By Cliff Stanton and Jeremy Frank
Performance Reporting’s Frankenstein
Through mid-September the classic 60/40 portfolio has produced a return of 5.5%, with the S&P 500 Index up 5.7% and the Barclays Aggregate Bond Index advancing by 5.2%. The holders of the roughly $12-$14 trillion in negative yielding government bonds are starting to get worried, and equity markets are playing chicken with the Fed, rewarding the certainty of support (read, “rallying on bad economic data”) and punishing the uncertainty of progress (read, “falling on good economic data”). Advisors who we’ve been speaking to have noted that this is one of the most difficult times in their careers, as keeping up with the Dow Joneses is increasingly uncomfortable; but defending risk mitigating and truly diversifying strategies has become a thankless task each quarter when they sit down with Mr. & Mrs. Smith.
In this regard, we think our industry has created its own problem. Having worked with hundreds of financial advisors over our collective careers, we’ve observed that the way in which quarterly performance reports are constructed often times ensures an unproductive conversation that puts advisors on the defensive. These quarterly conversations should be focused entirely on the clients’ goals and the objective progress toward achieving those goals. But instead, most reports that we’ve seen contain elaborate analyses of each fund, ETF or separate account manager in isolation. In addition, frequently there is some sort of report card that provides a summary of which managers are outperforming or underperforming on various measures, and the conversation then turns to what led to Manager A’s outperformance and Manager B’s underperformance over the last 3 months, a time frame that has absolutely no explanatory power whatsoever about the efficacy of a manager’s approach.
The result of this granular focus is unnecessary turnover. We are all biased to act, and so managers with too many red boxes are fired, likely at a point when the strategy is simply out of favor rather than being “broken,” and new funds or ETFs are purchased, which invariably have done well recently; performance that new clients in the funds will not experience.
But if the client’s goals in terms of wealth accumulation or preservation are being met, and the total portfolio’s risk metrics are in line with stated preferences, then the total portfolio is doing exactly what it was built to do. There will always be a component of any portfolio that is underperforming, but that doesn’t necessarily mean it should be replaced.
A good portfolio is constructed in the same manner in which a good chef prepares a meal. The components are selected not for their individual merits alone, but for how they complement each other in order to achieve something truly rewarding. So the pertinent question is, what meal will sate the client’s hunger? If you’re serving what the client ordered, then you’re doing your job; let them know that, and avoid debating the virtues of raw cauliflower.
While global markets were essentially flat, alternative mutual funds produced mixed results. Long/short credit had the strongest month, earning just over 1%. This put the category—which has struggled in a world of ever-declining rates—at the head of the pack on a year-to-date basis, with a solid return of 3.44%. On the other end of the spectrum, managed futures funds hit a headwind, losing 1.86%. However, on a longer term basis, managed futures funds have substantially outperformed the other major alternative categories, earning 4.29% annually over the last three years.
In what is becoming a familiar pattern, managed futures led alternative categories in net inflows, bringing in nearly $1 billion. And, once again, the flows were quite concentrated, with half of the $1 billion going to the largest fund in the category. On the other end of the spectrum, multialternative funds continued to bleed assets, losing $1.2 billion during the month, and $2.7 billion thus far in 2016. Long/short equity has also had a rough go, shedding $500 million during the month and nearly $5 billion for the year. The biggest news for the category was that the former dominant fund in the space, which peaked at over $21 billion of AUM in 2014, fell under the $1-billion-dollar mark during the month, which generally isn’t a good outcome for anyone hoping to see wider adoption of risk-mitigating strategies.
Morningstar Slams Fund for Hidden Fees
Morningstar analyst Jason Kephart recently criticized some alternative mutual funds for using a well-known loophole for getting around most limitations imposed by ’40 Act mutual funds. Many of the earliest managed futures funds took advantage of this loophole to invest directly in CTAs when managed futures mutual funds were first being introduced. The mechanism for getting around fee disclosure and risk limits is to invest in the underlying hedge fund via a total return swap, which will, for a fixed payment, allow the purchaser to receive the total return of an underlying reference index or other investment. By using a swap, a fund can move the underlying costs to a footnote and not have to disclose it in the fund’s published expense ratio. This leaves investors with very little insight into the true cost of their investment.
In reality, there is very little difference from this fee structure and what is paid when an institutional investor invests in a hedge fund-of-funds. The problem is that one of the expected benefits of investing in mutual funds is increased transparency, especially when it comes to fees paid by investors. We are somewhat surprised that this isn’t something that industry watchdogs or regulators haven’t put an end to long ago.
Hedge Fund Woes Continue…
As we mentioned last month, many of the world’s largest and best known hedge funds have been bleeding assets. It appears this trend continues to be widespread, as Bloomberg recently reported on many more industry-leading funds that are struggling with performance. Perry Capital, a hedge fund founded 28 years ago, has seen its assets fall to $4 billion from $10 billion one year ago. This as its main fund fell 18% from the end of 2013 through July. Paulson and Och-Ziff have also seen assets fall this year as their performance has disappointed investors, and Och-Ziff has faced legal issues. As an industry, July showed the largest outflows of 2016, with hedge funds seeing $25 billion in redemptions.
But all is not lost. Some institutions are rethinking portfolios in the current environment and are shifting into risk management mode, as demonstrated by CalSTRS announcement that they will allocate up to $8.7 billion to hedge funds in the next few years as part of a risk mitigation strategy. We suspect they’ll be getting a few calls from lonely hedge fund managers.
Interest Rate Risk
The current interest rate environment has been a source of much confusion and discussion recently. When building portfolios, we’ve always used the “yield” equals “expected return” formula. So, how do we deal with yield equaling negative returns? I’m currently sitting for Part II of the FRM (Financial Risk Manager) exam, and based on the study material, I won’t be the only “risk manager” out there confused by our current environment. I’m paraphrasing, but the study material essentially says that interest rate models need to make an effort to minimize/avoid the modeling of negative rates, since negative short-term rates do not make much economic sense. After all, who would lend at a negative rate?
So what’s an investor/risk manager to do if we find ourselves in a spot which conventional wisdom has taught us shouldn’t exist? The truth is, I don’t know. The 30-year Treasury Bond is yielding 2.44% as I write this. So a purchaser of this bond is guaranteeing (assuming the U.S. doesn’t default) a 2.44% nominal return over 30 years, but with equity like volatility. Moving to the Euro Zone things look even crazier; the Barclays Euro Government 1-3 Year Index is yielding -0.08% while the 5-year index is yielding -0.17%.
While negative rates were assumed to be an impossibility, clearly the assumption was wrong. And while interest forecasting models will need to be adjusted, the basic math of bonds has not changed. If interest rates rise, bond prices fall; if interest rates fall, bonds prices rise. This is an immutable fact. Leaving the possibility of default out, the question an investor has is two-fold. First, do they plan on holding the bond to maturity? If so, their rate of return is known to the them ahead of time; it’s the current, possibly negative, yield. However, if an investor doesn’t plan on holding the bond to maturity, interest rate volatility will create volatility in the bond price, thereby subjecting the investor to potential loss, as well as gain.
As mentioned above, there is currently $12-$14 trillion in negative yielding government bonds in the market. We’ve had many a discussion around the trade desk trying to understand an investors incentive in purchasing these government bonds. We would hazard a guess that most of these investors are unlikely to fall into the first group mentioned above, they do not plan on holding a bond to maturity that they know will lose money. Instead, one would speculate that they are hoping that yields will fall further and give a boost to the bond price. And since this is what yields have done for the last few years, what can go wrong? Well, to put it bluntly, a lot. I’ll use an extreme example, the Swiss sovereign yield curve., without doing deeper analysis, could lead to ill-informed conclusions.
On July 5th, 2016 the entire Swiss yield curve was negative, out to 50 years. The specific bond making up the last point on the curve has a duration of about 36 years, meaning that for every 1% move in yield, the bond will move inversely about 36%! It would seem the risk in this bond is asymmetric. The probability that yields stay negative over the next 50 years is pretty much 0% (although to be fair, I would have said the same about the above yield curve, so maybe I’m not the best judge). However, if things move to a more “normal” state, the probability of a significant loss is guaranteed. While not all government bond markets are as extreme as the Swiss, there certainly appears to be asymmetric risk profiles across most major markets. Investors are purchasing medium to longer term bonds with low to negative yields in return for equity like volatility, presumably on the hope that they will be able offload the bonds at even lower yields. Is this the legal greater fool theory at work? If so, sovereign debt may be among the greatest bubbles of our lifetime.
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