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The Ultimate Guide To Risk Parity And Rising Interest Rates

Click to enlarge Risk Parity has had a phenomenal year-to-date. One popular provider of the strategy for retail clients is up nearly 9% while the S&P is up a little over 3%. This is primarily due to big rallies in both the bond and commodity markets, as the Fed has continued to ease off on interest rates while the global outlook has stabilized. YTD Performance of Major Asset Classes vs. Risk Parity (labeled “You”) Source: Yahoo Finance, Federal Reserve , WSJ , Hedgewise Despite this strong outperformance, the bond rally has raised a familiar worry: what happens when interest rates rise? Given the strategy has a heavier bond allocation than most traditional portfolios, does it continue to be a viable option? Fortunately, we have decades of historical data that show that rising interest rates are not a cause for great concern. In times of high inflationary pressure, like the 1970s, the strategy is protected by assets like commodities and inflation-protected bonds. While higher short-term rates do reduce the benefits of using leverage, our backtested model still performed at least as well as the S&P 500 throughout the 70s. The absolute “worst case” scenario is one in which rates are being driven up by continuously strong real growth, such as the post-WWII economy from 1950 to 1970. In this situation, both bonds and real assets like gold will tend to perform poorly while the stock market rockets ahead. Though Risk Parity will probably underperform the S&P 500 over such a stretch, you will still make solid returns ; they simply won’t be as high compared to a portfolio of 100% equities. In exchange for this possibility, you avoid the risk that the next 2008 may be right around the corner. While rising interest rates may seem like a foregone conclusion, recent history in Germany and Japan demonstrates that rates may be just as likely to fall. In short, it only makes sense to move away from Risk Parity if you are absolutely sure we will experience a booming, robust economy over the next 20 years and you can afford a few 40% downturns along the way. If you have this conviction, by all means, move to 100% equities. If you aren’t sure, though, recall that Risk Parity is a long term investment strategy that has consistently produced reasonable returns without the need to predict the future. Modeling Performance in the 1970s: Inflation Protection Works From 1970 to 1983, the Federal Funds rate rose from 4% to nearly 20%, or a whopping 1600 basis points. The US was facing a vicious combination of rising prices and falling economic activity, also known as “stagflation”. This provided an excellent environment to pressure test the Risk Parity framework, which you might expect to do terribly given its heavy bond allocation. However, just the opposite occurred: our model outperformed equities nearly the entire time . To create the historical model, we had to make a few key assumptions: We are using a modified form of our proprietary risk management framework, as there was not nearly the amount of market data available in the 70s as there is today. Our belief is that this is a handicap, and we expect our framework would perform even better than is shown here if we had the same data available. We limited the portfolio to nominal bonds (NYSEARCA: IEF ), equities (NYSEARCA: SPY ), and gold (NYSEARCA: GLD ) because inflation-protected bonds (NYSEARCA: TIP ) did not yet exist, nor did reliable data on the price of commodities like oil and copper. The assets that we had to exclude all tend to perform well in periods of high inflation, and would likely buoy performance within our full model. Risk Parity is typically available at multiple ‘risk levels’, the higher of which amplify expected returns through leverage. We ran an unleveraged “Low Risk” version of the model as well as a leveraged “High Risk” version. The portfolios are based on end-of-day index prices and do not account for live trading conditions. All dividends and coupon payments are included and assumed reinvested. Leverage is assumed to have a cost equal to the rate on one-year treasury bonds. The model does not include the cost of commissions or management fees. Performance of Risk Parity “Low Risk” and “High Risk” Models vs. S&P 500, 1970 to 1982 Click to enlarge Source: Hedgewise Analysis Despite one of the worst decades for bonds ever in history, both versions of the Risk Parity portfolio outperformed equities for nearly this entire stretch. This was possible for two reasons. First, ten-year bonds still achieved an annualized return of about 6% during this timeframe. Even though rising rates eroded the principal value of the bonds, this was counterbalanced by consistently higher yields. Second, assets that provide protection from inflation, like gold, performed incredibly well in this environment as the value of the US dollar plummeted. That said, it is interesting to note that based on total return over the entire timeframe, the “High Risk” portfolio failed to outperform the “Low Risk” portfolio even though it was far more volatile and leveraged. This makes sense when you realize that short-term interest rates were often higher than long-term rates during this period. In other words, you were often paying more in interest than you were making back. Does this mean that using leverage doesn’t make sense when interest rates are rising? Not necessarily. The “High Risk” portfolio actually was outperforming most of the time; the net result was highly influenced by the final period in which rates rose most rapidly. Still, it is accurate to say that leverage will be less useful compared to periods of flat or falling interest rates. Taken together, these facts lead to a few important takeaways. Even if you are relatively certain that inflation is about to pick up, Risk Parity would still be a great choice . In this kind of environment, higher risk level portfolios may occasionally fail to outperform the lower risk levels, though they would all generally perform well compared to the S&P 500. If you are absolutely convinced that we are heading for another period like the 70s, you might consider avoiding leverage, but it certainly wouldn’t make sense to abandon the strategy altogether. Before we move on, keep in mind that the decade of the 70s was the earliest period of rising rates in which we had enough data to do a proper simulation of our model. When studying the 50s and 60s, we must rely on a drastically more simplistic version. Still, this severely handicapped portfolio can effectively demonstrate some of the timeless concepts of the Risk Parity Framework. Modeling Performance in the 1950s and 1960s: The Boomer Years The Post-WWII economy in the US was incredibly robust. For nearly 20 years, we experienced strong real growth with relatively limited inflation and no major recessions. The S&P 500 grew by over 10% annually, while nominal bonds returned only 2% annually due to consistently rising real rates. You’d expect a portfolio of 60% bonds would make no sense; never mind adding leverage to the mix! However, such a portfolio still provided solid, steady returns with a lower risk of drawdowns . Using leverage also successfully increased returns, though not significantly. This was true even with no active risk management and during two of the worst performing decades for nominal bonds in history! To be clear, in hindsight, equities were the top performing asset class, and any mix besides 100% stocks probably underperformed. However, this fact misses the entire point of diversification: you just don’t know what is going to perform well next. Of course you will do better if you always switch into the asset class that is about to blow the others away, but you’ll often be wrong. Risk Parity allows you to consistently do well regardless of the environment. With that said, let’s take a look at the data from these decades. Here’s how we constructed the model this time: Since data was not available to implement active risk management, we assumed a static split of 40% stocks and 60% bonds for the Risk Parity portfolio. We took this same mix and added 75% leverage, for a final mix of 70% stocks and 105% bonds. This is a simple, static performance model that is limited to two assets. Performance of our full model in the same time period would likely have been better. Performance of 40% Stock / 60% Bond Mix and Leveraged 40/60 Mix vs. S&P 500, 1953 to 1970 Click to enlarge Source: Hedgewise Analysis As expected, the bond-heavy mix was unable to keep up with equities over this timeframe. However, both the unleveraged and the leveraged versions of the portfolio still performed reasonably well from an absolute standpoint. The unleveraged 40/60 mix averaged an annual return of 5.5% with less than half the volatility of the stock market and significantly smaller drawdowns. If your goal was capital preservation and moderate growth, this portfolio may have still been a better choice. While it’s easy to argue otherwise when you look over the 20 years, stocks experienced a number of significant declines during that timeframe that may have been unacceptable for someone close to retirement or with a shorter time horizon. For example, stocks lost as much as 31% during the dips in 1958, 1962, 1966, and 1968. If you needed to exit the market during these periods, or you were actively taking withdrawals out of your investments along the way, such losses could significantly damage your outlook. With our leveraged mix, we see a similar theme to what occurred during the 70s: you will still achieve higher returns using leverage, but not significantly so. Importantly, this dispels the myth that levering up a Risk Parity portfolio will be disastrous when bonds do poorly. The leverage is not harmful; it just isn’t as helpful compared to other times. Plus, remember that the modern day version of the portfolio would likely exhibit a much smaller performance gap compared to the one shown here. The key to this analysis is deciding what it means to you. First, consider how sure you are that stocks will be the top performing asset class over the next 20 years due to strong real growth and low inflation. If we experience any other kind of environment, Risk Parity will tend to outperform. Second, evaluate how damaging each worst-case scenario might be for you personally. If you moved to 100% equities at the peak of the dot-com bubble, it took you nearly a decade to recover your losses. If you utilized a simplistic version of Risk Parity during the Post-WWII era, you still made 6.6% instead of 10.4%. As with any kind of diversification, it only makes sense if you agree that the future is quite uncertain. As much as it may seem that bonds are about to enter a prolonged bear market, there’s a good deal of evidence that suggests quite the opposite. Where Have the Rising Interest Rates Gone? Supposedly, the bond bull market in the US has been on the verge of ending for about 4 years now. There was the so-called ‘taper tantrum’ in 2013, during which yields rocketed over 100bps when Bernanke announced the end of ‘Quantitative Easing’. Yet the US economy continued to sputter along slowly and global weakness brought yields back down. In late 2015, the Fed was expected to raise rates as many as 6 times in the near-future. Then, a global collapse in commodity prices and rapidly slowing growth in China caused them to back-off again. Meanwhile, ten-year bonds have continued to hover around 2%. 10-Year US Treasury Yields Since 2000 Click to enlarge The gut reaction to this graph is to think that we must be near the bottom. However, there is no reason that we can’t fall well below a 2% yield for decades. Japan, for example, has had ten-year yields under this level for almost 20 years. 10-Year Japanese Treasury Yields Since 1990 (2% yield emphasized) Click to enlarge Many are quick to point out that our economic history is quite a bit different than Japan’s. Instead, let’s take a look at Germany: 10-Year German Treasury Yields Since 2000 (2% yield emphasized) Click to enlarge The reality is that the entire world remains in a very fragile state. On a relative basis, yields in the US are actually still pretty high. In the EU, a number of countries have recently introduced negative interest rates to continue to combat recessionary pressure. The point is that we may be at the end of the bond bull market, but it’s also entirely possible that we are not. Conclusion: Rising Rates Are Not a Big Concern The evidence presented in this article helps clarify some extremely important concerns about Risk Parity. In the thirty-year stretch from the 1950s to the 1980s, adding leverage to a bond-heavy portfolio never resulted in disaster; it just had less of a positive effect on returns. During the most inflationary period in US history, our model outperformed the S&P 500 for a majority of the time. These facts boldly refute the idea that Risk Parity only ‘works’ during bond bull markets. As with any kind of diversification, there will always be periods when one asset is outperforming the others. In exchange for tolerating this, you get steadier, more reliable returns which do not depend on you predicting the future. You become less vulnerable to a crash in any given market. You’ll tend to make money even when interest rates are steadily rising, but you’ll make less than you could have if you had perfect foresight. Even if you do have a strong conviction that rates are about to rise, an unleveraged Risk Parity portfolio remains an excellent choice for investors with a shorter timeframe because of its significantly smaller drawdowns and steady historical returns. We would absolutely recommend such a portfolio over cash regardless of the market environment. For longer term investors, be wary about the likelihood that we are about to enter a period of growth similar to the post-WWII economy. As many countries in Europe and Asia have already demonstrated, another recession may be a far bigger risk. Finally, please keep in mind that this article focused on extreme scenarios, including the naïve construction of the model portfolios and the chosen start and end dates of the analysis. If the Risk Parity framework can hold up relatively well despite these handicaps, there’s little reason to keep worrying about the specter of rising interest rates. If you are interested in learning more about Risk Parity, check out this white paper overview . We’ll also be publishing the current construction of our “Low Risk” and “High Risk” portfolios early in May. Be sure to follow us if you’d like to receive it. Disclosure: I am/we are long SPY, IEF, TIPS, GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. To the extent that any of the content published may be deemed to be investment advice or recommendations in connection with a particular security, such information is impersonal and not tailored to the investment needs of any specific person. Hedgewise may recommend some of the investments mentioned in this article for use in its clients’ portfolios. Past performance is no indicator or guarantee of future results. This document is for informational purposes only. Investing involves risk, including the risk of loss. Information in this document has been compiled from data considered to be reliable, however, the information is unaudited and is not independently verified. Performance data is based on publicly available index or asset price information and does not represent a live portfolio except where otherwise explicitly noted. All dividend or coupon payments are included and assumed to be reinvested monthly.

How To Play The Demise Of The U.S. Dollar

The US dollar currently is the world’s reserve currency. What that means, other currencies are ‘backed’ by the dollar. Foreign central banks hold US dollars as a reserve, making their own currencies more valuable. It has replaced the previous standard, the gold standard because the USD was ‘good as gold.’ There seems to be an underlying fear that the US dollar will be ‘replaced’ by an alternative such as the Chinese yuan, Russian ruble, Arabic dinar, amero, or some other ‘One World Currency.’ We’ll display here facts proving that this is impractical for the next 20 years at least. The latest threat comes from Saudi Arabia. A new law would allow families of victims of the tragic events of 9/11 to sue a sovereign government, Saudi Arabia, for involvement in the attacks of some kind. WSJ has written an explanation of what it means and how it can impact markets: President Barack Obama ‘s trip to Saudi Arabia this week and pending legislation that would enable families of people killed in the Sept. 11, 2001 terrorist attacks to sue the Gulf kingdom have prompted fresh calls to declassify 28 pages of a congressional report said to describe links between Saudi Arabia and the terrorists. “If all of the information comes out and [the legislation] is passed we can move forward against the Saudis,” said Jim Kreindler, one of the lawyers representing the families of Sept. 11 victims. But is it really feasible, that the Kingdom sells huge amounts of US assets? Marc Chandler proposed the most recent analysis in a recent article on the topic : There is something else Saudi Arabia could do. It could take a page from the playbook of the former Soviet Union. When it saw how the US treated its special ally Great Britain in the Suez Crisis, the Soviet Union was wary of the US using its financial power for political ends; it feared that its assets in the US could be frozen. It took the dollars it had in the US and deposited them with a UK merchant bank. That merchant bank was able to lend out those dollars without the interest rate cap that prevailing in the US at the time. This is to say that the offshore dollar market was launched not by good capitalists and the internationalization of savings, but the Communists seeking to move out of reach of US officials. Saudi Arabia could do the same thing. It could takes its US Treasury holdings and bring them to a foreign custodian, who is not subject to US laws. This may be more difficult to do with some of the other assets it may own in the United States. Overall this course would prove to be less disruptive for it than selling Treasuries. That means, there are a number of practicalities not considered by those who promote this idea that somehow a foreign power such as Saudi Arabia, China, Russia, or others; could trigger a US markets event that could lead to a run on the US dollar. Could it happen? Of course. But if it did happen, even in the worst case scenario, there are number of protections in place (similar to ‘circuit breakers’) that would prevent something extreme. Electronic markets mean that on the one hand, information ripples around the world at light speed, and institutions can make decisions in seconds and with 1 click sell or buy trillions in assets. But on the other hand, they have allowed the consolidation of control into one power. In the case of the stock markets, that’s the exchange. The NYSE reserves the right to halt trading or implement other measures, should a situation such as 9/11 occur. This has never happened in currency markets, but if it did, the Fed could literally halt US dollar markets around the world. Because the Fed controls all US dollar payments. It could be impossible to ‘sell’ the dollar, at a rate that would create severe decline. Also remember that the Fed works in conjunction with other central banks, to provide US dollar funding (among other functions): In response to mounting pressures in bank funding markets, the FOMC announced in December 2007 that it had authorized dollar liquidity swap lines with the European Central Bank and the Swiss National Bank to provide liquidity in U.S. dollars to overseas markets, and subsequently authorized dollar liquidity swap lines with each of the following central banks: the Reserve Bank of Australia, the Banco Central do Brasil, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Korea, the Banco de Mexico, the Reserve Bank of New Zealand, Norges Bank, the Monetary Authority of Singapore, Sveriges Riksbank, and the Swiss National Bank. Those arrangements terminated on February 1, 2010. In May 2010, the FOMC announced that in response to the re-emergence of strains in short-term U.S. dollar funding markets it had authorized dollar liquidity swap lines with the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank. In October 2013, the Federal Reserve and these central banks announced that their existing temporary liquidity swap arrangements–including the dollar liquidity swap lines–would be converted to standing arrangements that will remain in place until further notice. And remember – currencies are traded in pairs – so if the US dollar is ‘sold’ – something must be ‘bought’ – it’s not like a stock. It’s not possible to sell the US dollar without ‘buying’ something else, such as the Euro, Pound, Swiss Franc, or Gold. Looking at it from one perspective, although forex markets are completely unregulated, they are also completely manipulated. That’s because the central bank controls its own currency completely. Central banks cannot control other currencies, only their own – which is why they usually work together, through institutions such as the BIS. In any event, during a currency crisis of any kind, like minded nations would turn to each other and the BIS. But investors must understand that modern Forex is a closed system, as explained in detail in the “Splitting Pennies” book. If any currency poses a threat to the US dollar – it’s bitcoin, not the yuan. That’s because bitcoin is not manipulated, and not inside the forex system – it’s an externally manufactured currency, not created by a central bank. The problem with our modern forex system is that there are 10 myths for every 1 fact, and they don’t teach it in school. Finally, these fears about China somehow smashing US markets by a fire sale are completely unfounded. First, China is incapable of managing its own economy . They say the western fiat economic monetary system is a ‘Ponzi’ – if it is, then China is a super- Ponzi . Don’t forget the history – China’s economy is just about as old as the Forex market itself. It needs time to evolve and grow. There are still many elements in the Chinese economy which are missing, but are necessary for a financial world leader capable of managing a world reserve currency. Yes, they are taking steps, such as the recent gold price fixing . But these are baby steps, it will take decades before China can crawl, walk, and finally run. At the moment it relies on US support, financially, politically, and economically. The US is currently China’s biggest customer. It’s a cozy relationship – the US prints US dollars and sends to China, China sends manufactured junk to the US. This is one leg that supports the US dollar, created by Richard Nixon. The other leg being the petro dollar system. By recycling US dollars in US markets, it ties China to the US as well, provides natural demand for USD. For China to completely abandon this system, would crash their economy. America is capable of producing cheap junk, should the need arise. It would even be politically popular, and regenerate the US manufacturing sector. But China is incapable of creating by itself, a world class banking system. They need western involvement, even if it’s a simple copy and paste operation. China is not Japan – it can take China 100 years to adopt western systems, or longer. They have long term thinking, which is a good thing generally, compared to the quick timeline of Western thinking. But insofar as there is any threat to the US dollar, from China, Saudi Arabia, or elsewhere, it’s preposterous. So although we have debunked these myths about the fallacy of real paradigm shift in regards to the US dollar, all these new players may provide pressure on the US dollar, as some choose to sell their US assets in favor of new systems, especially regional players who until now, didn’t have a choice other than the USD. Currently the US dollar has a monopoly on the global Forex market which isn’t a good thing. Competition is healthy, it will ultimately make global markets more stable. At the end of the day, the US dollar is supposed to create an environment for markets to exist, not be a market itself, which it has become. Ways to trade the fear of US dollar Demise 1. Short USD ETFs (NYSEARCA: UUP ) and (NYSEARCA: USDU ). ETFs offer great alternatives to Forex because of their availability in stock markets, and their wide variety of options. UUP has options going out 2 years, to 2018, with decent liquidity. By trading options on an ETF, you have the security of US regulations and the security of US protections against fraud. Broker-dealers don’t go bust often like Forex brokers do, and are regulated by FINRA. Also, for some it may be convenient to hold these contracts in the same account for which you do your other investing. 2. Long Gold & Silver. There are many ways to play gold and silver. The most popular gold ETF is (NYSEARCA: GLD ) and the most popular silver ETF is (NYSE: SRV ). Similar to other ETFs, deep out the money options provide a great way to play this strategy, and will provide the best bang for the buck. One futures strategy employed by some traders, to buy the Gold contract and not roll it over, thus receiving delivery of the underlying. Futures trading offers a great alternative to stock ETFs , as you would be trading the actual commodity itself, in this case Gold & Silver. 3. Long Forex banks Any bank that utilizes multiple currencies, such as Everbank (NYSE: EVER ), will profit from their strategic positioning. Banks who do business in emerging markets, who will capture this new Forex business, will profit too. The point here is that when China comes online completely, it will be a good thing – it’s a new customer. Don’t worry though, markets will be organized by western banks for as long as all of us are alive. We just have too much of a head start. In conclusion, be wary of claims made by those who do not fully understand how the global Forex system works. The US dollar will have less and less role to play in the world – US dollar hegemony was an accident. Forex was an accident, created by a US President, Richard Nixon. At the same time, Nixon opened China, and we are now seeing the result of those protocols – China is close to having a real free market system (just remember to bring your stomach medicine if you visit, or bring your own food and water). Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

My Passion Is Puppetry

We are supposedly living in the Golden Age of television. Maybe yes, maybe no (my view: every decade is a Golden Age of television!), but there’s no doubt that today we’re living in the Golden Age of insurance commercials. Sure, you had the GEICO gecko back in 1999 and the caveman in 2004, and the Aflac duck has been around almost as long, but it’s really the Flo campaign for Progressive Insurance in 2008 that marks a sea change in how financial risk products are marketed by property and casualty insurers. Today every major P&C carrier spends big bucks (about $7 billion per year in the aggregate) on these little theatrical gems. This will strike some as a silly argument, but I don’t think it’s a coincidence that the modern focus on entertainment marketing for financial risk products began in the Great Recession and its aftermath. When the financial ground isn’t steady underneath your feet, fundamentals don’t matter nearly as much as a fresh narrative. Why? Because the fundamentals are scary. Because you don’t buy when you’re scared. So you need a new perspective from the puppet masters to get you to buy, a new “conversation”, to use Don Draper’s words of advertising wisdom from Mad Men . Maybe that’s describing the price quote process as a “name your price tool” if you’re Flo, and maybe that’s describing Lucky Strikes tobacco as “toasted!” if you’re Don Draper. Maybe that’s a chuckle at the Mayhem guy or the Hump Day Camel if you’re Allstate or GEICO. Maybe, since equity markets are no less a financial risk product than auto insurance, it’s the installation of a cargo cult around Ben Bernanke, Janet Yellen, and Mario Draghi , such that their occasional manifestations on a TV screen, no less common than the GEICO gecko, become objects of adoration and propitiation. For P&C insurers, the payoff from their marketing effort is clear: dollars spent on advertising drive faster and more profitable premium growth than dollars spent on agents . For central bankers, the payoff from their marketing effort is equally clear. As the Great One himself, Ben Bernanke, said in his August 31, 2012 Jackson Hole speech: “It is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC’s decision to greatly expand securities purchases.” Probably not a coincidence, indeed. Here’s what this marketing success looks like, and here’s why you should care. This is a chart of the S&P 500 index (green line) and the Deutsche Bank Quality index (white line) from February 2000 to the market lows of March 2009. Click to enlarge Source: Bloomberg Finance L.P., as of 3/6/2009. For illustrative purposes only. Now I chose this particular factor index (which I understand to be principally a measure of return on invested capital, such that it’s long stocks with a high ROIC, i.e. high quality, and short stocks with a low ROIC, all in a sector neutral/equal-weighted construction across a wide range of global stocks in order to isolate this factor) because Quality is the embedded bias of almost every stock-picker in the world. As stock-pickers, we are trained to look for quality management teams, quality earnings, quality cash flows, quality balance sheets, etc. The precise definition of quality will differ from person to person and process to process (Deutsche Bank is using return on invested capital as a rough proxy for all of these disparate conceptions of quality, which makes good sense to me), but virtually all stock-pickers believe, largely as an article of faith, that the stock price of a high quality company will outperform the stock price of a low quality company over time. And for the nine years shown on this chart, that faith was well-rewarded, with the Quality index up 78% and the S&P 500 down 51%, a stark difference, to be sure. But now let’s look at what’s happened with these two indices over the last seven years. Click to enlarge Source: Bloomberg Finance L.P., as of 3/28/2016. For illustrative purposes only. The S&P 500 index has tripled (!) from the March 2009 bottom. The Deutsche Bank Quality index? It’s up a grand total of 10%. Over seven years. Why? Because the Fed couldn’t care less about promoting high quality companies and dissing low quality companies with its concerted marketing campaign – what Bernanke and Yellen call “communication policy” , the functional equivalent of advertising. The Fed couldn’t care less about promoting value or promoting growth or promoting any traditional factor that requires an investor judgment between this company and that company. No, the Fed wants to promote ALL financial assets, and their communication policies are intentionally designed to push and cajole us to pay up for financial risk in our investments, in EXACTLY the same way that a P&C insurance company’s communication policies are intentionally designed to push and cajole us to pay up for financial risk in our cars and homes. The Fed uses Janet Yellen and forward guidance; Nationwide uses Peyton Manning and a catchy jingle. From a game theory perspective it’s the same thing. Where do the Fed’s policies most prominently insure against financial risk? In low quality stocks, of course. It’s precisely the companies with weak balance sheets and bumbling management teams and sketchy non-GAAP earnings that are more likely to be bailed out by the tsunami of liquidity and the most accommodating monetary policy of this or any other lifetime, because companies with fortress balance sheets and competent management teams and sterling earnings don’t need bailing out under any circumstances. It’s not just that a quality bias fails to be rewarded in a policy-driven market, it’s that a bias against quality does particularly well! The result is that any long-term expected return from quality stocks is muted at best and close to zero in the current policy regime. There is no “margin of safety” in quality-driven stock-picking today, so that it only takes one idiosyncratic stock-picking mistake to wipe out a year’s worth of otherwise solid research and returns. So how has that stock-picking mutual fund worked out for you? Probably not so well. Here’s the 2015 S&P scorecard for actively managed US equity funds, showing the percentage of funds that failed to beat their benchmarks over the last 1, 5, and 10 year periods. I mean … these are just jaw-droppingly bad numbers. And they’d be even worse if you included survivorship bias. % of US Equity Funds that FAILED to Beat Benchmark 1 Year 5 Years 10 Years Large-Cap 66.1% 84.2% 82.1% Mid-Cap 56.8% 76.7% 87.6% Small-Cap 72.2% 90.1% 88.4% Source: S&P Dow Jones Indices, “SPIVA US Scorecard Year-End 2015” as of 12/31/15. For illustrative purposes only. Small wonder, then, that assets have fled actively managed stock funds over the past 10 years in favor of passively managed ETFs and indices. It’s a Hobson’s Choice for investors and advisors , where a choice between interesting but under-performing active funds and boring but safe passive funds is no choice at all from a business perspective. The mantra in IT for decades was that no one ever got fired for buying IBM (NYSE: IBM ); today, no financial advisor ever gets fired for buying an S&P 500 index fund. But surely, Ben, this, too, shall pass. Surely at some point central banks will back away from their massive marketing campaign based on forward guidance and celebrity spokespeople. Surely as interest rates “normalize”, we will return to those halcyon days of yore, when stock-picking on quality actually mattered. Sorry, but I don’t see it. The mistake that most market observers make is to think that if the Fed is talking about normalizing rates, then we must be moving towards normalized markets, i.e. non-policy-driven markets. That’s not it. To steal a line from the Esurance commercials, that’s not how any of this works. So long as we’re paying attention to the Missionary’s act of communication , whether that’s a Mario Draghi press conference or a Mayhem Guy TV commercial, then behaviorally-focused advertising – aka the Common Knowledge Game – works. Common Knowledge is created simply by paying attention to a Missionary. It really doesn’t matter what specific message the Missionary is actually communicating, so long as it holds our attention. It really doesn’t matter whether the Fed hikes rates four times this year or twice this year or not at all this year. I mean, of course it matters in terms of mortgage rates and bank profits and a whole host of factors in the real economy. But for the only question that matters for investors – what do I do with my money? – nothing changes . Stock-picking still won’t work. Quality still won’t work. So long as we hang on every word, uttered or unuttered, by our monetary policy Missionaries, so long as we compel ourselves to pay attention to Monetary Policy Theatre, then we will still be at sea in a policy-driven market where our traditional landmarks are barely visible and highly suspect. Here’s my metaphor for investors and central bankers today – the brilliant Cars.com commercial where a woman is stuck on a date with an incredibly creepy guy who declares that “my passion is puppetry” and proceeds to make out with a replica of the woman. Click to enlarge What we have to do as investors is exactly what this woman has to do: get out of this date and distance ourselves from this guy as quickly as humanly possible. For some of us that means leaving the restaurant entirely, reducing or eliminating our exposure to public markets by going to cash or moving to private markets. For others of us that means changing tables and eating our meal as far away as we possibly can from Creepy Puppet Guy. So long as we stay in the restaurant of public markets there’s no way to eliminate our interaction with Creepy Puppet Guy entirely. No doubt he will try to follow us around from table to table. But we don’t have to engage with him directly. We don’t have participate in his insane conversation. No one is forcing you keep a TV in your office so that you can watch CNBC all day long! Look … I understand the appeal of a good marketing campaign. I live for this stuff. And I understand that we all operate under business and personal imperatives to beat our public market benchmarks, whatever that means in whatever corner of the investing world we live in. But I also believe that much of our business and personal discomfort with public markets today is a self-inflicted wound , driven by our biological craving for Narrative and our social craving for comfortable conversations with others and ourselves , no matter how wrong-headed those conversations might be. Case in point: if your conversation around actively managed stock-picking strategies – and this might be a conversation with managers, it might be a conversation with clients, it might be a conversation with an Investment Board, it might be a conversation with yourself – focuses on the strategy’s ability to deliver “alpha” in this puppeted market, then you’re having a losing conversation. You are, in effect, having a conversation with Creepy Puppet Guy. There is a role for actively managed stock-picking strategies in a puppeted market, but it’s not to “beat” the market. It’s to survive this puppeted market by getting as close to a real fractional ownership of real assets and real cash flows as possible. It’s recognizing that owning indices and ETFs is owning a casino chip, a totally different thing from a fractional ownership share of a real world thing. Sure, I want my portfolio to have some casino chips, but I ALSO want to own quality real assets and quality real cash flows, regardless of the game that’s going on all around me in the casino. Do ALL actively managed strategies or stock-picking strategies see markets through this lens, as an effort to forego the casino chip and purchase a fractional ownership in something real? Of course not. Nor am I using the term “stock-picking” literally, as in only equity strategies are part of this conversation. What I’m saying is that a conversation focused on quality real asset and quality real cash flow ownership is the right criterion for choosing between intentional security selection strategies, and that this is the right role for these strategies in a portfolio. Render unto Caesar the things that are Caesar’s. If you want market returns, buy the market through passive indices and ETFs. If you want better than market returns … well, good luck with that. My advice is to look to private markets, where fundamental research and private information still matter. But there’s more to public markets than playing the returns game. There’s also the opportunity to exchange capital for an ownership share in a real world asset or cash flow. It’s the meaning that public markets originally had. It’s a beautiful thing. But you’ll never see it if you’re devoting all your attention to CNBC or Creepy Puppet Guy.