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Why Equity Outperforms Credit

In my new paper on asset allocation I go into quite a bit of detail about why certain asset classes generate the returns they do. Understanding this is useful when thinking in a macro sense and trying to gauge why financial assets perform in certain ways in both the short-term and the long-term. It’s important to understand the fundamental drivers of these returns in order to avoid falling into the trap that these assets generate returns due to the way they’re traded in the markets. One of the more common misconceptions I see in the financial space is that credit traders are smarter than equity traders. This is usually presented with charts showing how credit “leads” equity performance or something like that. One of the more egregious offenders of this is a chart that has been going around in the last few days from Jeffrey Gundlach’s presentation showing credit relative to equity: One might look at this and conclude that these lines should necessarily converge at some point. As if the credit markets know something that the equity markets don’t. This is usually bandied about by bond traders who are convinced that stock traders are a bunch of dopes.¹ But this is silly when you think of things in aggregates because, in the long-run, the credit markets generate whatever the return is on the instruments that have been issued and not because bond traders are smarter or dumber than other people.² For instance, XYZ Corporate Bond paying 10% per year for 10 years doesn’t generate 10% for 10 years because bond traders are smart or stupid. It generates a 10% annualized return because the issuing entity pays that amount of income over the life of the bond. In fact, the more traders trade this bond the lower their real, real return will be. Trying to be overly clever about trading the bond, in the aggregate, only reduces the average return earned by its holders as taxes and fees chew into that 10% return. The “bond traders are smarter than stock traders” myth is hardly the most egregious myth at work here though. The bigger myth is the idea that equity must necessarily converge with credit over time. For instance, let’s change the time frame on our chart for a bit better perspective: If you’d bought into this notion that credit and equity converge starting in 1985 you would still be waiting for this great convergence. The reason for this is quite fundamental though. Corporate bonds only give owners access to a fixed rate of income expense paid by the issuing entity. Common stock, however, gives the owner access to the full potential profit in the long-term. If we think of common stock as a bond then common stock has essentially paid a 12% average annual coupon over the last 30 years while high yield bonds have only paid about a 8% coupon. In the most basic sense, credit and equity are different types of legal instruments giving the owner access to different potential streams of income. Equity, being the higher risk form of financing, will tend to reward its owners with higher returns over long periods of time. Why equity outperforms credit is hotly debated, but it makes sense that equity outperforms because the return on financing via equity must be higher than the potential return an investor will earn on otherwise safe assets. That is, if I am an entrepreneur who can earn 5% from a low risk bond it does not make sense for me to invest my capital in an instrument or entity that might not generate a greater return. In this sense, equity generates greater returns than credit because it’s not worth the extra risk to issue equity if the alternative is a relatively safe form of credit. Of course, it doesn’t always play out like this in the short-term, but if you think of equity as a sufficiently long-term instrument then it will tend to be true over the long-term because it’s the only rational reason for equity to be issued in the first place.³ ¹ – As an advocate of diversified indexing I can rightly be included as a “dope” about both asset classes. ² – This return could actually be lower due to defaults, callability, etc. ³ – “Long-term” in this instance has been calculated as at least a 25 year duration for equity. This is a sufficiently long period during which we should expect to see equity consistently earn a risk premium over credit.

Are Hedge Funds Really That Evil? Challenging The Common Hedge Fund Myths

Click to enlarge I will not surprise anyone by concluding that the coverage of hedge funds in the media and the general public opinion about them is negative, including some regulators and representatives of the Academia. This is counter intuitive, because, as I explained before , properly selected hedge funds demonstrate great results and have the potential to improve any investment portfolio. But what we see in the headlines most of the time is “average performance”, “high fees”, “flashy” lifestyles of hedge fund managers or fraud related “scandals”. Indeed such topics generate more buzz than news about good performance, but part of the reason is that hedge funds are slightly mysterious and not fully understood, especially by individual investors, “grey area” in the investment field thus surrounded by many rooted myths. In this article I summarize, discuss and try to bust some of the most prevalent hedge fund myths and misconceptions. MYTH NO. 1: Hedge funds are only accessible to institutional investors and (ultra) high net worth individuals – they are not available to retail investors like me and you. REALITY: Due to structural innovations, e.g. liquid alternatives, UCITS funds, etc., hedge funds are lately as accessible to retail investors as ever since their minimum investment amount may be as low as USD10k or even USD1k. Moreover, some hedge funds are traded on exchanges (e.g. London Stock Exchange Hedge fund list or Eurekahedge UCITS database), while funds of hedge funds may pool private investors’ money together and invest into hedge funds otherwise harder to access. Finally, there is a wave of fin-tech startups engaging in various ways to replicate hedge fund strategies or pool investors’ capital that are entering the scene (e.g. Sliced). On the other hand, hedge funds are complex structures requiring knowledge and experience to comprehend, thus it is naive to expect and strive to have every mom and dad be able to invest with them. Besides, hedge funds are dedicated for long term investment and create the most value over long investment horizons, thus higher minimum investment amount makes sure to filter those who can afford themselves quarterly or even annual liquidity, i.e. are less likely to experience sudden liquidity needs. MYTH NO. 2: Hedge funds are very risky. REALITY: All investment tools, vehicles and strategies bare both general and their own unique risks. Most of hedge funds’ structure and operational risks are addressed via proper due diligence process, while if we define riskiness by the standard deviation of performance, hedge funds as a group are less volatile than such traditional assets as stocks. Click to enlarge So it means that owning stocks has significantly more downside risk than owning hedge funds, because the latter are more flexible, active and have a wider toolkit of strategies at hand, including shorting. Moreover, since hedge funds exhibit low correlation to most traditional asset classes (see below), once added to an investment portfolio, they are able to reduce the volatility of the overall investment portfolio. Click to enlarge Source: Natixis MYTH NO. 3: Investing with hedge funds, investors have to give up liquidity and access to their capital. REALITY: Liquidity profiles of hedge funds can range from daily liquidity (e.g. liquid alternatives), to very common monthly liquidity, to quarterly or annual, so if liquidity is the main criteria of an investor, (s)he definitely has a range of options. However, firstly, liquidity profile determines and affects directly the opportunity set the manager is able to tackle, so it is difficult to expect a daily liquidity fund post the same results as annual liquidity vehicle, and secondly, if your main criteria is liquidity, hedge funds might not be the place for you at all. To conclude, yes you can access highly liquid options in hedge fund space, but then you might need to give up some of the less liquid (but naturally higher potential) opportunities that hedge funds are only able to tackle due to their structure in the first place. MYTH NO. 4: Hedge funds are too expensive. REALITY: It depends very much who you are comparing to. Yes, hedge fund fees are higher in absolute terms than e.g. mutual fund fees. However, this is the price not only for the access to different, complex, unique, niche tools and strategies hedge funds provide, but also the risk management infrastructure in place to handle difficult situations in the markets better than yourself or a long only mutual fund manager would. Moreover, hedge fund fee structure serves in aligning the interests of investors and managers which are both interested in better results, while you can’t really call mutual fund fees “motivating”. Finally, hedge funds’ results we see are already after-fee results and they obviously satisfy investors and justify the fees since industry assets are at all-time highs and large part of the hedge fund inflows come from very sophisticated institutional investors. MYTH NO. 5: Hedge funds don’t help in a market crash. REALITY: As demonstrated earlier, hedge funds exhibit lower correlation to traditional asset classes, providing the real diversification (and downside protection) exactly when it is needed the most – during crises and market crashes. As seen in the picture below, hedge funds proved to fare better than stocks during each of the recent market downturns. Click to enlarge Hedge funds: HFRI Fund Weighted Composite Index. World stocks: MSCI World Net Total Return hedged to USD Source: Bloomberg, MSCI, Man Group MYTH NO. 6: The most important thing in hedge fund selection is a large house and a respected name. REALITY: While many investors see these attributes as an assurance of quality and investor trust, they are no way a substitute for proper due diligence on a fund. The same way as large and well-known banks appear to engage in rate fixing scandals, there are plenty examples of “large houses” and “respected names” among hedge funds that have conducted fraud, abused investor rights and/or blew up, the classic ones being the Galleon Group, SAC Capital, Madoff Investment Securities. It is true that large investment houses provide an exceptionally high level operational infrastructure, but these days even a 100-million fund is able to access most of those solutions. Moreover, due to being nimble, innovative and diligent, smaller and newer funds reportedly outperform many of the large renowned peers. To conclude, large house and a respected name should not be a hedge fund selection criteria: neither it protects from fraud, nor guarantees superior performance. However, hedge fund due diligence and selection requires specific expertise and experience-based judgment so it is advisable to consult specialists anyway. MYTH NO. 7: Hedge fund managers are dishonest, unscrupulous fraudsters. REALITY: This is exactly the public opinion formed by the media which tends to catch and escalate the juicy stories of exuberant lifestyles and securities fraud. However, those stories are relatively few compared to almost 15 thousand hedge funds existing out there so there are as many cheaters in the hedge fund industry as there are in oil and gas, pharmaceuticals, politics and anywhere else. The majority of the hedge fund managers are very talented investment professionals with a unique idea or skillset trying to exploit it and make a living by earning investors return and their capital. It is investors’ concern to ascertain who are they trusting their money with. MYTH NO. 8: Hedge funds are unregulated “blackboxes”. REALITY: In the aftermath of the recent financial crisis, hedge funds became as regulated as ever with such impactful regulations as AIFMD, UCITS, MIFID, Dodd-Frank etc. introduced in order to maintain the perceived stability of financial sector. It depends on certain jurisdictions, but generally the times of two dudes with a laptop at a garage are gone – it takes time, money and expertise to get and maintain all the operational, compliance, reputation checks from the regulators while investor expectations and standards, especially if you target institutional investors, has also brought operational and governance practices to a new level. When it comes to transparency, the industry standard has gone further away from opaque reporting and the current best practice is monthly distribution including, depending on a strategy, a certain level of portfolio transparency allowing for a picture of strategy implementation. On the other hand, a complete or regulated transparency would take away hedge funds’ competitive advantage that allows them to generate returns in the first place. MYTH NO. 9: Hedge funds are evil and does bad to the society REALITY: Besides helping people and institutions achieve their financial goals, hedge funds serve to the financial industry and society in general. They are sometimes the last resort buyers of assets no one else wants to buy providing liquidity to the markets. They often provide capital to innovative projects as well as small and medium size businesses that face difficulties raising capital from more traditional sources. Hedge funds employ very talented and professional people for highly paid roles, who in turn pay large amount of taxes. Hedge funds not only donate significant amounts to non-profits and charities, but also when included in investment portfolios of foundations and endowments help earn money to support communities, improve education, health, economic areas, foster cultural development. Included in investment portfolios of endowments, hedge funds help them fund scholarships while included in investment portfolios of pension plans hedge funds allow them provide retirement security to millions of people. In fact, most of the money recently flowing into the hedge fund industry is exactly the institutional money. Due to some or all of the mentioned myths rooted around hedge funds, some investors miss the opportunity to access unique ideas, niche strategies and innovative tools and achieve the portfolio enhancement hedge funds provide. While the negative views on hedge funds and the whole financial industry may continue attracting the media attention, what is important for an investor is to evaluate critically, realistically and objectively the information, avoid generalization and trust their own or their advisors’ competence in finding the best solutions. 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. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: MC Investments is a hedge fund due diligence and manager selection advisory.

Can You Deal With A Stock Market Downturn?

Sometimes we’re late to interesting polls, but hey, they’re still interesting. Back in November, Gallup and Wells Fargo polled people to ask them how well they could stomach a “significant” market downturn, publishing the results on January 22nd . Or note, they defined significant as 5-10%. The results were quite confident: Gallup/Wells Fargo Downturn Poll Some wacky lines there – 87% of stockholders were at least moderately confident in their portfolios, and 82% of investors overall. People in a better position to actually handle downturns with smaller returns – those who don’t hold stocks – were only 61% moderately or better confident. Should We Trust Our Peers at their Word? In a word, no. These are interesting results, for sure, but I see lots of problems here – not just the fact that a significant downturn is defined as only 5-10%. The most recent recession saw drops an order of magnitude larger – in percentage terms (!) – of over 50% in major indices. We lost major financial institutions over a hundred years old, investors panicked, and maybe 10% of people (that’s a stretch) were confidently buying at any opportune time, let alone not panic-selling everything they owned. (We played around with what a “significant” drop might actually be in the past, but found you can be more than a few years early with your calls in some circumstances and still weather a downturn.) So let’s concentrate on our peers’ answers themselves. Do you really think this poll accurately reflects how people would react in a downturn? No, neither do I. You’ve got something of a Lake Wobegon effect going on here – you know, the “fictional” town where everyone was above average. In reality, stock markets have a tendency to over-correct – markets historically oscillate somewhere between ridiculously overpriced and a bargain (of course, identifying those periods is, perhaps, impossibly hard except in retrospect). That’s because previously confident people are selling into a downturn – “locking in losses” – and buying only when the stock market has come back “buying the highs!”. In fact, identifying actual investor results backs up those statements to a degree you’d almost think impossible. Dalbar releases studies on actual investor performance in the markets versus price (or dividend reinvested price) returns, and the results are crazily disconnected: through November 2015, in the order of earning 5.5% on S&P 500 funds in the last 20 years, versus stated returns around 9.85% . (We have a calculator so you can see dividend reinvested returns for the S&P 500 and the Dow Jones Industrial Average). Okay Smart Guy, What Then? For the average investor – and, Wobegon aside, we’re all probably closer to average than we tell ourselves – the best move is to set it and forget it. Consistently, when we do have market downturns, it turns out that many investors have actually overestimated their intestinal fortitude. For a typical person, the best move is to set your portfolio during market doldrums , with a mind to setting in up in such a way that you won’t mind too much if there is a massive move to either the upside or downside. As for re-balancing, it’s best if you go in with a plan, and openly rebalance at a standard time – and, if you can, avoid doing it that often. Believing in your portfolio is one thing, but investing during mania or a crash is no formula for a successful long-time plan. So, make the case. Would you be prepared for a significant downturn without selling most of your portfolio? Why, or why not?