Tag Archives: investing-strategy

Stocks Aren’t Bad, They’re Just Not Good

When we’re doing our due diligence on an Alternative Investment, one of the first questions we ask managers is what are the market environments in which the program struggles to find returns. And once we get into when they’re likely to do poorly, we then analyze just what that poor performance looks like. In essence – how bad is it when it’s bad? Does everyone/anyone who tracks the stock market with low cost index tracking ETFs do the same? With stocks all but flat since mid-way through 2014, some investors are starting to question where the returns are, rightly so. But the stock indices aren’t human. We can’t tell them to try a little harder. Or go for a moonshot. Or shake off the rust and get back into the game. No, the stock indices are a rule-based investment model. So while pundits and economists are grasping at straws to identify the problem, we’re more apt to ask the manager of the investment model “Why is the current market making it difficult for your trading model to find returns?” We’ve said this before, but it bears repeating, stock indices like the S&P 500 are a trading system; or if you prefer a set of investment rules or stock picking model. Look no further than Winton Capital’s CEO on the matter. We really couldn’t have said it better. Harding: “The S&P 500 is a trading system. The S&P 500 is a set of rules for buying and selling stocks. And by the way… not a very good one! Think about this for a second. If you took the S&P 500’s monthly returns and put them under some sophisticated sounding hedge fund name, everyone would tell you the drawdowns are too large and last too long, while the annualized volatility is too high for the performance it generates. There would be a Bloomberg article demonizing the system for large drawdowns and for tricking investors. And what’s worse, this model is a one trick pony. It’s solely focused on one asset class, and only makes money when that asset class goes up. Of course, it does have the Fed doing everything in its power to avoid a 20% drawdown in the markets at the cost of creating a future bubble. Not to mention buybacks are preventing real growth while 3 companies make up 10% of the market’s capitalization . Put that all together and the S&P 500 is nothing more than an investment model that is high reward-high risk. We dare say, it’s a very basic equity focused hedge fund, choosing which stocks to “own” and which to avoid. To paraphrase Captain Barbossa, “You better start believing in hedge funds Ms. Turner – you’re in one !” There’re bouts of volatility, drawdowns, and low risk-adjusted returns. But that doesn’t make the most beloved system in the world a bad investment. By all means, take a look at it. There’s a lot to like. Chief among them is probably choosing to align yourself with the majority of investors out there; the government and a huge industry hell-bent on seeing it go up year after year. The S&P 500 isn’t a bad investment, it’s just not a good one. It will test your nerve, and then test it some more. As a recent post by Reformed Broker noted: Just because it’s cheap and easy to get exposure to stocks these days, that doesn’t mean it’ll be mentally cheap and easy to stick with them.

Buy-And-Holders Predict Future Returns Every Day, While Claiming That Predictions Don’t Work

By Rob Bennett Buy-and-holders don’t believe in return predictions . They say it is not possible to predict returns effectively. Their cardinal rule is that investors should never engage in market timing, and so they object strongly when valuation-informed indexers use return predictions to change their stock allocations. That’s market timing. It doesn’t work. It’s crazy. It’s a mistake. They believe this stuff. They are sincere in their repulsion for market timing and for return predictions. But the buy-and-holders make return predictions themselves! They don’t know it. They fool themselves into thinking they are not making return predictions. But it’s not possible to buy stocks without first forming some idea in your mind as to what return you expect to obtain. The buy-and-hold idea that it is not a good idea to make return predictions is not only strategically flawed, it is a logical impossibility. Say you were thinking of buying a car, and for some odd reason you vowed not to consider price when doing so. Could you do it? You could physically do it. But you couldn’t do it with a clear mind. Human reason demands of us that we consider price when trading money for something that we want to obtain. It works that way with stocks too. It’s not possible to buy stocks without the thought entering your head that you would like to obtain a return on your money that is greater than the return you could obtain from buying less risky asset classes. And it’s not possible to go ahead with the purchase without some notion of what return you expect to obtain entering your thought process. The buy-and-holders kid themselves about this. They need to believe that return predictions are not possible or they could not remain buy-and-holders (buy-and-holders who elect to become clear thinkers are transformed into valuation-informed indexers!). But they are not able to keep themselves entirely in the dark. Common sense intrudes. That’s why buy-and-holders become uncomfortable when people like me write on the internet about the implications of the last 35 years of peer-reviewed research in this field. Buy-and-holders believe they are going to obtain a return of 6.5 percent real on their stock investments. That’s the average return. So that’s their default. They compare the 6.5 percent return they expect to obtain from investing in stocks with whatever return they can obtain from less risky asset classes and elect stocks when the expected return from stocks is better. It always is. That’s why buy-and-holders invest most of the money that they do not expect to need within a few years in stocks. Buy-and-holders, of course, understand that they are not going to see that 6.5 percent return every year. There are some years in which stocks provide a return of 30 percent, and there are some years in which stocks provide a return of a negative 30 percent. But a positive 6.5 percent is the norm. That’s what buy-and-holders expect. That’s what buy-and-holders predict. Ask a buy-and-holder what he expects his stock return will be after the passage of 10 years. He will say that he expects something in the neighborhood of 6.5 percent. He doesn’t expect precisely that. Of course, valuation-informed indexers don’t expect their predictions to apply precisely either. He view the predictions we make by looking at the valuation level that applies on the day we make our stock purchases as in-the-neighborhood numbers. That’s how buy-and-holders view their prediction that the usual 6.5 percent return will establish itself once again. The reality, of course, is that there is a strong chance the 6.5 percent return will not re-establish itself. It’s reasonable to expect such a return for stocks purchased at fair value prices. But stocks are frequently sold either at inflated prices or at deflated prices. When stocks are sold at wildly inflated prices or at wildly deflated prices, it is not likely that the 6.5 percent return will apply in 10 years. The likelihood is that a return a good bit lower than 6.5 percent will apply (for stocks purchased at wildly inflated prices), or that a return a good bit higher than 6.5 percent will apply (for stocks purchased at wildly deflated prices). A poster at the Bogleheads Forum once stated this idea in compelling fashion: “I don’t go into a bank and say ‘I’d like to buy three certificates of deposit’ without first asking what rate of return applies – Why should it be different when I buy stocks?” It shouldn’t be any different. We cannot know the return we will obtain from stocks with precision. But then, we cannot know the return that we will obtain from certificates of deposit with precision either. The inflation rate is unknown at the time of purchase of certificates of deposit, and the inflation rate affects the real return obtained. With certificates of deposit, we all do the best we can. We look up the nominal return and form some reasonable expectation of what inflation rate might apply. We educate ourselves to the best of our ability. This is the step that buy-and-holders fail to take when they buy stocks. Why? Buy-and-holders want to know the return they will obtain from the certificates of deposit they purchase. Why don’t they want to know the return they will obtain from the stocks they purchase? They want to believe in bull markets. They want to believe that the 6.5 percent average return is a floor that applies even when prices are insanely high, but that returns that exceed the 6.5 average return are real and do not pull future returns down. They want to believe in a fantasy that makes it impossible for them to purchase stocks in as informed a manner as they purchase certificates of deposit. Disclosure: None.

The Upside And Downside Of Market Capture With Alternatives

By Richard Brink Over the long run, alternative investments have outpaced traditional 60/40 stock/bond portfolios with lower volatility. What’s the secret? Gaining more in up markets than they lose in down markets. The Upside/Downside Capture Ratio Successful alternative strategies are managed to capture some part of the equity market’s upside and an even smaller part of the market’s downside. The concept is to win by not losing, and it’s reflected in the up/down capture ratio. Let’s take a strategy with an up/down capture ratio of 50/20. When markets are doing well, it delivers 50% of the upside; when markets are down, it delivers 20% of the downside. Capturing only half of the equity market’s gains in an up market with an alternative strategy may not sound too appealing on the surface. But what’s the flip side? In bear markets, investors experience only 20% of the downside. Alternatives vs. Equity: The Tortoise and the Hare Let’s compare a hypothetical $10,000 investment made in 1995 – for 20 years – in the S&P 500 equity index with an equal investment in a hypothetical alternative strategy with a 50/20 up/down capture ratio (Display). It ends up looking a lot like the fable of the tortoise and the hare. The S&P 500 – the “hare” in this scenario – got off to a fast start. During the tech bubble buildup in the late 1990s and early 2000s, the equity market dominated – and the gap between the two investment approaches widened. But then the tech bubble burst, and the S&P 500 lost major ground. The 50/20 alternative strategy – the “tortoise” – which had been steadily, if modestly, plugging along at “half-speed” until the sell-off, pulled ahead. As we know, markets eventually stabilized and US equities resumed their upward march. But just as the S&P 500 started to catch back up, the 2008 financial crisis sent stocks reeling again. The S&P 500 lost 51% of its value by early 2009, while the 50/20 declined by only 10%. The importance of that is found in the time needed to recover the losses. In the recovery that followed, the 50/20 was back to its previous peak in nine months. The S&P 500 took more than three years. Indeed, despite very strong US equity market performance over the past several years, the S&P 500 has still not caught up. Over a 20-year span of this tortoise and hare battle, the alternative strategy would have ended up delivering dramatically higher returns than the S&P 500 – but with less than half of the stock market’s volatility. Pretty crafty turtle. Click to enlarge The Insurance Perspective Why doesn’t everyone find an alternative strategy with 50/20 up/down capture? After all, this isn’t just hypothetical – the average up/down capture ratio of the entire HFRI Equity Hedge category, for example, is 65/32. In large part, it likely has to do with the investment experience. In other words, some investors would rather simply fire a manager who delivered just 50% of the market’s upside in a rally. When that frustration sets in, it’s easier to dismiss a strategy’s effectiveness in bear markets. This was magnified in the past few years by a central bank-supported “beta trade,” with strong performance and generally short-lived downturns. That appears to be changing, but investors need to be diligent in searching for a strategy that fits their long-term needs. It helps to think of a strategy’s up/down capture ratio as an insurance policy. For the strategy with 50/20 up/down capture, the difference between the market’s gain and the strategy’s up capture – in this case, 50% of the full market gain – is the insurance premium you pay in terms of sacrificed upside potential during up markets. The “down” capture of 20% can be viewed as a deductible – you experience a loss of 20% on the alternative strategy before its “policy” kicks in and protects the downside. Finding the Right Fit Alternative strategies come with many different combinations of upside and downside market capture. We think the best way to approach the choice is by following three steps: 1) Find a strategy with a level of upside capture you’re comfortable with 2) Make sure there’s a complementary downside capture 3) Gain confidence that the manager can continue to deliver that experience consistently It all comes back to a point we’ve emphasized before: Investors should know what they want when they’re looking for an alternative strategy. And they should identify the right manager who can consistently deliver the return experience they’re looking for. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management team s Richard Brink, CFA – Managing Director-Alternatives and Multi-Asset