Grey Owl’s letter to clients on the increasing prevalence of indexing.
“Two roads diverged in a wood, and I— I took the one less traveled by, And that has made all the difference.” – Robert Frost, “The Road Not Taken”
The increasing prevalence of indexing, combined with the Federal Reserve’s quantitative easing and a general tendency for market symmetry during bull markets has led to tight correlation among most security categories over the past several years. This is changing. Market capitalization, sector, and single stock divergences that became pronounced during the second quarter of 2014 increased further during the third quarter. October was even more dramatic. Historically, expanding deviations among stock categorizations have coincided with the end of a bull market. This is not a forecast, just a statement about the current environment.
In this quarter’s letter we emphasize our primary objective to protect and grow investor capital in an absolute sense. We continue to offer index benchmarks for comparison, but emphasize that they do not play an a priori role in how we structure investor portfolios.
Here is the performance table for the Grey Owl Opportunity Strategy as of September 30, 2014:
Grey Owl: Investment Objectives and Benchmarks
Every quarter in this letter, we compare the after-fee performance of the Grey Owl Opportunity Strategy with the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) and the iShares MSCI ACWI Index Fund (NASDAQ:ACWI). Over an almost eight-year period beginning in October of 2006, the Grey Owl strategy has bested the MSCI All-Country World Index by a good margin. It lags slightly the S&P 500.
Comparing the raw return numbers of the Grey Owl Opportunity Strategy with these indices certainly has value. An investor who wants equity exposure to the largest U.S. companies could easily buy SPY and be done. Likewise, an investor looking to expand her equity exposure to include the broader universe of equities outside of the U.S. (in addition to U.S. equities) could purchase ACWI.
Yet, tracking these indices, over even multi-year periods, is not our primary objective. What we aim to provide is an investment approach that protects capital from permanent loss, retains purchasing power, and smoothly grows that capital over time. With those objectives in mind, total return is but one analysis criteria.
Grey Owl: Protect From Permanent Loss
At first blush, protecting against permanent loss seems like a low hurdle. Sure, putting all of one’s money in a single security could lead to permanent loss. It even seems possible if one were to put all of his money into a speculative sector using an index – say, biotechnology or cloud computing. But is it really possible with a diversified portfolio in the form of a broad index?
Over a really long time, it is unlikely one would suffer a permanent loss of capital holding an equity index fund. However, from a practical standpoint, it is very possible. First, a “really long time” is a REALLY long time. This is more than withstanding a one or two year drawdown. Second, many investors require withdrawals, so while not “risk” in the purest Warren Buffett-sense, volatility and drawdowns do present risks to most investors.
Imagine an investor who retired in August of 2000, right as the stock market peaked. Further imagine that this investor rolled over his corporate pension plan and decided to invest all of it in the S&P 500. He would have shown a negative return for over six years, including dividends, from August 2000 until September 2006. There would have been a short period of time between October 2006 and May of 2008 (less than a two year window) when his return would have been slightly positive – only 2.3% annualized at its peak in October of 2007! Then in May of 2008, the full period return went negative again until October 2011. If that hypothetical investor had almost any withdrawal requirement whatsoever, he would have suffered a permanent loss of capital. Even without a withdrawal requirement, that investor is only up 3.9% annualized today… after 14 years.
See full PDF here.