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

Vulture Capitalism

640px-White-backed_vultures_eating_a_dead_wildebeest
Source: Wikipedia

Predictably, the Sears bankruptcy has attracted much wailing and gnashing of teeth around so-called “vulture capitalism” as practiced by hedge funds and private equity firms (here in the biz we use terms like “activism” or “distressed” investing). “Vulture” is of course used as a pejorative in these articles. Personally, though, I think practitioners should embrace the label.

In nature, vultures play an important role in ecosystems:

When vultures are unable to clean up the carrion in an area, other scavenger animals increase in population. The scavengers that tend to move in where vulture populations are low include: feral dogs, rats, and blowfly larvae. While these animals do help to remove carcasses from the landscape, they are also more likely to spread disease to human populations and other animals as well. In India, for example, the feral dog population increased significantly after vultures consumed cow carcasses poisoned with diclofenac, a painkiller. These feral dogs carried rabies and went on to infect other dogs and local people. Between 1993 and 2006, the government of India spent an additional $34 billion to fight the spread of rabies. India continues to have the highest rate of rabies in the world […]

[…] It is important to remember that even though the vulture species lacks the cute cuddly appearance of some endangered species, it is still a critical piece to a much larger, complex ecosystem. The world needs vultures to help control the spread of disease.

Likewise, vulture capitalists pick apart the corpses of dead and dying firms. Eventually that capital is recycled elsewhere in the market ecosystem.

Now, clearly this is not a pretty process. It is gruesome. It involves ruthlessly cutting costs; it involves firing good, hardworking people; it involves selling off assets and extracting cash instead of going through the “feel good” motions of reinvesting that cash into a dying enterprise. The firms that specialize in these activities are at the pointy end of Schumpeter’s “creative destruction.” It’s not exactly shocking that they’re unpopular with the general public.

But here’s the thing about “vulture capitalists.” They don’t feed on healthy companies. And there’s a good reason for this. Healthy companies are too expensive for distressed funds and buyout firms to get their claws into.

The popular notion that Sears, as a business, is dead money has been around since at least 1988. 1988! That’s thirty years. Three decades. Take a moment and think about that.

For thirty years now it’s been pretty clear the investment case for Sears rests largely on a sum-of-the-parts valuation of the real estate assets. There were very few possible worlds in which Sears would reinvent itself as a thriving retail business—particularly given brutal competition from Wal-Mart, Target, CostCo and others.

So when we talk about Sears we’re talking about the business equivalent of a sickly, dying wildebeest. Vulture capitalists consuming the carcass is simply the natural order of things. Even though hedge funds and private equity firms lack the cute, cuddly appearance of certain other market participants, they remain important pieces of a much larger, complex ecosystem.

Blood and Oil

Why do you think everyone suddenly cares about some Saudi journalist?

Which of the following seems more plausible to you?

#1. The world suddenly cares deeply and passionately about human rights in Saudi Arabia. (note that this wailing and gnashing of teeth was conspicuously absent when Crown Prince Mohammed Bin Salman decided to go full Michael Corleone on the Saudi elite last year)

#2. The US financial/political/industrial complex cares deeply and passionately about inflationary pressures and what they might mean for the future path of interest rates, is irritated that the Saudis prefer a higher oil price, and has lucked into the perfect issue with which to needle Riyadh.

Forgive my cynicism, but this all strikes me as by-the-numbers geopolitical gamesmanship.

Update (10/18/18): A more robust analysis can be found here and here. As this story has evolved it seems clearer that this is less about the US using this as leverage and more about plain old-fashioned virtue signaling.

Weapons Of Mass Destruction?

There is this meme out there that the increasing popularity of ETFs as investment vehicles is eventually going to blow up the world. This came up in a meeting I attended recently. Whenever I have these conversations what I take away from them is that a shocking number of financial market participants do not actually understand how ETFs work.

The meme goes like this: there are too many people investing through ETFs these days and when there is a nasty bear market they will all redeem from the ETFs at the same time and the ETFs will all explode. On the off chance you’re wondering how this meme got started this graphic should set you straight.

ETF_flows
Source: ICI

As you can see, if you’re an active equity mutual fund manager you’ve got several hundred billion reasons to portray the rise of the ETF as a harbinger of doom. And so here is the first and most important thing everyone needs to know about ETFs:

ETFs are not mutual funds!

From what I can tell, the ETF-As-Weapon-Of-Mass-Destruction meme is founded on the incorrect assumption an ETF is like an open-ended mutual fund or hedge fund that needs to liquidate holdings to meet redemption requests in cash.

That’s basically the opposite of how an ETF works.

An ETF is much closer in nature to a closed-end fund that can trade at a premium or discount to net asset value over time. The difference is that certain sophisticated market participants (“authorized participants”) can transact with an ETF issuer to create or retire shares. In theory, this mechanism should keep an ETF’s share price in line with its NAV (Arbitrage 101, friends).

Here is a helpful diagram, courtesy of ICI:

ETF_create_redeem_process
Source: ICI

When individual investors like you and me want to sell ETF shares, we don’t participate in the creation/redemption process. We couldn’t participate in that process if we wanted to. Instead, we have to sell our shares in the secondary market like a stock. The price we can transact at is determined by supply and demand. This can be a blessing or a curse, depending on circumstances.

Some Grains of Truth

ETF investors do face risks as they transact in the secondary market. The biggest risk is that they become forced sellers when the market for a particular ETF is thinly traded. In that case, they’ll have to take a haircut to unload their shares. This is no different from what happens when someone tries to unload shares of an individual stock in an illiquid market. That’s Trading 101.

Thus, if you’re going to invest in ETFs you need to pay attention to liquidity. This goes for your personal liquidity (under what conditions might I become a forced seller of this security?) as well as market liquidity (are bid-offer spreads for this security going to stay reasonably tight across a range of market conditions?).

If, for example, you own the S&P 500 index in ETF form you probably don’t have much to worry about from a liquidity standpoint. This won’t protect you from behaving like an idiot as an individual, but it’s fairly unlikely you will ever have to part with your ETF shares at a 50% discount to NAV. In fact, the early S&P 500 ETFs have been battle-tested across a number of stressed market environments, including the global financial crisis. They have yet to explode.

If you own more esoteric things, however, (e.g. the EGX 30 index, high yield debt, bank loans, complicated VIX derivatives) you need to think carefully about liquidity. Shrewd traders will eat you alive if you try to unload esoteric stuff in a dislocated market. In general, it’s dangerous to assume a share of something can ever be more liquid than the stuff it owns or represents. Yes, bank loan and high yield ETF investors, I’m looking at you here.

But these risks aren’t unique to ETFs. They’re present with every exchange traded security. It’s just that mutual fund investors aren’t used to thinking about this stuff. They just buy or redeem each day at NAV.

In Conclusion

Never generalize about any security or type of security.

Securities are not inherently good or bad. Investing is not a morality play.

In fact, any time someone is presenting a security or investment philosophy as a black/white, good/bad, dualistic type of situation it’s a good sign he’s financially incentivized to sell you something.

There are smart ways to use ETFs and stupid ways to use ETFs. But that’s more a comment on investor behavior and specific implementations of ETF investment strategies than the structure itself.

You Have To Earn It

Personally, I’m relieved to see market volatility pick up again.

I’m sick of all this feel-good, bull market crap where everyone can be investing geniuses as long as they focus on the “long term” and own the lowest cost, most tax efficient index funds. It’s high time some volatility comes along and shakes some weak hands out of the market.

People want to live in a riskless world where all the market ever does is go up. You know what kind of returns you are entitled to in a riskless world where all the market ever does is go up?

T-bills.

(Arbitrage 101, friends)

Lately, we’ve gone soft. We’ve forgotten good investment returns aren’t some god-given, inalienable right. Good returns must be earned. And here are some ways you can earn them:

  • By being so far ahead of a secular shift in technology or market structure that everyone else thinks you’re insane.
  • By investing in esoteric stuff no one else can sell to an investment committee.
  • By putting money to work when the world looks to be going to hell in a hand basket.
  • By enduring short and medium-term pain in unloved assets.
  • In spite of inevitable blowups and meltdowns in individual investments.
  • More generally, by persevering when fear and loathing reign supreme in the markets.

Whenever volatility picks up and people start freaking out, I’m reminded of Nick Murray’s definition of a bear market: “a period when stocks are returned to their rightful owners.”

The Alchemy of Risk, Revisited

In a meeting last week an asset manager predicted that whenever the next major market drawdown occurs, a massive central bank intervention will immediately follow. This will prop up asset prices. The drawdown will be brief and v-shaped.

Th natural follow-up question: how long can this go on?

In theory, of course, it can go on forever. As long as market participants are willing to believe in the infallibility of ever-wise and benevolent central bankers, the Fed can effectively outlaw market crashes.

But that implies central bankers can somehow destroy financial risk. We know from market history risk can never be destroyed. It can only be transformed and laid off elsewhere.

So, what kind of risk transformation underlies this process?

What’s happening is financial risk is being transformed into political risk. Or, if you prefer, market volatility is being transformed into political volatility.

In an old Epsilon Theory note, Ben Hunt describes central banks as “creatures of capital:”

Not to get all Marxist here, but these vampires share the DNA of Capital, in opposition to the DNA of Labor, and this is why you will never see the Fed or any other central bank lift a finger against them. Because the Fed is also a creature of Capital — not a vampiric destroyer as these modern manifestations of Capital have become — but a creature of Capital nonetheless.

Meaning what, Ben? Meaning that all of the Fed’s policies — and particularly the monetary policies that are most impactful on our investment portfolios — are in the service of Capital. Sometimes, as we’ve experienced over the past eight years, that means incredibly accommodative monetary policy to support asset collateral prices. Sometimes, as we’ve seen in the past and I think we’re about to see again, that means punitive monetary policy to crush labor and wage inflation.

Pop quiz: What do President Donald Trump and Alexandria Ocasio Cortez have in common?

Answer: They’re creatures of Labor.

In the case of Trump that might seem like a controversial statement. But think about it. Do trade barriers serve Capital or Labor? Does restrictive immigration policy serve Capital or Labor? Cheap imports and immigrant labor sure are good for Capital. Not so much for Labor.

There’s certainly more nuance to it than that. There’s an argument to be made that Trump merely duped the voting public into seeing him as a creature of Labor. But for the purposes of this post that’s irrelevant. In politics, all that matters is what the crowd believes. (Enough of the crowd to sway an election, anyway)

Trump speaks the language of Labor in front of crowds of steel workers and the like who have spent decades on the pointy end of globalization. Likewise when Ocasio Cortez talks about “economic dignity” she’s speaking the language of Labor.

The way Labor traditionally puts the hurt on Capital is through collective action. Ideally that’s political participation and modest civil disobedience. But in the worst cases it’s violent revolution. (Talk about tail risk)

Speaking of tail risk–a similar dynamic is afoot in China.

China’s economy is more or less run as a closed system. This is extremely important for the CCP, which needs to be able to push imbalances around the system to keep it from collapsing. There’s an argument to be made that the Chinese economy is a perpetual game of whack-a-mole with the CCP always needing to pop a bubble here and let another one inflate there.

This is another dynamic that can in theory go on forever but for villagers-with-pitchforks risk. There’s a practical reason the Chinese government has constructed a massive surveillance state.

It’s the tail hedge.