Good and bad answers to the biggest portfolio puzzle

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The big question that every investor must be wrestling with right now as we go into 2021 is the prospect for future returns. Do we need to take more risk to earn decent returns in a world of zero interest rates?

This could be biggest investing puzzle of our time (a question Josh Brown posed on a recent podcast which is a worthwhile listen on this topic).

Do we need to take more risk to earn decent returns?

The answer’s yes. That’s it. That’s the blog.

For the simplest example look at UK government bonds. 10 years ago you’d get 4% p.a. returns investing in gilts, the safest asset going for a UK investor (in the US you could get returns of 3% p.a. in government bonds as recently as 2018). Today, you won’t get much more than that from equities. That’s a huge shift up the risk spectrum for return levels that only just grow your assets in real terms after fees. I believe this shift is yet to be fully internalised within the industry.

That isn’t quite the end of the story. The thing is, a lot of people in investing and finance go out of their way to dodge this issue. There is a heavy behavioral bias against telling your clients that you don’t have a magic solution to the problem (who knew?) so all manner of answers get peddled or at least exaggerated in their effectiveness. This contributes to the failure to properly internalise the shift.

There are good, bad, and helpful-but-overstated answers to this problem – let’s take a look at some of them.

The bad

Be more active. To me this is among the more egregious of the bad answers. Usually couched in terms of intelligent-but-vague words such as be “opportunistic”, “rotational” and “selective”. Active management in equities has had a bad decade and there isn’t a lot of evidence that it can help. Active asset allocation have done worse. This isn’t another hit-piece knocking active management though (goodness knows the world has enough of those already), if you like a bit of active that’s fine, nothing wrong with that. Just don’t depend on active management any more than you already are.

Double down on the cheapest sectors and countries (that appear to offer higher returns). This is a difficult one as it can be so seductive. One of the downsides of an iron focus on a target level of return is that as return expectations fall, it pushes you deeper and deeper into areas that appear to offer slightly higher returns. This can cause a number of problems. Those sectors and countries are often cheap for a reason. There’s always another side to the coin and often it is because a sector is full of the companies most likely to be obsolete, the dividends most likely to be cut and the bonds most likely to default. Sure the market can go too far on these points but be aware that’s the bet you are making: that the market has been too pessimistic, not that you can get “free” extra returns in these areas.

Worse, if you go too far down this road your portfolio ends up heavily dependent on a particular vision of the future playing out. And if that doesn’t play out you are doomed to rail and rage against the Fed, against inflation, against interest rates and whatever seems to be getting in the way of your singular vision materialising. Plenty of investors who have gone down this road end up backed into a corner and frustrated. Don’t do it. For me it violates two of my fundamental principles of investing: accepting reality as it is (not as you’d like it to be), and aligning your portfolio to as wide a variety of possible future as possible. The world is surprising.

Forget growth and just hunker down. the last of the “bad” solutions in my view. Some advocate just trying to protect capital and not get drawn down the risk spectrum to achieve returns. Two issues with this.

  1. Inflation. you really can’t preserve your real value of assets without taking a decent amount of growth risk, so any hunkering down approach comes with the reality that your assets will get eroded by inflation. That’s the price you’re paying.
  2. Reality. Equities do tend to go up. That’s the evidence of hundreds of years of returns. They do so in a very wide variety of circumstances: high rates, low rates, inflation, low inflation, Republican and Democratic presidents. In surprising and unsurprising ways. From high P/E ratio starting points and low ones. On Tuesdays, Wednesdays and months ending in “ber”. Your base case should be to be invested in markets.

The helpful but overstated

There’s a quartet of reasons here that seem good on the face of it – and actually do have merit. If you aren’t doing any of them at the moment then taken together they can make a difference to your portfolio, and they should be looked into as your first port of call. But my peeve is that they are frequently overstated, and used as a way of dodging the core tough questions about risk.

Get more alternative. Here’s a magic new asset class that solves all your issues. Another compelling story but not one that has stood up in the real world. Many alternative strategies emerged out of the wreckage of the 2008 crash, as allocators freaked out about equity risk. But few have enjoyed a good decade since then. It is worth remembering there are really only two ways to earn returns: own equity or lend. These come in a range of flavours but most everything is correlated when it really matters, it’s a fallacy to think there are loads of great untapped asset classes out there that zig when everything else zags.

Diversification. This one definitely belongs in the less-bad camp as there is of course some truth to it. You want diversification in your portfolio, and if you aren’t making the most of it you should do the work to make sure you are. However this is all-to-often offered up as a cop-out answer or a silver bullet when people don’t want to tell their clients they should accept more risk or reduce their expectations. The limits of diversification are achieved fairly easily: a global portfolio, diversified across sectors and countries of perhaps 50+ stocks. High-yield bonds, some real assets and bonds if they fit your objectives. Beyond that diversification isn’t going to work magic for you, and it might even work to pull down your returns.

Get more illiquid. This is another of the less-bad answers as there is some truth to it. There are good returns to be had in illiquid asset classes but I routinely see the benefits exaggerated. One of my biggest peeves is the casual assertion that because an asset is illiquid it auomatically “allows you to harvest the illiquidity premium”. The illiquidity premium is notoriously elusive and needs to be justified every time on a deal by deal basis. There are huge global pools of capital chasing all assets these days which turns the supply/demand dynamics on their head in many assets – including illiquid ones. Most deals will get picked over by many different asset owners, driving down returns as only the most aggressive bids win. Many illiquid assets carry little or no premium and after fees could be substantially worse propositions than basic liquid assets.

Portfolio protection. A good idea on the face of it but tends to work better in theory than in practice. Genuine portfolio protection by insuring using options is a very expensive way to manage your risks – if it was a super cheap way to reduce risk then simply everyone would do it. Protection strategies often compare unfavourably to simply holding less equities. It is no silver bullet. Also be wary of indirect hedges that are put forward to try and cheapen the cost of insurance, they often work in backtests, not so much in practice.

The good

Lower fees. the least exciting, least sexy and most likely to invite hemming and hawing from industry people about net-of-fees returns. This one isn’t popular among asset managers which will surprise no-one. But before everyone starts spluttering about net returns being what matters, it is worth internalising that fees are the one certainty you have in investing. The total cost you pay to invest matters. It can be quite surprisingly high especially for individuals when you add up asset managment, platform and advice charges (2% p.a. or more according to consultancy LangCat). Here’s the thing – back in the days when we could earn 4% per year taking no risk, charges didn’t matter so much. But at low expected returns, charges are eating up a much bigger part of your expected returns – for lower risk portfolios we estimate that fees could eat up over 60% of your expected return, from below 30% a decade ago (more here). You could be taking risk, simply to try and pay your adviser’s fees.

Historically the asset management industry has been great at creating fantastic economies of scale, but not sharing any benefits of these with their clients, but this is changing. Fees have come down hugely over the last decade but the poor competition and transaprency in the fund management industry means that many overpriced funds still have a lot of assets. It’s a strange thing, we go out of our way to shop around on things like car insurance, mortgages or energy bills, but leave vastly higher sums on the table in our savings. The Sunday Times recently covered this – highlighting how a nascent price war in individual asset management could be about to change this. Vanguard and Interactive Investor have both launched disruptive low cost offerings that are worth a look. Review your allocations, the platform you are using, use passive where you can.

More risk. The one that no-one wants to say but might be the tough conversation you need to have. A realistic conversation about what a higher risk portfolio looks like, what it might feel like to hold it might be the most effective answer to this. Perhaps moving your classic 60/40 strawman to 75/25 or 80/20. Maybe using a higher cash allocation to allow you to hold a bit more equities. Many younger investors or strong institutions probably can afford more risk and can peel back some of the prudence and caution that tends to get layered onto portfolios over the years – a proper blank sheet of paper approach. When push comes to shove most investors could probably live with another 10% of assets in stocks.

This conversation is most important – but toughest- for those investors in lower risk and bond-heavy portfolios, that could be left with minimal expected returns after fees.

In one example of this CalPers pension scheme was broadly criticised in many quarters for its strategy of putting more leverage into the portfolio to try and achieve returns. But with rates so low, for strong institutions this might be a better solution -and perhaps a brave decision – compared to some of the mirages described above, which present less “career risk” for those advising and managing.

I’ve laid out here the nine most common solutions I see put forward to the biggest portfolio puzzle – what have I missed?

The core of the puzzle – evaporating risk-free rates have reduced forward-looking returns across the board

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