Faux-Sophistication

By Matt Malick and Ben Atwater



“That’s been one of my mantras - focus and simplicity. Simple can be harder than complex:  You have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.” - Steve Jobs, 1998 Business Week Interview

We have written extensively over the last five years about the effectiveness of a simple, understandable, transparent and low-cost investment philosophy.  The way we invest, which we outlined for the first time in September 2008, stems from the discomfort we experienced while watching our industry slip into darkness.  Luckily, our timing could not have been better.

For the five years ending September 30, 2013, the most basic index of American stocks, the Standard and Poor’s 500, doubled the annualized performance of the Hedge Fund Research Incorporated Fund Weighted Composite Index - 10.02% versus 5.01%.  This means that a passive basket of U.S. stocks dramatically outperformed the sophisticated, “go anywhere” strategies that the most brilliant practitioners on Wall Street conceived.

Lately we have fielded several inquiries about alternative investment strategies as a way to manage risk.  It seems to us that despite all the evidence to the contrary, investors are still searching for something that doesn’t exist – a formula to sidestep market losses while also getting a better return than bonds currently offer.

And this impossible quest is not limited to individual investors. The New York Times recently reported that “so-called alternative investments now account for almost one-quarter of the roughly $2.6 trillion in public pension assets under management nationwide, up from 10 percent in 2006, according to Cliffwater, an adviser to institutional investors.”

The Rhode Island pension plan, for example, has increased its investments in alternatives from zero to almost $2 billion, or 25% of its assets, in the last two years.  The result has been poor performance and outrageous fees.  Their investment expenses for the year ended June 30^th were $70 million versus a prior estimate of $11.5 million, primary due to alternative investments that charge up to 2.5% annually of assets under management plus another 20% of profits.

In reference to individual stock investing, the legendary Fidelity Magellan Fund manager, Peter Lynch, said, “The simpler it is, the better I like it.”  We think this sentiment applies to investing in general.  You can observe a great example of this in 2008, a terrible year for the stock market, and the ensuing market recovery in 2009.

In 2008, the S&P 500 fell a whopping 37%.  But, interestingly, the Barclays U.S. Aggregate Bond Index actually rose 5.24% that year.  So, if you had a 50% stock and 50% bond portfolio, you would have lost 15.88%.  Not good, but far from devastating.

Then in 2009, the S&P 500 rose 26.46% and the Barclays U.S. Aggregate Bond Index rose 5.93%.  The same 50 / 50 portfolio would have gained 16.20%.  If the portfolio was rebalanced annually, then less than a year removed from the financial crisis and Great Recession, an investor in a plain vanilla balanced portfolio would have almost fully recouped all losses.

Lastly, in 2010, the same 50 / 50 portfolio would have generated 10.8% returns, putting the portfolio back in the black and well-positioned for robust returns in the years since.  (Even without annual rebalancing, a 50 / 50 portfolio would have produced positive three-year returns from 2008 through 2010.)

As evidenced above, risk mitigation techniques do not need to be fancy, overly complex or expensive.  Frankly, in our experience, the more esoteric these schemes, the less effective they are.  Make no mistake, finding the proper allocation to high-quality bonds to complement your stock exposure is the best risk management strategy – it is straightforward, transparent and low-cost.

The chart below shows that even during a protracted bear market for bonds (1941-1981) - a time when interest rates rose and bonds prices fell – they still proved an excellent risk manager.  The standard deviation (a statistical measure of variation around the mean) for a 50% stock / 50% bond portfolio was half that of an all-stock portfolio, or half the risk.
 
 
 

Ignoring the advice of Leonardo de Vinci that “Simplicity is the ultimate sophistication,” many risk-averse investors will buy anything, as long as it sounds sophisticated, regardless of whether they understand it.  Or maybe the fact that they don’t understand it gives a certain level of comfort – if it’s that complicated, it must be good!

The old economic axiom, “There’s no such thing as a free lunch,” provides a cautionary message to people looking to manage risk via magic trick.  Investors are naïve to believe strategies actually exist that can consistently shuffle money from one asset class to another with precision, or predict which stocks will spike over the short-term even when the market declines, or that can use options to truly protect against the downside without considerable cost, etc.

The martial artist and movie star Bruce Lee believed that, “It is not a daily increase, but a daily decrease.  Hack away at the inessentials.”  From an investment standpoint, be honest with yourself about what you are trying to accomplish.  Don’t subscribe to the myth that a black box exists that will protect you from high stock prices and low bond yields.  Instead, avoid the temptation to purchase investments that are supposedly sophisticated enough to outperform the tried and true.

A final thought from Peter Lynch: “All the math you need in the stock market you get in the fourth grade.”  This may sound unreasonable, but it’s surely true.  A real investment discipline will outperform all of the gimmicks.

UPDATE: Washington Woes

  by Matt Malick and Ben Atwater

“Politics is the art of looking for trouble, finding it whether it exists or not, diagnosing it incorrectly, and applying the wrong remedy.” - Ernest Benn
 
“Politicians are like diapers.  They both need changing regularly and for the same reason.” - Unknown

The continuing government shutdown and the impasse over the debt ceiling make this a stressful time for investors.  Particularly frustrating, as investment managers, is the impossibility of handicapping political martyrdom.

That said, our most likely scenario is that moderate Republicans will persuade Speaker Boehner to bring a “temporary” debt ceiling vote to the House floor.  Many believe that a majority exists in the House to pass such a measure today.  This legislation would likely be a stopgap measure to include a side agreement for future talks.  Over the last few days, Speaker Boehner’s camp seems to have delinked Obamacare from the debt ceiling debate, recognizing it is a political loser.  So future negotiations will probably be linked to entitlement reform and other spending reductions.

However, we believe that investors have been too sanguine about a resolution to this political drama.  There is no reason to think that President Obama and Speaker Boehner won’t go to the 11^th hour.  We would not be surprised to see heightened market volatility next week.

From its September 18, 2013 closing high of 1725.52, the Standard and Poor’s 500 Index fell just 4.2% as of Wednesday’s close, before rallying aggressively Thursday and Friday.  From a contrarian perspective, we would frankly prefer to see the market a little more panicked at this point . . . In a way, the equity market seems to be giving Washington the benefit of the doubt.  Perhaps investors concur with Winston Churchill, who once said, “Americans can always be counted on to do the right thing . . . after they have exhausted all other possibilities.”

Maybe investors are also remembering that we have seen this movie before.  In July of 2011, Obama and Boehner brought us to the brink of default over failed debt ceiling negotiations, resulting in a drop of 20% in the S&P 500 and also in Standard & Poor’s downgrade of U.S. sovereign debt from AAA to AA.  When the smoke cleared, markets recovered quickly.

Another possible factor behind the market’s complacency is that the consequences of default are so unthinkable that it is difficult to contemplate such self-destruction by our leaders.  But investors may be a little too comfortable with this consensus view.  Politics has become a narcissistic profession and stubborn pride could lead to great harm.

That said, despite dangerous ideology and extreme arrogance, we are cautiously optimistic that sense will prevail over mutually assured destruction.

At the height of the last debt ceiling crisis on July 26, 2011, we wrote to you that:

“Our highest probability scenario is that the government will act “in time” to raise the debt limit (a peculiar necessity considering Congress made the expenditure and revenue decisions which created the structural debt to begin with).” 

The atmosphere in Washington seems even more poisonous now that it was then.  However, given the backdrop of a financial crisis, a completely dysfunctional government and a sluggish economy, some amount of good news over the next few years should fuel additional interest in capital markets.  But, such frequent self-induced crises are enough to dampen our enthusiasm.

That said, frustration aside, we see an ultimate resolution to the crisis du jour.  Now is not the time to make rash investment decisions.  Nothing fundamental has yet changed and as a result we still believe that patience will reward investors who stick to their discipline (as has always been the case).