The New Finance For A New Era

The myth persists that buy-and-hold strategies are worthless. We live in a new era, we’re told. The old rules of finance are gone. Ours is new age of active management for all portfolios at all times. But the reality is that not much has changed. Markets are still volatile, predicting return is still hard, and trading costs and taxes still take a heavy toll on gross returns over time. There are, however, new insights that inspire modifying the old advice. But that still falls short of throwing out the baby with the bathwater.

That’s a nuanced point, and one that’s too often minimized if not ignored outright. Why? It’s not for lack of intelligence. But it’s also true (still) that different constituencies in the money game have different agendas. Wall Street, to cite the ancient example, is still conflicted between its business model and clients’ best interests. No wonder that the first and last question to ask when it comes to Big Finance and your money is still: Where Are the Customers’ Yachts?
There are other agendas to consider as well when it comes to your money. One might be called the media-finance complex, which is driven by the need to keep investment journalism focused on complexity and promoting the idea that nothing less than a homegrown hedge fund-type strategy will suffice for the new era that reportedly bedevils us all. But what makes for scintillating copy doesn’t easily translate to worthwhile investment advice.
It’s true, of course, that financial economics over the last several decades has identified a broad array of insights that help us predict risk premiums for all the major asset classes. An extraordinary new book—Expected Returns: An Investor’s Guide to Harvesting Market Rewards—surveys this literature. The message is two-fold. One, investors can’t afford to ignore this market intelligence. The opportunity to enhance realized return, reduce risk, or both, is quite real. But there’s a dark side as well, and this new book from Antti Ilmanen, a senior portfolio manager at Brevan Howard who earned a finance Ph.D. from the University of Chicago, does a masterful job of emphasizing the dual nature of what we’ve learned over the past generation:

Finance theories have changed dramatically over the past 30 years, away from the restrictive theories of the single-factor CAPM, efficient markets, and constant expected returns. Current academic views are more diverse, less tidy, and more realistic. Expected returns are now commonly seen as driven by multiple factors. Some determinants are rational (risk and liquidity premia), others irrational (psychological biases such as extrapolation and overconfidence). Expected returns on all factors may vary over time.

The smoking gun in all this, Ilmanen writes, is “required asset returns have little to do with an asset’s standalone volatility and more to do with when losses can be expected to occur. Investors should require high-risk premia for assets that fare poorly in bad times, whereas safe haven assets (that fare well in bad times and less well in good times) can justify low or even negative risk premia.” More precisely,

Forward-looking indicators such as valuation ratios have a better track record in forecasting future asset class returns than rearview mirror measures. The practice of using historical average returns as best estimates of future returns is dangerous when expected returns vary over time.

The implications of this market intelligence: a) portfolios should be diversified across risk factors; and b) the mix of risk factors should be actively managed in some degree, a point I discuss at some length in Dynamic Asset Allocation.
But here’s the problem: the substantial progress in peeling away the onion skin of uncertainty in projecting risk premia is, at best, only a partial solution. Even if you’re a wide-eyed optimist and argue that our confidence in predicting return is 50%, that implies that active asset allocation should constitute half of the portfolio strategy. What should dominate the other half? Passive management.
If expected returns were perfectly and forever random, asset allocation should be completely passive. There’s no point in trying to predict returns if future performance will be distributed along a bell-shaped curve. If that’s the case, it suggests holding a passive mix of assets, as implied by a market-value-weighted portfolio. But we know that returns aren’t randomly distributed. That provides us with some confidence for making forecasts and expecting a success rate that’s higher than what random results allow.
Unfortunately, the ability to make informed forecasts with a higher degree of accuracy is still well short of perfection. Returns aren’t randomly distributed, but over the long term they come close. The short term, of course, is another story. Even with all the intellectual firepower that comes from standing on the shoulders of giants in finance, we still make mistakes. We should invest accordingly by factoring in our recurring capacity for screwing up.
The other challenge is a lack of discipline, a habit that afflicts the human species in matters of money management. It’s one thing to be told that expected returns vary and that there are tools for identifying how and when those forecasts vary. It’s quite another to consistently marshal the psychological fortitude to act on those forecasts–a discipline that’s inherently a contrarian-based investment strategy.
History suggests that investors generally have little if any ability to exploit extreme conditions in a timely manner as it relates to expected return. For instance, few were buying stocks in late-2008 when equity prices were falling sharply. Conversely, the crowd was buying in 2006 and 2007, when prices were rising dramatically.
In fact, the limited ability of the average investor to exploit fluctuations in expected return goes a long way in explaining why ex ante risk premia bounce around so much. Yes, it’s reasonable that the market offers bigger incentives for taking risk when potential threats loom large, or that Mr. Market is apt to be greedy in extending payments when the expectations are rosy. It’s no less surprising that investors overall are frightened when trouble lurks, or overly exuberant when all seems well. No wonder, then, that average investment results are so tough to beat, a point that brings us back to buy-and-hold investing strategies.
Given what we know about asset pricing, managing asset allocation should be partly active. Exactly how much is debatable; a fair amount of the answer depends on the investor, and so the appropriate counsel will vary from person to person (or institution to institution).
Meantime, decades of financial research tell us that we shouldn’t ignore the clues that Mr. Market offers in the quest to peer into the future. But we should also be wary, a point that Ilmanen emphasizes:

Although I present large amounts of empirical evidence about historical returns and forward-looking indicators, as well as numerous theories in an attempt to make sense of the data, I believe it is important to stress humility. Hindsight bias makes us forget how difficult forecasting is, especially in highly competitive markets. Expected returns are unobservable and our understanding of them is limited. Even the best experts’ forecasts are noisy estimates of prospective returns.

The humility side of the equation suggests that we should make an effort to share in the premiums that arise from simply holding betas through time. As a simple example, consider how a 60% equity/40% bond portfolio fared over the 10 years through the end of 2010, as shown in the graph below. This portfolio was formed at the close of 2001. The equity piece was evenly divided at first between U.S. stocks (Russell 3000) and foreign stocks (MSCI EAFE). The bond slice was represented solely with U.S. investment-grade debt (Barclays Aggregate Bond). The buy-and-hold version of this strategy earned a 4.1% annualized total return over the last 10 years. If we rebalanced back to the initial 60/40 mix every December 31, the return increased to 4.9% a year.

The message is that asset allocation with little or no active management yields modest returns over time. That’s a point that’s routinely overlooked in the financial press, which likes to point out that a buy-and-hold strategy for U.S. equities led to a lost decade recently. True, but finance theory doesn’t recommend making extreme bets in asset allocation, which is what a U.S. equity-only portfolio amounts to.
Instead, investors should stay focused on the two broad pieces of strategic intelligence that have been documented over the past generation. One, the unmanaged market portfolio (or a reasonably proxy) will deliver competitive risk-adjusted returns over time. Given that this multi-asset class market beta is easy to procure, most investors should consider tapping into it as a foundation for their investment strategy. Two, expected returns fluctuate with some amount of predictability.
Putting these two “facts” together suggests that we should manage asset allocation actively to a degree, but only to the extent that we don’t completely give up the easy rewards of passive allocation. Advice that counsels going to either extreme is, well, extreme. The financial media aren’t fond (for the most part) of making this point. Why? Perhaps it’s a bit boring and repetitive compared with the sexier approach of highlighting the fund or manager du jour, or dissing this or that asset class in isolation while elevating another.
Don’t confuse the business demands of the media industry with prudent investing advice. Yes, the customers do in fact have yachts (or the financial equivalent), but they’ve been earned through strategies that you won’t routinely find with the usual suspects.