The Absolute Return Letter May
“It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait.”
Charlie Munger
The Lollapalooza effect
The answer is the Lollapalooza effect. The question you may recall from last month’s Absolute Return Letter – what’s the opposite of a perfect storm, or put another way, what do you call it when an unusual combination of constructive factors creates an outcome that is extraordinarily positive? A reader was kind enough to provide the answer, which was coined by Charlie Munger years ago. As a non-American, the answer was at first complete gobbledygook to me, but a quick Google search convinced me that the answer is absolutely legitimate. Thank you.
With that sorted out, let’s turn to this month’s subject. Last month I promised to provide some thoughts as to which investment strategies would be the most appropriate in the sort of return environment we expect over the next several years, and which ones should be avoided. Before you blow me out of the water, I do recognize that this month’s letter is full of generalizations. For example, when I argue that equity long/short is not a terribly exciting strategy for the foreseeable future, I do realize that some equity long/short managers will deliver outstanding results. No doubt about it. All I am saying is that I expect the strategy, on average, to disappoint (more about this later).
Our expectations for economic growth and interest rates
Before I go any further, it is probably worthwhile summarizing our views, but do not expect too many details. For all the reasons why, please go back to the last handful of Absolute Return Letters which you can find here.
GDP growth is likely to be below historical averages for at least the next 5-10 years and possibly for longer. The most indebted countries, and those with the worst demographics, are likely to face the lowest growth trajectory, which essentially means that, for many years to come, Europe should grow at a lower rate than the United States. That doesn’t mean, though, that economic growth won’t disappoint in the U.S., either.
Inflation is not likely to pick up significantly any time soon, although I do expect it to come back to life in the U.S. more quickly than what will realistically happen across continental Europe. The U.K. is likely to fall in between the other two, but virtually no inflation in its own backyard (which also happens to be its largest trading partner) should keep U.K. inflation at modest levels.
As a result I don’t expect interest rates to make a dramatic move upwards for many years to come. However, lessons from Japan have taught me that, even if rates stay comparatively low, they can easily move 0.5-1.0% over a relatively short period of time, and a 1% move in the wrong direction can do a lot of damage to the P&L if it happens at the longer end of the curve (chart 1).
Chart 1: % decline in bond value if interest rates rise by 1%
Source: J.P. Morgan Asset Management. Data as of December 2013.
Or, as one commentator put it in 1994 as investors all over the world suffered massive losses as a result of falling bond prices:
“The precipitous fall has little to do with inflation – and everything to do with the sudden bursting of a huge speculative bubble in the global fixed-income markets.”1
You may actually wonder who on earth is buying bonds at current levels? With 10-year yields now negative in Switzerland, and 5-year yields negative in several European countries, who in their right mind would buy a bond when you are guaranteed to lose money, assuming you hold it to maturity?
The most likely answer is that investors do not plan to hold these bonds to maturity. They are jumping on a gravy train that has been spectacularly successful over the past few years (chart 2). It is obviously a risky trade, as it is not inconceivable that there will be a stampede by the exit door when the first smoke can be smelled.
Chart 2: Cumulative flows into mutual funds and ETFs
Source: J.P. Morgan Asset Management, Investment Company Institute
As one investor succinctly put it:
“When the door closes, they won’t all fit through the cat flap.”
That is, in my book, a far bigger risk to the bond market than the Fed or other central banks suddenly overwhelming the bond markets with sell orders.
Our expectations for equities
In last month’s Absolute Return Letter I discussed our longer-term expectations for equity returns, and it shouldn’t be necessary to repeat myself, so the following will be short and sweet. Suffice to say, we don’t expect equity returns over the next 10 years to be nearly as spectacular as they have been for the past 35 years since the equity bull woke again in 1981 after a 15-year slumber.
That does not imply that we expect equity returns to be negative though. Extraordinarily low interest rates will continue to drive many investors into equities and ensure that they do better than they strictly speaking should, given the overall growth in the economy and corporate profits. Over the next 10 years, we expect equities to deliver mid-single digit annualized returns.
That should be enough for equities to outperform bonds where our annualized return expectations over the next decade are in the range of -5% to +5%, subject to duration and credit risk.
One of the many implications of this is that the 60/40 model, which has proven immensely popular for the last many years (and for good reasons if you look at past returns in chart 3), is on the way out – at least temporarily. Investors will increasingly look in other directions to achieve the returns they desire (and need).
Chart 3: Annualized returns over the last 100 years (U.S. only)
Source: Research Affiliates, Bloomberg, Robert Shiller
A word or two on LDI
Before I go any further, I need to make an important distinction. Institutions with fixed liabilities (such as many pension funds and life insurers) don’t think of their portfolio as one but two portfolios.
The portfolio matching their future liabilities is called the liability driven investment (LDI) portfolio, whereas the other one is simply called the return portfolio. The reason this is important in the context of this month’s Absolute Return Letter is that, going forward, everything I say will relate only to the return portfolio. The LDI portfolio is structured to address each investor’s specific liabilities and is usually full of cash, swaps and bonds, and I cannot possibly add any value as to how it is best constructed, as everyone’s needs will differ.
The return portfolio is different. This is an area where everyone has the same basic objective – the highest possible return for the amount of risk that one is prepared to take. The rest of this letter should be read as my thoughts on how to construct the return portfolio in a low return environment. A couple of caveats: U.K. law prohibits me from being too specific. Call or email us if you want to take this discussion to the next level. Secondly, if you are a private investor, unfortunately some (but not all) of the following is prohibited land for you. Again, call us if you need clarification.
How David Swensen has changed the style of investing
Approximately 30 years ago, when I moved to London, U.K. pension plans typically pursued a rather simple investment strategy. Only equities and bonds were considered worthy of a place in the portfolio, and investments were almost entirely domestic. Without having detailed information on other countries, I would be quite surprised if it was much different anywhere else.
Then David Swensen entered the frame. He was recruited by the Yale Endowment in 1985 and gradually established a brand new investment style, based on more diversification and an entry into alternative investments. Yale’s spectacular returns over the following years made people all over the world sit up and listen.
Yale’s results have been widely attributed to its large allocation to alternative investments, and the model has been extensively copied. But, as Forbes observed in a now classic article from 2012 (see here), reading about the Yale model alone doesn’t make you a better investor, just like reading about Tiger Woods doesn’t turn you into a world-class golfer.
As a consequence of disappointing returns among many (but not all) institutional investors, the trend has begun to reverse again, and today many institutional investment managers focus more on themes like active vs. passive, smart beta and illiquid alpha than they do on actual investment strategies.
And now to the Holy Grail
I rarely make promises. A long life in investments has taught me the validity of not doing so and, apart from that, in the financial industry we are not supposed to do it in the first place. Having said that, I can (almost) promise you one thing. Equity returns over the next decade or two will, on average, be much lower than the returns we have enjoyed in the great equity bull market of the last 35 years.
Full letter below
