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.

Data Source: Ken French’s Data Library

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

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.

Mental Model: How To Make Money Investing

In my line of work, I see a lot of client investment portfolios. Very few of these portfolios are constructed from any kind of first principles-based examination of how financial markets work. Most client portfolios are more a reflection of differences in advisory business models.

If you work with a younger advisor who positions her value add as financial planning, you’ll get a portfolio of index funds or DFA funds.

If you work with an old-school guy (yes, they are mostly guys) who cut his teeth in the glory days of the A-share business, you’ll get an active mutual fund portfolio covering the Morningstar style box.

No matter who you work with, he or she will cherry-pick stats and white papers to “prove” his or her approach to building a fairly vanilla 60/40 equity and fixed income portfolio is superior to the competition down the street.

My goal with this post, and hopefully a series of others, is to help clarify and more thoughtfully consider the assumptions we embed in our investment decisions.

So, how do I make money investing?

There are two and only two ways to get paid when you invest in an asset. Either you take cash distributions or you sell the asset to someone for a higher price than you paid for it.

Thus, at a high level, two factors drive asset prices: 1) the cash distributions that can reasonably be expected to be paid over time, and 2) investors’ relative preferences for different cash flow profiles.

What about gold? you might wonder. Gold has no cash flows. True enough. But in a highly inflationary environment investors might prefer a non-yielding asset with a perceived stable value to risky cash flows with massively diminished purchasing power. In other words, the price of gold is driven entirely by investors’ relative preferences for different cash flow profiles. Same with Bitcoin.

So, where does risk come from?

You lose money investing when cash distributions end up being far less than you expect; when cash distributions are pushed out much further in time than you expect; or when you badly misjudge how investors’ relative preferences for different cash flow profiles will change over time.

That’s it. That’s the ball game. You lose sight of this at your peril.

There are lots of people out there who have a vested interest in taking your eye off the ball. These are the people Rusty and Ben at Epsilon Theory call Missionaries. They include politicians, central bankers and famous investors. For some of them almost all of them, their ability to influence the way you see the world, and yourself, is a source of edge. It allows them to influence your preferences for different cash flow profiles.

Remember your job!

If you’re in the business of analyzing securities, your job is to compare the fundamental characteristics of risky cash flow streams to market prices, and (to the best of your ability) formulate an understanding of the assumptions and preferences embedded in those prices.

If you’re in the business of buying and selling securities, your job is to take your analysts’ assessments of cash flow streams, as well as the expectations embedded in current market prices, and place bets on how those expectations will change over time.

Ultimately, as the archetypical long-only investor, you’re looking for what the late Marty Whitman called a “cash bailout”:

From the point of view of any security holder, that holder is seeking a “cash bailout,” not a “cash flow.” One really cannot understand securities’ values unless one is also aware of the three sources of cash bailouts.

A security (with the minor exception of hybrids such as convertibles) has to represent either a promise by the issuer to pay a holder cash, sooner or later; or ownership. A legally enforceable promise to pay is a credit instrument. Ownership is mostly represented by common stock.

There are three sources from which a security holder can get a cash bailout. The first mostly involves holding performing loans. The second and third mostly involve owners as well as holders of distressed credits. They are:

  • Payments by the company in the form of interest or dividends, repayment of principal (or share repurchases), or payment of a premium. Insofar as TAVF seeks income exclusively, it restricts its investments to corporate AAA’s, or U.S. Treasuries and other U.S. government guaranteed debt issues.
  • Sale to a market. There are myriad markets, not just the New York Stock Exchange or NASDAQ. There are take-over markets, Merger and Acquisition (M&A) markets, Leveraged Buyout (LBO) markets and reorganization of distressed companies markets. Historically, most of TAVF’s exits from investments have been to these other markets, especially LBO, takeover and M&A markets.
  • Control. TAVF is an outside passive minority investor that does not seek control of companies, even though we try to be highly influential in the reorganization process when dealing with the credit instruments of troubled companies. It is likely that a majority of funds involved in value investing are in the hands of control investors such as Warren Buffett at Berkshire Hathaway, the various LBO firms and many venture capitalists. Unlike TAVF, many control investors do not need a market out because they obtain cash bailouts, at least in part, from home office charges, tax treaties, salaries, fees and perks.

I am continually amazed by how little appreciation there is by government authorities in both the U.S. and Japan that non-control ownership of securities which do not pay cash dividends is of little or no value to an owner unless that owner obtains opportunities to sell to a market. Indeed, I have been convinced for many years now that Japan will be unable to solve the problem of bad loans held by banks unless a substantial portion of these loans are converted to ownership, and the banks are given opportunities for cash bailouts by sales of these ownership positions to a market.

For you index fund investors snickering in the back row—guess what? You’re also looking for a cash bailout. Only your ownership of real world cash flow streams is abstracted (securitized) into a fund or ETF share. In fact, it’s a second order securitization. It’s a securitization of securitizations.

I’m not “for” or “against” index funds. I’m “for” the intentional use of index funds to access broad market returns (a.k.a “beta”) in a cheap and tax-efficient manner, particularly for small, unsophisticated investors who would rather get on with their lives than read lengthy meditations on the nature of financial markets. I’m “against” the idea that index funds are always and everywhere the superior choice for a portfolio.

Likewise, I’m not “for” or “against” traditional discretionary management. I’m “for” the intentional use of traditional discretionary (or systematic quant) strategies to access specific sources of investment return that can’t be accessed with low cost index funds. I’m “against” the idea that traditional discretionary (or systematic quant) strategies are always and everywhere the superior choice for a portfolio.

What sources of return are better accessed with discretionary or quant strategies?

That’s a subject for another post.

Investing vs. “Getting Market Exposure”

Like “financial advisor” and “hedge fund,” the word “investing” is probably one of the most abused terms in our financial lexicon. These days many people use the word “investing” when what they are really talking about is “getting market exposure.”

For fun I googled the definition of investing:

Source: Google

I also re-read this post from Cullen Roche where he discusses “allocating savings” (what I would call “getting market exposure”).

It’s funny how “investors” abuse the term “investing”. What we’re really doing when we buy shares on a secondary exchange is not really “investing” at all. It’s just an allocation of savings. Investing, in a very technical sense, is spending for future production. So, if you build a factory and spend money to do so then you’re investing. But when companies issue shares to raise money they’re simply issuing those shares so they can invest. And once those shares trade on the secondary exchange the company really doesn’t care who buys/sells them because their funds have been raised and they’ve likely already invested in future production. You just allocate your savings by exchanging shares with other people when you buy and sell financial assets.

Now, this might all sound like a bunch of semantics, but it’s really important in my opinion. After all, when you understand the precise definitions of saving and investing you realize that our portfolios actually look more like saving accounts than investment accounts. That is, they’re not really these sexy get rich quick vehicles. Yes, the allure of becoming the next Warren Buffett by trading stocks is powerful. But the reality is that you’re much more likely to get rich by making real investments, ie, spending to improve your future production. Flipping stocks isn’t going to do that for you.

This leads you to realize your portfolio is a place where you are simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss. It’s not a place for gambling or getting rich quick. In fact, it’s much the opposite. It’s a nuanced view, but one I feel is tremendously important to financial success.

I have promised myself I will stop using “investing,” “getting market exposure” and “allocating savings” interchangeably.

For me, the semantic line between investing and “getting market exposure” is a little different from what Cullen proposes. For me it’s this: as an investor you are looking to compound capital at a rate exceeding your cost of capital (opportunity cost), while avoiding permanent impairment of capital.

Yes, “extraordinary” is a fuzzy term. To me, pretty much anything above 10%, net of expenses, is extraordinary. That will give you nearly a 7x return over 20 years. If you can do 15% (an extraordinary achievement, btw), that multiple jumps to over 16x.

Some of you are no doubt thinking you can net 10% annually forever in an S&P 500 index fund. And maybe you are right. In my view the odds are stacked against you over the next 10 years. In fact, I would gladly take the other side of that bet over next 10 years. But beyond the next decade or so it is hard to tell.

The reason is broad market returns measured over long time periods are sensitive to starting valuations. If you ask the average equity analyst he will probably tell you the market is “fairly valued” today based on the one-year forward price/earnings multiple. Which is another way of saying “meh.” By other measures, such as the Shiller CAPE, the US market is extremely expensive. But if you are allocating your savings based on one-year forward earnings multiples you’ve got bigger problems than parsing the nuances of various valuation multiples.

Source: JP Morgan

Also, analysts kind of suck at forecasting earnings growth. So the forward price/earnings multiple is a flawed input at best.

Source: Business Insider

Anyway, if none of this stuff interests you, you aren’t thinking like an investor. The whole point of investing is to seek out asymmetric risk/reward propositions. That’s very different from “simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss.”

Trolling Warren Buffett

So the annual Berkshire letter is out and Buffett could not resist taking another swipe at Wall Street over his bet with Protégé Partners. I am not going to re-hash the letter or the bet here. (Incidentally, I highly recommend giving this annotated version a read) Rather, I want to draw your attention to one particular bit no one ever seems to talk about:

Sources: Berkshire Hathaway; Safal Niveshak (highlight)

Am I the only person on the internet who believe this was a completely insane way to build a portfolio? Obviously, in the aggregate, the best investors can hope to do is match the market return, less fees (they can of course do considerably worse). It cannot be otherwise. There is nothing especially profound about the observation that it makes no sense to try and replicate the broad market with scores of active managers.

Fama and French demonstrated long ago that the aggregate portfolio of all investment managers more or less resembles the market cap weighted portfolio (read: an index fund, but with higher fees). Behold:

The high management fees and expenses of active funds lower their returns. If we measure fund returns before fees and expenses – in other words, if we add back each fund’s expense ratio – the α estimate for the aggregate fund portfolio rises to 0.13% per year, which is only 0.40 standard errors from zero. Thus, even before expenses, the overall portfolio of active mutual funds shows no evidence that active managers can enhance returns. After costs, fund investors in aggregate simply lose the fees and expenses imposed on them.

Adding insult to injury, the aggregate portfolio of active mutual funds looks a lot like the cap-weighted stock market portfolio. When we use the three-factor model to explain the monthly percent returns of the aggregate fund portfolio for 1984-2006, we get,

RPt – Rft = -0.07 + 0.96(RMt – Rft) + 0.07SMBt – 0.03HMLt + eit,where RPt is the return (net of costs) on the aggregate mutual fund portfolio for month t, Rft is the riskfree rate of interest (the one-month T-bill return for month t), RMt is the cap-weighted NYSE-Amex-Nasdaq market return, and SMBt and HMLtare the size and value/growth returns of the three-factor model.

The regression says that the aggregate mutual fund portfolio has almost full exposure to the market portfolio (a 0.96 dose, which is close to 1.0), but almost no exposure to the size and value/growth returns (0.07 and -0.03, which are close to zero). Moreover, the market alone captures 99% of the variance of month-by-month aggregate fund returns.

In short, the combined portfolio of all active mutual funds is close to the cap-weighted market portfolio, but with a return weighed down by the high fees and expenses of actively managed funds.

Therefore, in my view, Protégé’s failure was first and foremost a failure of portfolio construction. It’s totally fair to fault Protégé for this, just as it’s fair to fault many investors for buying into a collective delusion around hedge funds as magical assets* in the mid-2000s. To the extent Warren is underscoring that point, I wholeheartedly agree with him.

Beyond that, I don’t know the outcome of this best offers much insight into investment manager selection or the merits of investing actively. (See my Truth About Investing post for more on that subject) Warren Buffett did not get to be a billionaire buying index funds. Neither did Jim Simons. Or David Tepper. Or Seth Klarman.

Someone please sit down with Jim Simons or David Tepper or Seth Klarman or Howard Marks or any of the dozens of hedge fund managers who have trounced the S&P 500 over the past couple of decades and lecture them about the aggregate performance of active management. I would love to hear how it goes.

*  When I write about magical asset classes I am referring to any asset class or strategy people believe is inherently superior to others. In the mid-2000s investors clearly believed they could generate outperformance just by “being in” hedge funds. There are lots of reasons why aggregate performance has declined since then. First and foremost, hedge funds became victims of their own success as the space attracted large amounts of investor capital and many hundreds of talented money managers. Now that hedge funds are out of favor, the magical asset classes of today are private equity and venture capital. Also, hedge funds are not an asset class. They are a type of fund structure, just like closed end funds and mutual funds are types of fund structures. Similarly, you can argue that private equity isn’t a unique asset class so much as a levered investment in illiquid small caps and micro caps.

The Truth About Investing, Part II

(See Part I for the background on this post. As usual, none of this should be treated as financial advice as it does not take your personal circumstances into account. If you want advice, talk to a professional advisor. Trust me, there are plenty  of highly competent, ethical professionals out there who are excited to help you achieve your goals.)

After sharing the original post with some savvy friends, subsequent discussion stirred up some additional ideas for questions and answers. So here are some additions to our little Socratic dialogue.

So back to this active versus passive investing thing. It sounds like you are pro passive?

If I absolutely have to take a position, I would say most people are probably better off investing passively. Unless they happen to be really good at investing actively, of course.

Ugh. There you go again. But how can I figure out if I’m good at investing actively?

We can look at your returns 20 or better yet 30 years from now. That will give us a pretty good idea.

Double ugh. How can I know BEFORE I start making active bets? If I start down this path and it turns out I suck I may lose a lot of money.

You can’t know ahead of time. Don’t waste your time trying to “know” things that are fundamentally unknowable.

There are certain skills and psychological traits that may make you a better active investor than someone else. For example, skilled poker players typically make for good active investors. They intuitively understand expected value, probabilistic thinking and mental models for decision making under uncertainty. They understand the interplay between luck and skill in determining outcomes. Psychologically, they know how to handle a “bad beat” (or several) without blowing up. They are used to making calculated bets, and therefore also have an intuitive understanding of risk management.

If you are a good portfolio manager (you’ve got “poker skills”), you don’t have to be a great financial analyst to do well. The reason for that is that randomness plays a huge role in the markets (as it does in life). Thus it is more important in the markets to optimize decisions under uncertainty than it is to be “right” analytically. You still need to have an above average understanding of accounting, capital markets and basic principles of economic value creation to avoid making stupid, otherwise obvious mistakes. These things are easier to learn than “poker skills,” if you are willing to put in the time and effort.

Ultimately, if making decisions under uncertainty makes you queasy, I suspect you will have a difficult time investing actively.

That seems complicated and unhelpful.

Then invest passively. Or find someone you trust and respect to develop an active investing program suited to your goals (whether that is picking managers or individual stocks).

Okay. Let me try this another way. What I have really been asking this whole time is this: what is The Best Thing To Do?

There is no Best Thing To Do. There is only The Best Thing For You To Do.

So what does YOUR portfolio look like, big shot?

Approximately 70% of my investable net worth (ex-cash) is invested in actively managed strategies that should earn something like broad market returns over time. If I am lucky maybe a little extra. If I am unlucky maybe a little less. The remaining 30% is invested in a concentrated portfolio of individual securities with the goal of generating extraordinary capital appreciation over a multi-decade time horizon.

How do you know these managers will perform well over time?

I don’t. Honestly,  just try to put money with folks doing sensible things who I think will be good stewards of my capital over a multi-decade time horizon, and who I believe charge reasonable fees for managing my money. That frees me up to do the work I want to do on individual securities, which will potentially compound value at a much higher rate over time.

Why this 70/30 split? Why not just go all in on the stuff that you think will go up the most?

Because if 30 years from now it turns out I really sucked at this I will not have laid waste to my net worth or my family’s financial security.

Risk management, remember?

The Truth About Investing

I was inspired to write this post by a conversation I had this afternoon at a lunch event. I sat next to a gentleman who has been working in the capital markets for about 40 years. We were discussing active, passive and smart beta strategies. Our conversation revolved around the idea that much of what passes for investment strategy is an incoherent jumble of half-truths and gross oversimplifications. The reason for this is that investors are always looking for THE ANSWER. You can move a lot of product pretending to have it.


It is the magic asset, or strategy, or star manager that beats the market like clockwork. It is the alluring promise of “equity returns with less risk” (whatever that’s supposed to mean). It is the siren song that drew investors to hedge funds in the mid-2000s and draws them to private equity and venture capital today.

In reality of course there is no magical asset class, strategy, or manager. There is only the ever-shifting landscape of the capital markets. In capital markets, the only constant is change. Fortune ebbs and flows. Just when you think you have the game figured, the game will change. Count on it. George Soros calls this “reflexivity.” The game changes in response to how we play it. Don’t like it? Too bad. That’s America.

People do not like change. They especially do not like change of the reflexive kind. And don’t get me started on cognitive dissonance. Nothing wrecks Average Joe’s head quite like trying to hold two contradictory ideas in his head at the same time. Because people prefer order, stability, predictability and logical coherence, we as financial professionals tend to coddle them. We show them charts of historical capital market data and pretend it is meaningful. We make neat little graphs showing historical drawdowns and recoveries and emphasize that things always turn out okay in the long run. What we don’t give them is THE TRUTH. Most of them can’t handle the truth.

Because THE TRUTH is that there is no single ANSWER. There is only a long list of general principles in constant conflict with one another. And the reality is that sometimes things don’t turn out okay in the long run.

In that spirit, I will endeavor to answer some common questions as truthfully as I can. Note that as always, this is not financial advice. I have no idea what your personal situation may be. I am not in a position to be advising you to do anything. And anyway when you are through reading you will probably be more confused than when you started. Silver lining: you will be incrementally closer to understanding the truth about investing.

So here we go.

Is it better to invest actively or passively?

It depends on what you want to achieve.

If you are comfortable earning broad market returns, and you want to maximize tax efficiency and minimize costs, passive strategies are probably the tools you are looking for.

If your goal is to generate extraordinary capital appreciation, you must concentrate capital in equities with extraordinary compounding potential, and you must hold these positions for a very long time. Perhaps that means starting your own business. Perhaps it means owning a concentrated portfolio of individual stocks. Perhaps it means investing a significant portion of your investable net worth with a single asset manager. Warren Buffett didn’t get to be a billionaire buying index funds, no matter what he writes in his shareholder letters.

What if the broad market doesn’t return what it has historically and it ruins my financial plan?

Too bad. There is no law saying you are entitled to a particular return over time. The future is fundamentally unknowable. The best way to protect yourself from unexpected financial shocks is to save a significant portion of your income, carry as little debt as possible and invest a portion of your savings in personal development. Note that all of those things are things you can control, unlike the financial markets and the macroeconomy.

What if I can’t pick the right stocks/managers/business opportunity and I lose all my money?

Too bad. There is no law saying you are entitled to a particular return over time. However, if you are unwilling to devote a significant amount of time learning about business, accounting, capital markets and psychology, it is unlikely you will do well investing. Don’t be ashamed of that. It just means you will need to seek out professional advice, the way I sought out a coach when I wanted to change careers from writing to finance. You will be better for it in the long run, and contrary to what you read in the news there are many highly competent advisors out there who want to help you achieve your goals.

What if I can’t pick the right stocks/managers/business opportunity and I significantly underperform the broad market averages?

Too bad. There is no law saying you are entitled to a particular return over time. If you are that concerned about underperforming the broad market averages you should invest passively. The future is fundamentally unknowable. The best way to protect yourself from unexpected financial shocks is to save a significant portion of your income, carry as little debt as possible and invest a portion of your savings in personal development. Note that all of those things are things you can control, unlike the financial markets and the macroeconomy.

How do I know I am picking the best investment manager?

You don’t and you can’t. Don’t waste your time and energy thinking about this. If you go this route, focus more on avoiding the worst managers, and developing an investment discipline you can stick to over time, through thick and thin.

Isn’t it true that no one can beat the market?

The average investment manager will not beat the market over time, especially net of fees and taxes. However, that is the “average” and there are many talented managers who do outperform over the long run on a net basis. Unfortunately, most of the managers who outperform over the long run will suffer extended periods of underperformance, and most investors will not be sufficiently disciplined to stick around for the good times. In my opinion, picking managers is every bit as difficult as picking stocks. Perhaps even more so.

So if I am invested with a poorly performing manager I should just hold on longer until the good times come?

No. Poor performers often continue to perform poorly, and this poor performance is exacerbated by outflows of investor capital. If this persists for an extended period, it will render the asset manager’s business non-viable and the fund will liquidate, crystallizing your losses.

So how do I know if performance will turn around?

You don’t know. And you can’t.

Grrr… this is getting annoying. Fine. How can I try and figure it out?

Better, grasshopper. You are slowly learning to ask the right questions!

You need to understand the manager’s investment philosophy. You need to understand the way she looks at the world, the way she thinks about value creation and what she perceives as her “edge.” Is she focused on long run intrinsic value creation or the shorter term re-rating of market expectations? (Hint: when she models companies, does she use a discounted cash flow or earnings methodology, or does she compare price multiples such as EV/EBITDA to peer companies?)

You need to assess whether her portfolio is in sync with how the capital markets are trending, or whether she is a contrarian. If she is a contrarian, you need to assess whether and when the market will turn in her favor, and whether you can hold out for that long psychologically.

You also need to understand her investor base, the health of her business, the loyalty of her team and her personal goals. If she is losing assets and is motivated primarily by business success (versus “winning” at the game of investing) she will be more likely to liquidate (a.k.a return investor capital to spend more time and energy with family).

This sounds hard.

Why should it be any easier than mastering any other technical or artistic skill?

Well, I can trade commission free on Robinhood.

You can cook elaborate meals in your home kitchen, too. Yet you don’t expect your butternut squash risotto to earn three Michelin stars.

Thinking back on the first part of this conversation, I notice you repeat yourself a lot.

Is that so? Gee. Maybe there’s something to that…

4Q17 Factor Performance

A while ago I created some charts to track factor performance in the US equity market. The data is from Ken French’s Data Library. As you might expect, it is the Fama French Five Factor data, as well as data for the North American Momentum Factor.

From an analytical point of view I always find it helpful to dis-aggregate investment returns, as this can offer a more nuanced picture of the fundamental drivers of equity market returns.

Source: Ken French’s Data

Our first factor is Market. Looking at this chart it’s no wonder there has been a bull market in passive investing lately. Since May of 2014 simply being in the market has return a cumulative 45%. Getting market exposure as cheaply as possible has proven to be a great strategy over this time period.

Source: Ken French’s Data

Next up is size. As a whole small companies have not generated much of a return premium in recent years.

Source: Ken French’s Data

Value is a much beloved and storied factor and if you follow markets at all you have probably read plenty of material calling value investing into question lately.

Source: Ken French’s Data

Momentum has taken investors on a wild ride in recent years. 2015 in particular was an exceptional year for momentum, driven in large part by internet technology and biotechnology stocks. Despite a vicious drawdown in late 2015 and early 2016 momentum is surging again on the back of bullish sentiment.

Source: Ken French’s Data

Nothing to write home about in terms of operating profitability.

Source: Ken French’s Data

Investment is more or less the mirror image of the momentum chart. The investment factor is a bit counter intuitive in that it is measuring the premium associated with a conservative corporate investment policy. There have been a couple of inflection points in this chart and more recently investors seem to again prefer companies investing more aggressively in growth opportunities.

Finally, here is my updated chart of rolling factor returns back to 2000:

Source: Ken French’s Data

Observations & Implications

The most significant takeaway from this data is that since the financial crisis, the best performing factor has been Market by a wide margin. I don’t believe it is an accident that strong Market factor performance coincides with both the trend toward passive investing and the extraordinarily low interest rate environment we have seen since the financial crisis. I suspect there is some degree of feedback loop in play here: low interest rates push up equity valuations which enhances broad market returns which is a tailwind for low-cost, market cap weighted equity funds (a.k.a index funds).

Furthermore, since the financial crisis several factors have shown muted performance versus their pre-crisis averages, notably Size and Value. This is a headwind for active mutual fund managers. Most of these managers run diversified portfolios where the factor exposures drive the majority of the variation in their returns. If they are good (or lucky) they will add some incremental return through security selection. Many managers also intentionally tilt their portfolios toward small stocks and value stocks. They have not been rewarded for these tilts in recent years.

The trillion dollar question here is whether Market factor dominance is a secular or cyclical trend. I am inclined to believe it is cyclical, albeit with a significant caveat.

My significant caveat is that Market factor dominance will last at least as long as global interest rates remain low. In this low rate environment the notion that There Is No Alternative forces capital that would otherwise be content to earn 5% annually in long-dated Treasury bonds into risk assets, pushing up valuations indiscriminately. Until investors with lower risk preferences determine they have viable investment alternatives, equity valuations will remain elevated across the board and the Market factor will perform well.

Sentiment seems quite bullish so far in 2018. This has animated the spirits of a number of investment managers. Yet here is the YTD data for the Treasury yield curve. The market is absolutely not pricing for significantly higher economic growth, inflation or interest rates over the very long term (20-30 years). I am not sure there is any actionable insight in this but it is a troubling disconnect.