Stay Rich And Maybe Get A Bit Richer Without Dying Trying

If you’ve read this blog for any length of time it’ll come as no surprise to hear that I’m rather disillusioned with the prevailing wisdom around asset allocation. It goes something like this:

Adjust a 60/40 split based on your age and risk tolerance and close your eyes for 40 years or so and the world will probably be a better place when you finally open them again. Here are some charts showing “long term” equity returns to make you feel better about enduring 50% drawdowns.

Here are my key issues with the prevailing wisdom:

  • Prevailing wisdom is biased heavily toward equities based on historical experience. This is the market Skinner box in action. There are no physical laws requiring future equity returns to look like past equity returns over any particular length of time.
  • Equity risk drives outcomes within most portfolios, despite these portfolios appearing more diverse when visualized in a pie chart.
  • The notion of “the long term” is at best squishy. “Long term,” we’re all dead. No one’s investment time horizon is infinite. We ignore sequence risk at our peril.
  • Prevailing wisdom is robust to neither inflationary nor deflationary busts. Which are really the conditions that ought to keep us up at night. Particularly inflationary busts. Because other than a few cranks no one is prepared to invest in a highly inflationary environment these days. (What? You think the inflation of the early 1970s or 1980s can’t happen again? LOL. Just Google MMT )

So this is going to be a post about the permanent portfolio, which is where I’ve landed as an alternative to the prevailing wisdom. This post should absolutely not be taken as investment advice. There are opportunity costs involved here and they may be significant. Particularly if your inclination would otherwise be to allocate 60/40 to US stocks/bonds and US equity continues its run of strong returns for an extended period of time. See my disclaimer for more on why making investment decisions based on random blog posts is an incredibly stupid thing to do.

Fundamental Assumptions & Principles

There are some key assumptions underlying my views on all this. I want to lay them out explicitly up front, because many of these can be debated endlessly. I’m not trying to argue all of this is capital-t Truth. This is simply the framework I’m operating within.* So for example, if you’re a guy or gal who wants to own five stocks forever, I’m not trying to convince you to do it differently. And you’re probably not going to agree with any of this. That’s fine.

  • We should build portfolios as regret minimizers and not utility maximizers. Note that regret minimization is subjective. We can regret both realized losses AND foregone gains. The exact “regret function” will vary with each individual. The first sentence of this bullet is in bold because it’s the foundation for everything else. I’d hypothesize that human beings in general tend more toward regret minimization than utility maximization. But I can’t prove that.
  • The starting point for any portfolio should be wealth allocation. A wealth allocation consists of at most three buckets. It is possible and sometimes even desirable to have fewer. Wealth allocation is consistent with regret minimization.
    • Bucket #1: Protect Lifestyle (cash, annuities, etc.)
    • Bucket #2: Maintain Lifestyle/Purchasing Power (traditional MPT portfolio)
    • Bucket #3:  Enhance Lifestyle (business ownership, concentrated single stock positions, etc.)
  • This post is primarily concerned with Bucket #2.
  • Equity ownership is absolutely essential for preserving and growing purchasing power over long time periods. However, equities can go through substantial and lengthy drawdowns. Major drawdowns are problematic in a number of ways:
    • They create sequence of returns risk for the portfolio (e.g. massive drawdown immediately prior to retirement)
    • They may encourage poor investor behavior (buying high and selling low)
    • The portfolio will have the least liquidity and buying power when expected returns are highest (e.g. at the trough of a major drawdown), preventing opportunistic purchases of assets subject to forced selling, etc.
  • Reliably forecasting economic cycles for the purpose of tactical asset allocation is impossible.
  • Traditional methods of hedging tail risk are frequently expensive and can be a significant drag on returns if utilized in meaningful size. They can also be extremely challenging, if not impossible, for individual investors to implement.
  • Ideally what we want is a core allocation capable of delivering approximately 5% real returns while minimizing drawdowns across different market regimes. The regimes that are of particular concern are:
    • Inflationary Booms
    • Deflationary Busts
    • Inflationary Busts
  • The goal of this exercise is not to build an Armageddon-proof portfolio. In the case of extreme tail events (nuclear war, zombie apocalypse, socialist revolution) your portfolio is going to be the last thing you’re worried about. And anyway, what you’ll really need in those situations are food, medicine and bullets.

The Permanent Portfolio

I think the permanent portfolio offers a solution. The investment analyst Harry Browne devised it specifically for robust performance across a range of different economic conditions. In its original form the permanent portfolio consisted of:

  • 25% US Stocks
  • 25% Long-Term Treasuries
  • 25% Cash
  • 25% Gold

The underlying intuition is a model of parsimony. This is a combination of assets where “something should always be working,” regardless of the macroeconomic environment. Long-term Treasuries and gold are less correlated and often negatively correlated with equities. Long-term Treasuries do well in deflationary busts. Gold does well in periods of high inflation.

I do have some quibbles with the permanent portfolio in its original form:

  • It holds too much cash.
  • It is under-allocated to equities.
  • It is strongly biased toward the US.

But perhaps we can address these issues through portfolio construction.

Analyzing The Permanent Portfolio

I used Portfolio Visualizer to run some analysis using historical data. I compared two different permanent portfolio implementations with a 60/40 allocation to US Stocks/US Treasuries. I set the portfolios to rebalance any time an asset class reached +/- 10% of its target weight.

I’ll walk through a couple observations in this post but if you’d like to explore the analysis yourself here is the link to exactly what I ran. (aside: I can’t recommend Portfolio Visualizer enough as a free analytical tool) Below are my three portfolios.

Portfolio 1Portfolio 2

Portfolio 3
Source: Portfolio Visualizer

I was able to backtest these allocations back to 1986 with the available data. Unfortunately, the periods where the permanent portfolio really shines versus 60/40–the stagflation of the 1970s and the high inflation and interest rates of the early 1980s–lie outside this time period. If you drop the international equities you can capture the late 1970s and early 1980s, however.

Starting in 1986, Portfolio 1 rebalanced 7 times. Portfolio 2 rebalanced 9 times. Below is a growth chart comparison.

Growth
Source: Portfolio Visualizer

This 30-year period has been truly extraordinary for US stocks and long-dated Treasuries. It comes as no surprise that the permanent portfolios have lagged a 60/40 allocation. And, of course, the permanent portfolio with ex-US equity exposure lagged even more.

But you’re still getting your 5% annualized real returns, with milder drawdowns than the 60/40 portfolio. And in the bargain, you’re better protected from an inflationary regime than you would be with a 60/40 portfolio.

Portfolio Returns
Source: Portfolio Visualizer

Obviously, if you don’t believe in allocating to ex-US equity you will prefer Portfolio 2 over Portfolio 1. I don’t share that belief, personally. But I certainly can’t prove US equity returns won’t continue to dominate going forward.

We can also look at returns over rolling periods, which paint a similar picture.

Rolling Returns
Source: Portfolio Visualizer

If you’re willing to use volatility as a quantitative proxy for risk, you can see the permanent portfolios are significantly more diversified in their sources of risk and return than the 60/40. Equity risk dominates the 60/40 allocation. Imagine the extent to which it dominates in a 70/30 or 80/20 split.

Risk Decomposition
Source: Portfolio Visualizer

The tradeoff here is simple: give up some upside for a more attractive risk profile.

But what if you could juice the returns a bit?

Because this strategy is robust across market regimes it should also be fairly amenable to leverage. In an ideal world I’d take the more diversified flavor (Portfolio 1) and lever it something like 1.25x  to 1.50x. This is the intuition behind risk parity: take a well-diversified portfolio with the risk exposures you want, then lever them to reach your target return. So instead of being limited to 33%/33%/33% you would be allocated maybe 45%/45%/45% for 135% notional exposure.

Unfortunately, as an individual investor it’s not straightforward to lever a portfolio. So, there are some implementation issues to work around. The simplest solution appears to be to use mutual funds or ETFs that apply leverage via either equity or Treasury futures.** This essentially allows you to “bolt on” gold and/or other alternative strategies without having to cut back on your equity or fixed income exposure. I may do a follow-up on this analysis exploring this form of implementation in more detail.

The Permanent Portfolio In A Barbell Portfolio

There are a couple less obvious, ancillary benefits to the permanent portfolio structure I want to mention in closing.

First, because of the attractive drawdown characteristics, it may obviate the need for large cash allocations (e.g. “emergency funds” or “cash buckets” for individuals). There are significant opportunity costs associated with large cash allocations, particularly in real terms.

Second, in keeping with the above, the permanent portfolio provides an excellent stable core around which to build a satellite portfolio of opportunistic investments. For example, at the wealth allocation level you could implement a structure where 70% of the portfolio is permanent portfolio, and the remaining 30% of capital is allocated to private market investments, or high risk/high return single hedge fund investments, or concentrated single stock positions. From a wealth allocation perspective you would be looking at something like 0% Protect Lifestyle / 70% Maintain Lifestyle / 30% Enhance Lifestyle.

In the above configuration, you would also likely be able to use the permanent portfolio as a source of liquidity during major market dislocations, to fund opportunistic investments at precisely the times when expected future returns are highest.

In my view, this strikes a nice balance between staying rich, maybe getting a bit richer but without dying trying.

Essentially, what you’re doing here is building a barbell portfolio. You’re using the permanent portfolio to set a floor for the value of the overall portfolio. You’re then taking the “excess” capital and buying call options with it.

There are other ways for individuals to implement a barbell portfolio structure. You could just use cash to create the floor. Except that’s an extremely inefficient use of capital, in my view. You could also use an annuity.

My quibbles with the annuity approach:

  1. A fixed annuity with a modest inflation escalator leaves you vulnerable to inflationary booms and busts.
  2. I am deeply suspicious of variable annuities–in fact, any insurance product with bells and whistles designed to “protect” you from various risks. The pricing of the bells and whistles is usually opaque and therefore not a good deal for the buyer. It is a timeless truth of economics that opaque pricing always and everywhere obscures profitability (see: healthcare; college).
  3. No matter what route you go the insurance company will extract its pound of flesh.
  4. You give up the ability to opportunistically redeploy capital from the annuitized core of your portfolio.

That said, I think buying a simple fixed annuity with an inflation escalator is a straightforward option for individuals who want to implement a barbell portfolio, and who are unable or unwilling to go the permanent portfolio route.

 

*I’d encourage everyone reading this to spend some time writing out your investment framework as explicitly as you can. This is your Investing Code. Once you’ve written down your Code, compare it to your actual portfolio and see if they match. The results of this exercise may surprise you. Incidentally, my friend Rusty Guinn wrote a phenomenal series of articles on Investing Codes and portfolio construction, called Things That Matter/Don’t Matter. I can’t recommend it enough. It touches on the issues discussed in this post as well as many, many more.

** Thanks to @choffstein and @EconomPic for their help conceptualizing this via Twitter.

The Skinner Box

Skinner_box_scheme_01
Source: Wikpedia

A Skinner box is a device used to study animal behavior. Its more formal name is “operant conditioning chamber.” It was originally devised by the behavioral psychologist B.F. Skinner. Skinner used his box to study how animals respond to positive or negative stimuli. For example, a rat can be conditioned to push a lever for a bit of food. A dog can be conditioned to salivate whenever a bell rings.

Lest you be inclined to dismiss operant conditioning as silly games played with animals, it’s worth considering that slot machines, video games and social media all make use of operant conditioning to shape our behavior.

The financial markets, too, are a kind of Skinner box.

Do you suppose we believe what we believe about investing because there are immutable laws, similar to physical laws, that govern the price action in markets?

LOL.

We believe what we believe about investing because we’ve been conditioned to believe it. Much of what we think we “know” about investing is simply rationalized, conditioned behavior (the endless and pointless debate over “lump sum versus dollar cost averaging” is a perfect example–the “answer” is entirely path dependent). We investors aren’t so different from Skinner’s rats, working their little levers for their food pellets. It’s just that we’re after returns instead of snacks.

Below is what an operant schedule of reinforcement looks like.

Bet on Market Factor -> REWARD (GOOD RETURNS, CLIENTS HIRE YOU)

Bet on Momentum Factor -> SMALL REWARD (MAYBE)

Bet on Value, Size, Quality -> PUNISHMENT (BAD RETURNS, CLIENTS FIRE YOU)

1Q19_Rolling_Factors
Data Source: Ken French’s Data Library
1Q19_Trailing_Factors
Data Source: Ken French’s Data Library

The “lesson” here is very clear:

BETA IS ALL THAT MATTERS

BETA IS ALL THAT WORKS

This is what public market investors are being conditioned to believe. And if flows away from active management (particularly low beta strategies) are any indication, the market Skinner box is doing an admirable job. Demand for investment strategies is all operant conditioning, all the time.

Of course, the markets are more complicated than Skinner’s box. Market price action is both the input and output of investor behavior. It’s more like a Skinner box where the collective actions of the rats influence the operant schedule of reinforcement (this is another way of thinking about the concept of reflexivity).

The idea of markets-as-Skinner-boxes is inextricably linked to the idea of market regimes: patterns of correlations for economic variables such as interest rates, economic growth and inflation. It’s also inextricably linked to the idea of the zeitgeist: “the spirit of the age.” The relationship between these processes doesn’t flow so much as interlock. Each process acts on the others.

Regime_Graphic

This visualization isn’t ideal. It implies the interactions are mechanical in nature, and that the result is a straightforward, predictable system. It’s not. In reality it’s much more an interaction of planetary bodies and gravitational fields than clockwork mechanisms of wheels and gears. My friends Ben and Rusty describe this as the three body problem. But imperfect as the above visual may be, it gives you a rough idea of how all this interrelates.

Having Bought The Dip…

The Fed’s 4Q18 Z1 data is out so I am able to update this little model of prospective 10-year returns for the S&P 500. If we could run this again today I suspect it’d be forecasting about 6-7% for the next 10 years, given how we’ve rallied in 1Q19. Not spectacular but not awful, either. Clearly, in the aggregate we bought the dip.

4Q18_SP_ER
Data Sources: Federal Reserve Z1 Release & Demonetized Calculations

Below is the latest expected returns bar chart from RAFI. Definitely a less optimistic picture for US large cap equities, but I believe this is a (small) improvement over the last time I checked it. The “obvious” relative value play is of course ex-US equity and emerging market equity in particular. I put “obvious” in scare quotes here because there are real risks to tilting a portfolio this way, as I’ll discuss a bit more below.

20190308_RAFI
Source: Research Affiliates

This is merely a brief analytical exercise for perspective. Like all models, these ones have weaknesses. The most significant, in my view, is they’re not “macro aware.” For example, the S&P 500 model above would not have given you any warning of the global financial crisis. Today, as far as the differences in relative valuation between US and ex-US equities are concerned, we live in a time where there is a strong argument to be made that globalization is unraveling. And if globalization truly unravels, the intuition underlying global equity investing unravels along with it.

The two risks I worry most about these days?

Geopolitical fragmentation. Taken to a certain extreme, this would break the idea of a globally diversified equity portfolio.

A major spike in inflation. This would break the traditional 60/40 portfolio, at least in real terms.

These risks don’t just represent asset price volatility. They represent regime changes. They represent changes in the relationships between financial assets–changes in financial gravity. My friend Ben Hunt has written what I think is the best piece about what an inflationary regime change means for investors. The short version is that it’s the death of the long bond as an effective diversifier.

Geopolitical risk is trickier. I’m extremely skeptical anyone can effectively handicap geopolitical risk. It’s not something you predict. It’s something you observe. You deal with it when it manifests in the real world, as it happens. Of course, in theory you can hedge this kind of risk. The folks who sell this protection aren’t usually in the habit of giving it away at firesale prices, though I guess it never hurts to check around. Every once in a while you will find something stupid cheap like VIX calls circa 2017 and early 2018.

There is another factor in play here that I don’t consider so much a “risk” as a “force” that acts on everything else. That is fiscal and monetary policymaking–particularly monetary policymaking. Our friendly neighborhood central bankers have made it overwhelmingly clear they intend to remain supportive of financial markets. This will shape the market regime and therefore the relationships between financial assets. Like geopolitical risk, it’s not something you can effectively handicap. As I’ve written elsewhere:

Fed Watching is the ultimate reflexive sport. If you believe there is some kind of capital-T objective Truth to be found in Fed Watching, I am sorry to be the one to tell you but you are one of the suckers at the table. The Fed knows we all know that everyone knows the information content of Jay Powell’s statements is high. (We call them Fed Days, for god’s sake) The Fed plays the Forward Guidance Game accordingly. Sometimes it uses its “data” and “research.” Sometimes it speaks through one of its other hydra heads. The tools and tactics vary, but they’re all deployed to the same end: to shape the subjective realities of various economic and political actors.

I am critical of the current approach to monetary policymaking both in the United States and abroad. However, I do not think shorting the world or sitting 100% in cash or gold is a particularly good strategy. Two reasons:

  1. If the world ends you are probably not going to have much fun collecting on your bet because it will be the end of the global financial system as we know it. You’re better off investing in guns and ammo and maybe a bunker somewhere to express this view.
  2. You are betting against the combined fiscal and monetary policymaking apparatuses of every country in the world. Kind of like shorting a stock where the CEO has unlimited cash available to buy back stock.

Personally, I’m doing my best to balance cautious optimism with a healthy amount of paranoia.

Gluttons For Punishment

If you’re a longtime reader, you may recall my little hypothesis about active mutual fund manager and hedge fund performance. The aggregate performance of active mutual fund managers and hedge funds will not, and cannot, improve while Market factor performance dominates everything else. You’ll certainly have individual managers perform well here and there. But in the aggregate, performance versus long-only benchmark indexes will remain unimpressive.

If you’re wondering exactly what the hell it is I’m talking about here, compare the pre-financial crisis and post-financial crisis periods on the below chart.

4Q18_3YR_Trailing_FACTORS
Data Source: Ken French’s Data Library

And just for fun, here’s another chart, focused on the last five years or so:

4Q18_Trailing_Factor_Returns
Data Source: Ken French’s Data Library

If there’s one thing you should take from this post, it’s this: the market is conditioning you to be fully invested and in particular to be long US equity market beta. We can certainly debate the “whys” and “hows” of this (for instance, how it’s the stated policy goal of our Friendly Neighborhood Central Bankers to keep us allocated to equities for the long run). But as a practical matter, if you’re overweight US stocks, particularly large cap US stocks, you’re receiving positive reinforcement. If you’re underweight US stocks, particularly large cap US stocks, you’re receiving negative reinforcement. And god help you if you’ve been significantly overweight small cap value stocks or ex-US stocks over the last couple of years. If so, you’re being subjected to corrective shock therapy.

I don’t say this to make value judgments.

I say this to explain what’s driving investment decisions all over the United States, and indeed the world. I say this to contextualize why the most common conversation I have with investors of all types lately seems to be: “why do we own foreign stocks, anyway?”

If you’re the kind of person who likes to extrapolate historical return data to make asset allocation decisions, all the data is screaming for you to be fully invested in US large cap stocks. You’d be a complete idiot to do otherwise. Perhaps you’ve told your financial advisor this. Perhaps you’ve fired your financial advisor over this.

And you know what? You might be right.

In my own humble opinion, the number one question confronting anyone allocating capital right now is whether or not this market is “for real.” If it is, and you decide to fight it, either as a private individual or as a professional investor, you’re toast. But if this market isn’t “for real”–if it’s all just an artifact of easy monetary policy, and you decide to “go with the flow”, and it all unwinds on you, then you’re also toast.

In thinking about my own portfolio, what I want is to develop a financial plan offering me a decent chance of hitting my goals while assuming as little risk as possible. Those of you well-versed in game theory, such as my friends over at Epsilon Theory, would call this a minimax regret strategy

Notice I wrote “financial plan” and not “investment portfolio” above. From a pure portfolio perspective, you’re facing a no-win scenario. You have to handicap whether, when and how the whole QE-as-permanent-policy project comes undone. This is nigh on impossible. Investors have been trying and failing to do this for at least a decade now. When faced with a no-win scenario, your best strategy is to change the conditions of the game. In order to do that, you first have to understand the game you’re playing.

We investors and allocators like to believe we’re playing the investment performance game.

We’re not.

We’re playing the asset-liability matching game.

Investment performance only matters inasmuch as it helps us match assets and liabilities. You probably don’t need to “beat the S&P 500” to fund your future liabilities. You can probably afford to take less market risk. And investment performance is hardly the only lever we can pull here. We can increase our savings rates. We can decrease our spending. We can allocate some of our capital to the real economy, instead of remaining myopically focused on increasingly abstracted, increasingly cartoonish financial markets. We can start businesses that will throw off real cash flow, and own real assets.

We don’t have to remain fully invested at all times. We don’t have to be 100% net long and unhedged with the capital we do have invested.

We don’t have to be gluttons for punishment.

“Meh”, Again

Here are a couple updated charts courtesy of Aswath Damodaran’s latest data:

201901_Impl_Stdy_PE
Data Source: Aswath Damodaran
201901_Impl_Stdy_vs_FWD_PE
Data Source: Aswath Damodaran

I’ve posted similar charts before. These are a bit different in that I switched them over to use an implied equity risk premium and cost of equity derived from discounted free cash flows instead of dividends. The result is some moderation in the steady state multiple. However, the general trends in the data hold.

My reaction to the broad US market’s valuation continues to be “meh.”

Near as I can tell, at these levels you’re being roundabout fairly compensated for owning US equity risk. Yes, a near-term recession would send the market lower. But I’m not a recession forecaster, and I don’t adjust asset allocation on the basis of near-term economic data reads. The lower equities go, the more attractive the forward returns will become.

That said, if you pick individual stocks there are most definitely pockets of opportunity out there. It’s a great time to go bargain hunting if you were prudent about taking off some risk in the last couple years. Cash can be used to play offense as well as defense.

A World Of “Meh”

Right now, a lot of people are sitting out there trying to decide whether to dip-buy this market. They want to tick the bottom. Perhaps you are one of these people. In my own humble opinion, they are fools–fools engaged in a foolish game. Most will ultimately do more harm to their net worth than good, whipsawing themselves based on “sentiment” (a.k.a what they are seeing and hearing from the financial media).

For some perspective, I want to revisit forward-looking return expectations from a couple of different sources.

The chart below looks at prospective 10-year S&P 500 returns as a function of the equity share of US financial assets (a mouthful, I know). This is similar to the Buffett Indicator of stock market capitalization/GDP. The data runs through 3Q18, which is the most recent Z1 release from the Federa l Reserve.

(As far as I know, Jesse Livermore at Philosophical Economics was the first to do a deep dive into the efficacy of this model. David Merkel at Aleph Blog used to update it quarterly. Since David seems to have abandoned the project, I’ve decided to pick this up on my own)

SP_500_Proj_Return
Data Sources: Federal Reserve, Morningtsar

The predicted forward return bottomed in 1Q18, below 5% nominal. Since then, the proportion of equities to total assets has decreased a few points. This corresponds to a modest increase in predicted return over the next 10 years, to approximately 7%.

The second chart is an updated expected return bar chart from Research Affiliates:

201812_RAFI_10YR_ERs
Source: Research Affiliates

RAFI’s methodology is the simple model discussed in my post on investment return expectations. RAFI’s estimates are even less inspiring than the equity allocation model. Here US Large Cap is expected to return about 2.7% nominal over the next 10 years.

If we weight each forecast 50/50 to account for the inevitable errors and uncertainty, we get something like 4.8% as an expected return for US Large Cap Stocks over the next 10 years.

To which I say: “meh.”

This is neither a “run for the hills” number nor a “go all-in” number for someone whose investment strategy is oriented around asset allocation over a long time horizon. In fact, it’s rare to arrive at either of those conclusions from an exercise like this. Which is the whole point. For most of us, our reaction to most market moves should be “meh.”

Now, this certainly isn’t the only lens through which you can view financial markets. A trader or trend follower can safely ignore everything I’ve written here. Traders and trend followers are playing an entirely different game. Same for pure, bottom-up stock pickers.

However, most of us building portfolios for institutions and individuals are not traders, trend followers or pure, bottom-up stock pickers. We’re asset allocators who merely need to be directionally correct about the performance of a handful of different asset classes over a couple of decades.

How does a fundamentally-oriented allocator invest in a world of “meh?” 

I’d suggest the following core principles:

Balance. Never make “all-in” or “all-out” calls. Investing is an exercise in decision-making under uncertainty. It’s a probabilistic exercise, except we don’t know the “true” probabilities of the various outcomes. Only fools make all-in, all-out calls when making decisions under uncertainty. And yes, gunslinging hedge fund guys, fools who make all-in, all-out calls can become billionaires.

Prudence. Don’t reach for yield or return. Our world is overrun with yield pigs, but they’re generally not being well-compensated for the incremental risks they’re running to juice their returns. And yes, middle market private credit investors, that’s directed at you.

Flexibility. As Henri Poincaré famously said, “geometry is not true, it is advantageous.” Asset allocation is similar. You become overly attached to particular asset classes, strategies and their historical performance at your peril. And yes, “VOO for the long run” investors, that’s directed at you.

Creativity. If the financial markets are giving you “meh”, consider changing the way you play the game. For individuals, that could mean saving more, or starting a business to generate wealth through “real world” economic activity. For institutions, it’s tougher to make those kinds of changes, but mostly for political reasons.

It is a frustrating thing, to be stuck in a word of “meh.” But recognizing it and acting accordingly is a hell of a lot more productive than staring at your E-Trade account trying to tick the bottom for SPY.

Reaching For Yield

Are you a high net worth individual investor?

Are you feeling left out of the institutional yield chase?

Do you wish you could access the same esoteric, illiquid credits as pension funds and endowments?

If so, we may just have an investment opportunity for you.

Interval funds offer you, the high net worth individual, the full institutional investing experience. Not only do you get the high management fees and carried interest associated with traditional private equity investments, but as an added bonus you will invest through a seemingly liquid, mutual-fund like structure that is in fact subject to the vagaries of market conditions and the fund sponsor’s judgement.

That’s basically the pitch for interval funds. Interval funds are part of a larger growth trend for private credit and direct lending funds. Remember all the risky loans banks used to make prior to the financial crisis? Well, banks don’t make those loans anymore. They have regulation to thank for that. The risky loans didn’t go away, though. They just moved from bank balance sheets to private credit vehicles–unregulated hedge fund and private equity-like structures.

Up until recently private credit has remained out of reach of most individual investors. Interval funds are now being marketed as a way for a wider array of individuals to access private credit and even private equity. The idea is that a sponsor with expertise in these areas (like Carlyle) can sub-advise on a strategy that can be sold through a large asset manager with established retail distribution channels (like Oppenheimer Funds).

As you might guess I have several issues with interval funds. Here are the main ones:

  • You have know way of knowing whether the sponsor actually cares about performance or is just dropping mediocre deals into the structure to gather assets in a high fee product. I struggle to believe these sponsors are saving their choice deals for interval funds when they have longtime relationships with large, institutional investors to look after.
  • Illiquid things are being held in what is being marketed as an open-ended structure. This works right up until it doesn’t. In the event of a severe market dislocation these funds will suspend their repurchase programs and investors will be stuck.
  • In my view, you’re not being compensated particularly well for the risks you’re taking. Don’t take my word for it. Read the financials. Maybe you think 500-ish bps of spread is fair compensation for this kind of risk. Fair enough. But consider that JNK will give you nearly 400 bps of spread over 10-year Treasuries these days.

Here’s what the portfolio valuation disclosure for the Carlyle/Oppenheimer vehicle I’ve been linking to above looks like:

OPCIX_ASC_820
Source: OFI Carlyle Private Credit Fund Semi-Annual Report

This would be pretty typical for a private fund playing in credit such as a credit hedge fund. I have a mental rule of thumb for these things which goes like this: in a dislocated market, assume the fund will turn completely illiquid. Do not invest unless you’re prepared to live with the consequences.

The sales pitch for interval funds is straightforward. It’s yield!

There’s a pejorative term in the business for investors who chase yield without regard to risk. We call them yield pigs. And yield pigs almost always end up getting slaughtered.

We Need To Talk About Multiple Contraction

In light of recent market moves I wanted to revisit this post about discount rates and how they might impact valuation multiples (spoiler: it’s an inverse relationship). I think the post holds up pretty well. The key feature was this chart:

118_Implied_Cost_Equity_SP
Data & Calculation Sources: Professor Aswath Damodaran & Michael Mauboussin

Recall that there’s an inverse relationship between the discount rate and the multiple you should pay for an earnings stream. The discount rate has two components:

1) a riskfree interest rate representing the time value of money (usually proxied by a long-term government bond yield), and

2) a “risk premium” meant to account for things like economic sensitivity, corporate leverage and the inherent uncertainty surrounding the future.

Back in January I wrote:

By way of anecdotal evidence, sentiment is getting more and more bullish. Every day I am reading articles about the possibility of a market “melt-up.” If the market melts up it may narrow the implied risk premium and further reduce the implied discount rate. If this occurs, it leaves investors even more exposed to a double whammy: simultaneous spikes in both the riskfree interest rate and the risk premium. The years 1961 to 1980 on the chart give you an idea of how destructive a sustained increase in the discount rate can be to equity valuations.

I am reminded of this as I read this post from Josh Brown, featuring the below chart:

daily-shot-sp-attribution
Source: Bloomberg via WSJ Daily Shot & Reformed Broker

Taken together, this is a fairly vivid illustration of why the current level of corporate earnings matters far less than long-run expectations for margins, growth, and (perhaps most importantly) the discount rate.

(You do remember what’s happening with interest rates, don’t you?)

Assuming no growth, a perpetual earnings stream of $1 is worth $20 discounted at 5%.

Raise that discount rate to 10% and the same earnings stream is worth $10.

Raise it to 15% and the value falls below $7.

And so on.

Now, there’s no way to reliably predict what the discount rate will look like over time. The real world is not as simple as my stylized example. On top of that the discount rate is not something we can observe directly. The best we can do is try to back into some estimate based on current market prices and consensus expectations for corporate earnings.

So, what’s the point of the exercise?

First, I don’t think it’s unreasonable to expect some mean reversion when the estimated discount rate seems to lie at an extreme value. And yes, I counted short-term rates at zero percent as “extreme.” As the above attribution chart clearly demonstrates, multiple contraction can be quite painful.

Second, this should explicitly inform your forward-looking return expectations. Generally speaking, the higher the implied discount rate, the higher your implied future returns. There is good economic sense behind this. “Discount rate” in this context is synonymous with “implied IRR.” To look at a 5% implied IRR and expect a 20% compound return as your base case makes no economic sense. Assuming the implied IRR is reasonably accurate, the only way that happens is if you sell the earnings stream to a greater fool at a stupidly inflated price.

Do fools buy things at irrationally high prices?

Yes. Indisputably. All the time.

Does that make price speculation a sound investment strategy?

No, it does not.

“Multiple expansion” is just a fancy way of saying “speculative price increase.”

Likewise, “multiple contraction” is a fancy was of saying “speculative price decline.”

Private Credit Stats

Sometimes I hear people say we “deleveraged” following the 2008 financial crisis. Sure, the consumer may have deleveraged, but I can assure you there’s plenty of debt left sloshing around in the system. A bunch of it has moved from bank balance sheets to what can loosely be thought of as the hedge fund space.

We call this private credit or direct lending. It’s huge right now in the institutional investing world. Sometimes it feels like every scrappy hedge fund guy in the world is launching a private credit vehicle.

Today, I came across a great paper by Shawn Munday, Wendy Hu, Tobias True and Jian Zhang providing an overview of the space. If, like me, you’ve been inundated with pitch decks from private credit funds over the past couple years, you won’t find much in the way of new information. But the stats are worth perusing.

private_credit_aum
Source: Munday, et al
private_credit_Commits
Source: Munday, et al
pooled_MOICs_IRRs
Source: Munday, et al
IRR_by_vintage_year
Source: Munday, et al

If you are an allocator this is nice base rate data for the space. According to the pitch decks everyone is targeting a net IRR in the mid-teens. It doesn’t surprise me that the median IRR for the post-crisis era is closer to 10% than mid-teens.

Personally, I’m inclined think median returns over the next decade will look more like the 2006 and 2007 vintages. Anecdotally, I can tell you there are middle market deals getting done out there with six turns of leverage and 7% yields. Unless you’ve got warrant coverage, you’re not getting anywhere near 15% IRR on a deal like that.

That kind of behavior reeks of yield chasing.

And we all know what happens to yield hogs.

Eventually, they get turned into bacon.

3Q18 US Factor Returns

Below are my factor return charts, updated for 3Q18. As always, this data lags by one month, so it is technically through August 31. Note also that the more recent bout of market volatility lies outside this date range. It will fall inside the next update.

This one features more of the same. Returns to Market and Momentum continue to grind higher, leaving the more value-oriented factors in the dust.

At bottom I’ve added a snap of Research Affiliates’ latest factor valuations. They’re about what you’d expect given the return data, with Illiqudity (think VC and private equity) and Momentum at the high end of their historical ranges. Value remains at the low end.

It’s worth asking: what’s the point of this exercise?

To better understand and contextualize the following (thanks Rusty Guinn):

[T]here is no good or bad environment for active management. There are good or bad environments for the relatively static biases that are almost universal among the pools of capital that benchmark themselves to various indices.

For a diversified portfolio, the variation in returns is explained almost entirely by the aggregate factor exposures. You’d be surprised how many professionals are ignorant of this.

Now, some of that ignorance is deliberate. There’s a reason investment managers don’t often show clients factor-based attribution analyses. The data typically supports the idea that a significant portion of their returns come from the relatively static biases (“tilts”) mentioned above.

As an allocator of capital, it behooves you to be intentional about how your portfolios tilt, and how those tilts manifest themselves in your realized performance. This self awareness lies at the heart of a disciplined and intentional portfolio management process.

3Q18_rolling_avg_factor_returns
Source: Ken French’s Data Library & Demonetized Calculations
3Q18mkt
Source: Ken French’s Data Library & Demonetized Calculations
3q18size
Source: Ken French’s Data Library & Demonetized Calculations
3q18val
Source: Ken French’s Data Library & Demonetized Calculations
3q18mo
Source: Ken French’s Data Library & Demonetized Calculations
3q18_op_profit
Source: Ken French’s Data Library & Demonetized Calculations
3q18inv
Source: Ken French’s Data Library & Demonetized Calculations
201810_RAFI_Factor_Valuations
Source: Research Affiliates