White Knuckling It

By Cliff Stanton and Jeremy Frank

June 2016

A recent headline in Fundfire proclaimed “Institutions Build Up Risk to Meet Targets in Tough Market.” The story cites a WSJ article that says, “Institutional investors are assuming ever-increasing risks as they struggle to meet return targets, which have stayed high despite low interest rates and shallow growth.” The return targets being referenced are the 7.5% +/- return assumptions used by the majority of pension plans at present, and the author points out that such expectations are high, given current economic and market fundamentals. But at the same time, these expectations have come down considerably in recent years and are quite low by historic standards. In any event, what we know is that at such a moment, the answer cannot be to simply increase risk and hope for the best.

We saw the same thing play out amongst retail investors, who, tired of earning paltry returns on their bond portfolios, piled into high yielding MLPs not long ago, and proceeded to lose about 33% in 2015, wiping out many years of income in the process. Sometimes a low return is all that can be had without jeopardizing the very corpus of a portfolio that will be needed to generate better returns when the opportunity set improves.

Being a successful investor means being patient for (often times) excruciatingly long periods when there isn’t a clear payoff to risk taking. Of course if we’re honest about it, there never really is a truly comfortable time to invest; one only has to search the news archives of any given year to identify a seemingly endless stream of negative headlines that could rightfully give investors pause. But while investing is a risky endeavor (and if it weren’t you wouldn’t get paid), there are definitely better times and worse times to put capital to work, based on the starting point in terms of valuations and fundamentals. In our opinion, this is not one of those times to exceed one’s risk budget. Institutions at least have the luxury of investing into perpetuity; to some extent time can heal the wounds of an overly aggressive investment stance. But for individual investors, crossing the median can kill.

Scare tactics from an “alternatives manager?” Self-serving ≠ wrong. Risking up because you’re unable to hit your goals at present is no way to invest. While trends in the institutional space often make their way into the retail arena, we hope this isn’t one of those times. Stick to your risk budget. Stay diversified. Embrace differentiated sources of return. Or if nothing else, and you’re wary of the promises of alternatives managers (and skepticism is an important trait of successful investors), carry a healthy cash balance. We say this not because the world is going to end, but for a far simpler reason, we are in a low-return environment, and you’ve got to accept that.

The Data

Equity market returns were mixed during May, as the S&P 500 Index gained 1.8% while the MSCI EAFE Index lost 0.8% in dollar terms. Long/short equity posted the best returns amongst the alternative categories at 0.6%, bringing the category’s year to date return to just under 0.8%. For the second month in a row, managed futures was the worst performing category, losing 1.1%. Over the last 12 months it has also been the worst category, shedding nearly 6% as the mostly trend following crowd has had difficulty riding sustainable trends.

Equity market neutral has been the best performing category over the last 12 months, albeit with a -0.6% return, reflecting the difficulty of the environment in which we find ourselves. Similarly, over the medium term (i.e., 3 years) all of the major alternative strategies have struggled to produce meaningfully positive returns, but then again, these are the category averages and manager dispersion has been high; there have been managers in each category that have been able to navigate the challenging market environment created in part by the artificial support from central banks around the world.

Flows have slowed substantially across categories. With the exception of managed futures, all categories saw outflows during May. Even within managed futures, the vast majority of flows went to the largest manager in the category, with many others experiencing outflows. There has certainly been a change in momentum for alternative mutual funds over the last few months, as investors appear to be disappointed with recent performance, leading them to withdraw funds. If there is any solace for funds experiencing outflows, it’s that investors’ capitulation may just be a positive sign for future performance.

Alternatives in the News

In Case You Missed It – The 361 Capital Blog
Some recent posts that you might have missed:

  • Grating Expectations Verified
    Meb Faber recently referenced this BNY Mellon publication regarding institutional investment in alternative assets. It certainly verified institutional investors may in fact be delusional (Meb put it a bit more colorfully) when it comes to return expectations… Read More>
  • Volatility Simply Cannot Be Ignored
    Why do we continuously preach the virtues of lowering portfolio volatility? Well, aside from the fact that our funds are made to do just that, consider this from the Mutual Fund Observer…Read More>
  • Rise of the Machines Not Killing Off the Quants
    The hottest headlines in technology, whether it be autonomous driving, government surveillance, targeted ads on Facebook or quantitative investment strategies have been surrounding the ubiquitous idea of “machine learning” and “big data” … Read More>

Millennials and Investing

I avoided the “Millennial” label by a couple of years, and to be honest, I am glad of it. After all, has a generation ever been painted with such a broad brush? Certainly they aren’t as homogenous a group as is often portrayed in the media, but when it comes to investing they do exhibit a distinctly different profile from their elders. AMG recently put out a survey tracking the investing habits of millennials, entitled “Millennial Mentality.” Some key takeaways:

    • 73% of millennials agreed that a diversified portfolio should include alternatives (only 30% of older respondents agreed).
    • More than half of all millennials recognized that a portfolio with alternatives will perform better than a traditional one (an aside, is this a foregone conclusion?) Less than 35% of other investors agreed.
    • About half of millennials felt they were very/extremely knowledgeable about alternative investing compared to 3% of their elders.

The last bullet point was somewhat shocking to say the least. While we welcome such an outcome, we remain skeptical.

Black Swan?

I think Josh Brown captured our thoughts exactly…

I am delighted by the idea of a “black swan” event that has an actual date attached—and that everyone is talking about for months-and-months on end. And against which the pros are proactively “buying protection” against a few weeks before, as though they possess some sort of magical foresight that a billion market participants must have missed.

Hedge Fund Fee Structure Consumes 80% of Alpha

Some interesting points are made at allaboutalpha regarding the distortion of incentives as hedge funds have grown to institutional size and become much less reliant on performance fees. Worth some thought…


Drawdowns Happen

Once again the Attain Alternatives blog has a cogent discussion of an always-relevant topic, drawdowns. From their post:

“You see, drawdowns are messy. They feel impossible, and that they will never end. They feel like it’s the first time such an investment has gone through such a losing stretch.” They are speaking about managed future’s current drawdown in particular but the same could be said for any investment strategy (see value managers rough time). AQR founder Cliff Asness also spoke about the stress of underperformance in an interview for the book Efficiently Inefficient:

Suppose you look at a cumulative return of a strategy with a Sharpe ratio of 0.7 and see a three-year period with poor performance. It does not faze you one drop. You go: “Oh, look, that happened in 1973, but it came back by 1976, and that’s what a 0.7 Sharpe ratio does.” But living through those periods takes-subjectively, and in wear and tear on your internal organs-many times the actual time it really lasts. If you have a three-year period where something doesn’t work, it ages you a decade. You face an immense pressure to change your models, you have bosses or clients who lose faith, and I cannot explain the amount of discipline you need. (Emphasis added)

Drawdowns are certainly messy and generate more than a few gray hairs along the way. Not only that, they often lead to bad decisions by both money managers and investors. The best (and perhaps only) way to get through them is to do solid work ahead of time. Know what anomaly your strategy is exploiting, why it will persist, and that times of underperformance are bound to happen and eventually will revert. Additionally, educating clients ahead of time should give them the ability to stick with a plan even when times are rough. Pain will no doubt still be felt, but all involved will be less likely to make poor decisions under times of performance duress.

And Lastly

A Full Moon, Summer Solstice and Aspen Colorado…not a bad start to summer. Enjoy your time off.

Photo Credit: Lorie Shaull

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