octopus prophetically chose the correct winners of 8 matches, including picking Spain over the Netherlands in the final.
Paul the Octopus may be the most famous from this high-profile performance, but Paul was not the first and certainly not the last. There’s also been Nelly the Elephant, Predictaroo the Kangaroo, Shaheen the Camel, and Achilles the Cat, CNN has the story: Animals are better at predicting World Cup matches than you. (Well, some of them are).
Now take yourself back to before electronic markets and digital news. Information moved more slowly - most people accessed stock prices in the next day's newspaper - but investors and managers still had just as much of a desire for outperformance. The claim was made that a monkey throwing darts at a newspaper of the previous day’s stock closing prices (remember, no digital news!) could outperform most managers. And there was some evidence of this!
Apparently the monkeys were so successful at beating professional investment managers that they needed more of a challenge, so the monkeys then were blindfolded - and still they outperformed investment managers(!).
Amateurs, professionals and the monkey have now completed three rounds of competition from July 2000 through May 2001. If percentage gains are converted into dartboard points, the monkey has moved into the lead with 13.3 points, followed by the professionals with 4.4 points, and the amateurs with -81.22. The market, as measured by the MSCI Europe, scored -17 points.
Well, now hamsters are joining the animal stock picking party, Fortune has the story: A crypto-trading hamster is outperforming Warren Buffett, Cathie Wood, and the S&P 500.
Inflows
Via unprecedented demand, this graph from Bank of America goes a long way in explaining the historically unprecedented price increases in global equities.
ONE MORE THING…
High allocation to equities. Take it or leave it. The most accurate stock-market predictor was released this week. The next 10 years don’t look good.
Insider trading should remain illegal, especially for Congress. Quiver Quantitative is on-the-beat. Does Congress Outperform the Market?, also Stock trading by U.S. Senators and Representatives.
There’s always reason for concern. It’s how you process those concerns that matters. The six reasons why Jim Cramer is concerned about the stock market in September.
What The Rolling Stones can teach us all about investing. Add this to my Favorite Question variations. What the Rolling Stones can teach us all about investing.
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