The Notion Of The US Total Market Portfolio Is Redundant And Really Kind Of Silly

Today I am going to channel my inner Cliff Asness and demonstrate why it is more or less irrelevant whether you own a Total US Market index fund or an S&P 500 index fund. Intuitively, the reason for this is straightforward:

Since a Total US Market index fund is market capitalization weighted, it is dominated by the largest companies. The largest US companies are all included in the S&P 500. Hence, S&P 500 stocks drive the overwhelming majority of the return of the total market portfolio.

If you trust me, you can stop reading here. If you would prefer to see some supporting data, read on. Fair warning: it gets wonkish rather quickly.

Statistical Evidence

I used Portfolio Visualizer to run regressions on two widely held index funds using the Fama-French Three Factor Model. The model fits the index funds extremely well as evidenced by the respective R^2 values of 99.7% and 99.99% (this means the model explains over 99% of the variation in returns over the time time period analyzed). One regression was for VTSMX and the other for VFIAX. Below is the output:

Source: Portfolio Visualizer
Source: Portfolio Visualizer

The key numbers are in the Loading column. Do a quick visual compare/contrast. See how they are almost identical? That is because at the end of the day, when you own the market portfolio, most of your money is invested in S&P 500 stocks (you can verify this using the actual portfolio holdings if you want).

This is further underscored by Portfolio Visualizer’s performance attribution analysis:

Source: Portfolio Visualizer

In the attribution table, SMB means “the return you got from investing in smaller companies” and HML means “the return you got from investing in “cheap” (value) stocks versus “expensive” (growth) stocks. The total market fund earned basically no return from exposure to small companies over this time period, while the value/growth stock exposures are so similar as to be irrelevant.


The market cap weighted total US market portfolio does not provide a meaningful exposure to small company stock returns (or a meaningful tilt to value or growth stocks–a non-issue for the purposes of this post).

Put another way, in statistical terms, the total US market index behaves nearly identically to an S&P 500 index fund.

For people who are knowingly overweight US large cap stocks in the form of the S&P 500, I’ve got nothing to argue with you over. This bet has worked out pretty well over the last couple of decades. Maybe it will keep working (there are a lot of great businesses in the S&P 500). Maybe it won’t keep working (a lot of those companies are richly valued). Anyone who claims he can handicap future market returns with any degree of accuracy is an idiot or a liar (possibly both).

For people who are naively overweight US large cap stocks in the form of the S&P 500, I have this to say: like it or not you have made a bet on a particular market segment. Admittedly, these are high quality companies and the underlying revenue sources are globally diversified. However, the valuation risk is not necessarily very well diversified. Something like 20% of the portfolio is invested in FANG stocks (that’s an off-the-cuff number).

My point here is not to say definitively that the S&P 500 is a bad place to be invested. No one knows what the next 30 years will look like.

Rather, I am making a philosophical point about asset allocation. Namely, when you “passively” allocate assets predominantly to a market cap weighted US total market portfolio, you have implicitly made an active decision to concentrate your risk exposure in US large cap stocks. Only about 50% of global equity market capitalization is located in the US. If you truly believed in the logic behind a capitalization weighted total market portfolio, you would obtain all your equity exposure via something like ACWI.

However, I have yet to meet anyone who does this. Or any financial advisor who recommends it.


(a good subject for another post)

The Netflix Delusion

(Usual disclaimer applies: this is not financial advice. I do not own any Netflix. Nor am I short Netflix at pixel time (though the thought has crossed my mind). Netflix is actually a super dangerous stock to short at this juncture as it appears to trade purely on momentum as of 3/7/18)

Netflix happens to be a stock market darling.

Netflix’s earnings numbers also happen to be garbage.

To those readers who own NFLX in any real size, I have a simple question for you: how does NFLX generate half a billion dollars of GAAP earnings while simultaneously burning $1.79bn of operating cash?

Source: Morningstar
Source: Morningstar

As I’m sure the NFLX bulls know, it has to do with the way NFLX accounts for the cost of content. NFLX spends real cash today to produce and license streaming content. However, on its income statement it amortizes that cost over a longer time period to (allegedly) better reflect the economics of that content. While the cash flow statement shows $1 of spend on content going out the door today, the income statement spreads that same $1 over about four years.

Who determines the amortization schedule? Why, management, of course.

Here is the relevant disclosure:

Source: NFLX 10K

The table is a little hard to read so here is the text of the note again (emphasis mine):

On average, over 90% of a licensed or produced streaming content asset is expected to be amortized within four years after its month of first availability.

As of December 31, 2017, over 30% of the $14.7 billion unamortized cost is expected to be amortized within one year and 29%, 78% and over 80% of the $1.4 billion unamortized cost of the produced content that has been released is expected to be amortized within one year, three years and four years, respectively.

As it turns out, the NFLX of today is a massively capital intensive business. This wasn’t always the case. Back when NFLX distributed other people’s content it cash flowed quite nicely.

As a general rule I am suspicious of businesses that show growing GAAP income alongside large, negative operating cash flows (in NFLX’s case the cash burn actually gets larger over time–it is moving in the wrong direction). In these cases management’s judgement is driving the income statement. We have a special name for this in analyst land: “low earnings quality.”

So. Does the income statement or cash flow statement better reflect the economics of this business? This is hardly a trivial issue when you are buying a $138bn market cap company on 200x EV/EBIT. After all, it does you no good to add millions of subscribers if you have to burn up all your cash flow to retain them over time. Meanwhile you are funding that cash burn by taking on billions of dollars of debt:

Source: Morningstar (columns are annual figures in USD’000 from 12/31/08 – 12/31/17)

The Red Queen’s comment to Alice is instructive here:

“Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

As a CFA Institute publication on earnings quality notes:

The benefit of accruals for smoothing irrelevant volatility comes at a cost. Accrual accounting opens the door to opportunistic short-run income smoothing that can lead to future restatements and write-downs (e.g., Enron). Earnings quality can be improved when accruals smooth out value-irrelevant changes in cash flows, but earnings quality is reduced when accruals are used to hide value-relevant changes in cash flows. Distinguishing between these two types of accrual adjustments is critical to financial analysis. As we discuss in Chapter 3, an astute analyst cannot focus on earnings alone. To assess earnings quality, the analyst must evaluate the company’s cash flow statement and balance sheet in conjunction with the income statement.

Hence I have this niggling contrarian idea about NFLX. My niggling contrarian idea about NFLX is that the business valued at 200x EV/EBIT is an accounting illusion, and what NFLX will really be in the long run is a massive incinerator of cash. A massively levered incinerator of cash. In extremis: a potential zero.

This is not without precedent. The movie business, for example, is notorious for creative accounting.

Now maybe NFLX is cut from a different cloth than the bankrupt movie studios of yore. Maybe it has developed super sophisticated ways of allocating production capital so as only to back projects with a high probability of success and very long cash flow streams. Management sure doesn’t account for content that way in the financials. But hey, maybe they are just that rare conservative management team of a highly touted momentum stock.

Anyway, here is a fun chart via recode:

Source: recode

Has it occurred to anyone buying (or hawking) NFLX stock on 200x EV/EBIT that if you spend like FOX and Time Warner on content, maybe your stock should be priced similarly? (e.g. FOXA: 14x EV/EBIT BUT WITH $3.4BN OF FREE CASH FLOW)

I am not writing this up as a research note or an investment recommendation. This is simply an exercise in healthy skepticism.

What, you don’t believe me?

Ok. Fine.

This is simply an exercise in cynicism.

My Quixotic Obsession With Tail Hedging

We all have our weird niche interests and obsessions. For instance, my quixotic obsession with tail hedging. Conventionally, that means protecting portfolios against “rare” events (the VIX doubling in a single day, for instance). I am interested in tail hedging in a less conventional sense. I am interested in actually making money off “rare” events. I use “rare” in scare quotes here because contrary to the what you might hear from boilerplate financial advice, “rare” events are surprisingly common in financial markets.

If you are interested in the philosophical and mathematical underpinnings of tail risk, you should read Taleb’s Fooled By Randomness and Lo’s Adpative Markets (review forthcoming soon). But if you prefer practical applications, check out the below table:

Source: Alternative Investment Analyst Review

This is taken directly from the paper “A Comparison of Tail Risk Strategies in the US Market.” The intuition is simple: markets offer the highest expected returns when they are bombed out, when valuations are deeply discounted, when (to borrow a Buffettism) everyone is feaurful. A tail hedge not only provides excess returns in times of crisis that mitigate drawdown, but also a source of liquidity that can be redeployed into equity and/or fixed income securities at firesale prices.

So, hypothetically, you make 2% at the portfolio level off a small-ish tail hedge and reinvest it into equities at firesale prices. Over the subsequent months and years maybe that amount doubles, triples or quadruples.

Sounds great, right? What’s the catch?

The catch is the cost of the hedge and the resulting drag on returns:

Source: Alternative Investment Analyst Review

If you are interested in a detailed exploration of the strategies in the table, you will have to read the linked paper. However, at a high level the intuition is straightforward. When you are tail hedging you are essentially buying insurance. The person selling you the insurance wants to earn a premium for doing so.

The most common arguments against tail hedging are:

(1) there is no reason to hedge tail risk because in the long run equity markets always go up;

(2) the cost of the insurance is not offset by excess returns over time;

(3) there are better ways of mitigating tail risk.

I do not find Argument #1 compelling at all. All the data used to support this argument is subject to path dependency and survivorship bias. This is particularly true in the context of the US market, which is has been the best performing equity market in history. People tend not to respond well to my counterarguments because they imply an uncertain view of the future and they would rather extrapolate from the past (clients don’t like to face up to the uncertainty inherent in markets). People also have a difficult time with skewed payoffs–that is, understanding why a strategy with a 99% probability of a $1 loss and a 1% probability of a $100 gain is a good bet in the long run.

I do find Argument #3 compelling. AQR has a good paper on this that reaches similar conclusions to the Alternative Investment Analyst Review piece. However, AQR’s paper is focused on defensive applications of tail hedging strategies, whereas my interest is in playing offense. In full fairness, AQR addresses that in the paper:

We acknowledge that some investors might buy insurance for reasons other than reducing tail risk. For example, insurance can provide a cash buffer in times of market distress, potentially allowing investors to take advantage of fire-sales and other market dislocations. However, depending on the magnitude and frequency of the dislocations (and the manager’s ability to identify them), this opportunistic approach still might not make up for the negative expected returns from buying insurance. Other investors might occasionally have a tactical view that insurance is conditionally cheap. However, this is simply market timing in another form, and this decision should be made (and sized) in the context of other tactical views in the portfolio.

I have mixed views of Argument #2, mainly due to the issues of path dependency and survivorship bias noted above. If future equity returns look like the past 30 years or so, there is certainly no reason for long-term investors to tail hedge (assuming they have the wherewithal to stay invested in volatile markets). If the world becomes a more volatile and uncertain place over the next couple decades, investors may feel differently.

I have conducted some small experiments with real dollars over time. Most recently, I set up a long volatility trade using the VIXY ETF and ZIV ETN. It performed well during the February volatility spike, but was something of a blunt instrument (I have since closed out the position).

More recently I have been looking at Meb Faber’s TAIL ETF, which purchases a ladder of out-of-the-money put options on the S&P 500. Below is a rough scenario analysis I conducted to assess performance drag vs. crisis performance, as well as some historical monthly performance data for TAIL for context (the ETF has a short track record).

Source: Demonetized calculations
Source: Morningstar
Source: Morningstar

A couple takeaways:

  • This exposure has to be managed actively. When volatility spiked in early February 2018 the correct move would have been to trim the position on the back of the ~10% up move.
  • There is a consideration in play for me that is not in play for many retail investors, and that is that my compensation and career prospects are highly correlated to financial markets. For people with “bond-like” compensation (teachers, doctors) there is less benefit to spending portfolio dollars on a tail hedge from a pure risk management POV.
  • The real downside to putting on a position like this is not getting 18% annualized over a decade if the market returns 20% annualized. The real downside is getting an annualized 3% if the market returns 5%.

Billionaire Doomsday Prepping As Extreme Tail Hedging

Source: Wikipedia

I sometimes laugh when I read critical articles about billionaire hedge fund managers who are also doomsday preppers (this is enough of a “thing” that it has had a material impact on real estate prices in New Zealand). Of this behavior, The New Yorker commented:

Fear of disaster is healthy if it spurs action to prevent it. But élite survivalism is not a step toward prevention; it is an act of withdrawal. Philanthropy in America is still three times as large, as a share of G.D.P., as philanthropy in the next closest country, the United Kingdom. But it is now accompanied by a gesture of surrender, a quiet disinvestment by some of America’s most successful and powerful people. Faced with evidence of frailty in the American project, in the institutions and norms from which they have benefited, some are permitting themselves to imagine failure. It is a gilded despair.

I have a dramatically different reading: billionaire doomsday prepping is just an extreme form of tail hedging.

If you have a net worth of $1 billion, why not spend even $10 million of your net worth on a hedging strategy for the total collapse of civilization? This amounts to a 1% exposure. It’s a pretty good risk/reward tradeoff, if you ask me–especially if you are estimating your max downside as being drawn and quartered by some kind of Proletarian Justice Tribunal. Obviously, a financial hedge is not going to work here. You are going to need things like guns and butter. And some kind of bunker.

I am sure not all ultra-wealthy doomsday preppers look at it this way. But I am comfortable speaking for a majority. Even that New Yorker piece contains the following observation (they buried the lede, IMO):

Yishan Wong, an early Facebook employee, was the C.E.O. of Reddit from 2012 to 2014. He, too, had eye surgery for survival purposes, eliminating his dependence, as he put it, “on a nonsustainable external aid for perfect vision.” In an e-mail, Wong told me, “Most people just assume improbable events don’t happen, but technical people tend to view risk very mathematically.” He continued, “The tech preppers do not necessarily think a collapse is likely. They consider it a remote event, but one with a very severe downside, so, given how much money they have, spending a fraction of their net worth to hedge against this . . . is a logical thing to do.”

On Risk And Very Low Savings Rates


We can officially add the US personal savings rate to my list of late cycle indicators. For those of you keeping score at home, others include really rich high yield valuations and really, really silly bond issues. Oh, and don’t forget the worst leveraged loan covenant quality on record. There is a lot of commentary out there about what the equity market might do over the next few years but considerably less on the credit cycle. Apparently the steady erosion of covenant quality in the leveraged loan market does not make for riveting CNBC programming.

Readers may recall that I believe the credit cycle, and its attendant indicators, are the best signposts for where we stand in the economic cycle. Credit has a habit of leading the equity market. In the financial crisis era, credit began showing cracks in 2007, while the equity market didn’t wake up to the severity of the issues until later in 2008.

The yield spread between the lowest quality debt and Treasuries (blue line) tends to widen before recessions (gray bars) and market downturns (red line).

So whenever I am trying to understand where we are in the cycle, I am looking at credit markets first and then everything else.

A couple more reasons for that:

  • It is easy and intuitive intuitive to compare the yield to maturity on risky debt to one’s hurdle rate for risky investments.
  • Spreads of risky debt over Treasuries of equal maturity are a great indicator of how investors are pricing more equity-like risk.
  • Covenant quality is a “squishy” qualitative measure of trust in the financial markets. As an investor, you want to put capital at risk when trust is low and protect capital when trust is high. When investor trust levels are high and capital is plentiful, companies are able to do things like issue PIK bonds subordinated to other PIK bonds so they can pay insiders a dividend. (See “really, really silly bond issues” above)

I am not a fan of “all in” or “all out” market calls. Timing calls are really tough to get right and can be extremely destructive to a portfolio if they result in repeated whipsaws (selling out of the market at low prices and having to buy back in at successively higher prices). I am, however, a big fan of thoughtfully paring risk when the market is not rewarding you for bearing it.

So what does any of this have to do with the personal savings rate?

The Wealth Effect & Its Deleterious Impact On Investors’ Risk Preferences

The Wealth Effect is super easy to understand. As risk assets perform well, people feel wealthier. After all, their net worth is growing along with the value of their portfolios, their homes and, in all likelihood, their paychecks. They therefore begin to spend more of their disposable income, and take on more debt. Because they feel wealthier, they take more risk.

The problem with the Wealth Effect is that it is about the most pro-cyclical behavioral bias you can imagine. The Wealth Effect literally drives people to lever up their personal balance sheets and fritter away their free cash flow at the worst possible time–that is to say, when the market is offering very little compensation for taking on incremental risk. You aren’t just overextended. You are highly levered and overextended. Such a posture transforms even modest financial shocks into cataclysms.

This is what Buffett is driving at when he says: “be greedy when others are fearful and fearful when others are greedy.”

The advantage of approaching asset allocation through the lens of whether the market is offering a premium or demanding a discount for risk is that it obviates the need for price or return-based timing calls. Frankly I can’t believe more people don’t think along these lines.

I suspect there are two main reasons:

  1. If you are managing Other People’s Money it can be very difficult to act counter-cyclically for a whole host of business reasons.
  2. Greed.

The Insidious, Creeping Horror Of Artificially Low Interest Rates

Source: Night of the Living Dead

“Volatility is about fear… but extreme tail risk is about horror […] It is not the first act of the horror movie when people start turning into zombies… it is the end of the second act when the hero realizes he is the only person left not a zombie.”

Chris Cole, Artemis Capital, “Volatility and the Allegory of the Prisoner’s Dilemma”

Here is how a mutual fund manager responsible for billions of dollars in client assets is setting his return hurdles:

Source: Google Talks Transcript via MicroCap Club

You should read the whole talk. It is fascinating and informative. Bill Nygren is a well-regarded mutual fund manager. This post isn’t meant to impinge on his intelligence or skill (your humble blogger is acutely aware he is a nobody). What this post is meant to show is how some of the most capable investors in the world have been impacted by very low interest rates.

We know from prior analysis that the riskfree rate of interest has varied dramatically over the last 50 years, and that current rates plot on the low end of the historical range. Here is a visual from my discount rate post:

Data Sources: Aswath Damodaran & Michael Mauboussin

So is a 100 bps upward adjustment to the market yield really giving you a conservative hurdle rate?

Nygren is hardly an idiot. But he is running a multi-billion dollar mutual fund. If his team jacks their hurdle rate up to 10% it will get very, very difficult to find things to buy in the current market environment. And as we have discussed in the past, mutual fund managers cannot sit on large cash stockpiles.

This is the critical difference between an investor concerned with relative performance versus a benchmark index and an investor concerned with absolute performance that will compound capital at attractive rates over time. Ambitious absolute return goals should be accompanied by high return hurdles. When a hurdle is set at “bond yield + x bps” in a low rate environment it may underprice risk.

Why We Are Allocating Capital On Autopilot

In recent posts (here and here) I explored my view that today’s markets are systematically mispricing risk. My analysis isn’t exactly rocket science. So why does this mispricing persist? Why does everyone shrug their shoulders and say, “well, there is no alternative,” versus simply dialing back their exposures or hedging out some of the tail risk? At the very least, investors could increase the discount rates used in their valuations to correct for ultra-low riskfree interest rates and build in a greater margin of safety.

So why don’t they?

I would argue that more than anything, it is business and political pressures that drive this behavior. Importantly, I don’t believe this mispricing of risk is irrational. Rather, I believe decisions that seem rational on a micro level have led to irrational behavior in the aggregate. Investors are simply behaving how they are incentivized to behave–as a herd.

Here are my reasons:

Institutional investors must remain  invested. If you are a mutual fund manager or a hedge fund manager or venture capitalist, good luck explaining to your investors why you are sitting on a portfolio that is 40% cash. Many investors are loathe to stick with a manager who sits on a cash hoard for an extended period. Particularly in a buoyant market where cash will drag on returns. There is a sound rationale for this: the investor is perfectly capable of allocating to cash or hedging market risk on his own. Why pay some asset manager fees to sit on cash? While this makes plenty of sense from a business perspective, it makes no sense at all to an investing purist. The purist takes risk when the market is rewarding her for it and pares risk when the market is not rewarding her for it. Portfolios should be positioned more aggressively when markets are dislocated and prices are bombed out. They should be positioned more conservatively when valuations are high and expected returns are low.

Institutional investors are afraid to look different from their peers. Career risk drives a great deal of behavior in financial markets. It is the reason so many mutual funds look so similar to their benchmarks. This positioning makes no sense to a purist concerned with absolute returns. Yet it is perfectly rational for the mutual fund manager who will be fired if he drops into the fourth quartile of performance for a trailing 3-year period. Likewise for pension funds and endowments with trustees who may be penalized politically for contrarian positioning.

All investors have return hurdles to meet. If you are an individual or pension fund there is a certain rate of return that will allow you to fund your projected future liabilities. If you are an endowment or foundation there is some spending rule governing portfolio withdrawals, usually based on long-run capital market expectations. Altering these hurdles is a big deal. Reducing expected returns means pensions and individuals will have to save more to fund future liabilities. Endowments and foundations may have to cut financial support for certain programs. This can be psychologically devastating for individuals and extremely embarrassing for institutions. It is a powerful incentive for investors to take a “glass half full” view of the future, even if it is ultimately self-deluding and counterproductive.

Perhaps the most significant advantage you can get in the markets is what Ben Carlson calls organizational alpha. Put simply, this is the flexibility to do what others can’t, or won’t, as a result of business and political pressure. It is the freedom to switch off the autopilot and deviate from the pre-established flight plan.