Increase Equity Returns At No Added Risk – The Absolute Return Letter for September 2016.
“Greed is good. Greed is right. Greed works. Greed cuts through, clarifies, and captures the essence of the evolutionary spirit.” — Gordon Gekko
Following 17 months of mostly negative equity returns in Europe, very recently, I have noticed an inclination amongst European investors to increase the risk profile in their portfolios. They may not exactly be going for broke (yet), but the willingness to take more risk is clearly on the rise. The rising appetite for risk could be driven by one of two factors. Investors could either be turning more optimistic, or it could be the result of less benign factors, such as a need to generate higher returns, whether they really believe in such an outcome or not.
In short, I suspect investors are chasing returns that (I think) are unrealistic, and it is not the first time that happens. When investors are under extreme pressure, as I think many are now, they sometimes behave quite irrationally. They do things they would have sworn only a short while earlier they would never do.
I am not saying that we may not be heading for better times, at least in the short to medium term. Equities could very well enjoy a good spell over the next 6 to 12 months, driven by a cyclical upturn, or simply by psychological factors. That said, many years ago, I learned (the hard way) that Warren Buffett couldn’t be more right when he uttered the now famous words:
“If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.”
In my current state of mind, I find it hard – almost impossible – to become overly enthusiastic about equities, even in the short term, as I am as convinced as I possibly can be that the long term outlook is rather grim. That got me thinking. Is there anything else investors could do to raise the overall return level and, in particular, to generate more income without necessarily taking more risk? That is what this month’s Absolute Return Letter is about.
Equity Returns – The starting point
In a low return environment if the overall objective is to raise (expected) returns without adding to risk, first and foremost, you need to think outside the box. A conventional approach, such as simply changing the asset allocation, is quite unlikely to lead to the promised land.
My own starting point is almost always the conjecture of structural trends that we have identified at Absolute Return Partners – structural trends that will happen regardless of the economic cycle and the monetary and/or fiscal policy being pursued. You need to ask yourself how these trends are going to affect financial markets in the years to come.
Changing demographics (we call that trend the retirement of the baby boomers) is probably the most important trend of them all. We know that populations throughout the world will age substantially between now and 2050, but how is that change likely to affect bonds and equities?
Chasing Alpha or Beta?
Secondly, ask yourself why you invest in equities in the first place – are you looking to generate alpha or beta1? Many investors will probably say they aim for both but, at least in our experience, better results are usually achieved when investors separate the two sources of return and let the overall objective (alpha or beta) drive the portfolio construction process.
If you primarily aim for beta, in a low return environment, fees charged by the vast majority of active investment managers are way too high, and you should not hesitate to switch to a passive investment strategy, which will cost you a fraction and, on average, deliver better returns (as the average alpha after fees is negative).
I am sure that I will get a few emails now from active equity managers saying that they are certainly capable of generating both beta and some alpha on top, and to those people I will most likely say, if you are that good, why haven’t you done so consistently? Of course I bump into the odd exception but, in reality, there are very few, almost no, active equity managers who consistently generate a meaningful amount of positive alpha after fees.
With the beta sorted out, where should you go for your alpha? This is not the easiest question to answer, and I am not going to give you any names in this letter, but let me offer a couple of thoughts as to how the topic should be approached.
First, you need to validate an investment manager’s claim to alpha; why has he or she actually outperformed? Many, who do so, use leverage. Leverage is not a bad thing when used appropriately, but some investment managers don’t understand the meaning of the word appropriately.
Used excessively, the risk of accidents rises exponentially when the proverbial s*** hits the fan, and I would urge you not go down that road. One way to distinguish between skill (i.e. alpha) and luck is to track downside correlation – i.e. how well has the investment manager performed in falling markets?
You should also check the volatility of the investment manager’s return stream. Many investment managers who outperform only do so by tolerating excessive levels of volatility and, in my experience, it is only a question of time before those investment managers run into more difficult times.
With few exceptions I find that the most consistent generators of alpha are those investment managers who have reduced their beta exposure to an absolute minimum and, in order to do that, the manager in question needs to be able to go long and short, and that limits the universe quite dramatically.
One final note on active vs. passive equity management. You may subscribe to a particular investment style, e.g. value investing and, in that case, I fully understand that you may not really have an alternative to investing actively, but the other rules would still apply, i.e. only limited use of leverage, no excessive volatility, etc.
Desperate for income? What not to do
Allow me to return to the topic of changing demographics for a minute or two. Extraordinary low interest rates around the world have delivered a monumental blow to many investors. Falling interest rates have translated into rising liabilities for (defined benefit) pension plans and, secondly, millions of retirees, who depend on income from savings to take them through retirement, are struggling to make a decent living.
Consequently, investors take risks that they weren’t previously prepared to take, some of which I am comfortable with, and some of which I am not. Take US corporate high yield bonds. The prevailing view seems to be that US corporates (ex. energy) are in very good shape with loads of cash on their balance sheet, and that they therefore offer a relatively attractive, and a comparatively safe, investment opportunity.
I beg to disagree. Firstly, we are late in the economic cycle, and it is usually a bad idea to buy corporate high yield bonds late in an economic upturn. Secondly, let