June 15, 2018
Dear Clients and Friends,
We have recently had some great conversations with clients
concerning investments and have concluded that several important points from
these conversations need to be shared with all clients.
Please note that the “Total Gain/Loss” on Fidelity.com
or the “Unrealized Gain/Loss” on your Fidelity statements does not equal
performance for a particular position.
This value does not account for cash received by the position in the
form of dividends, interest or capital gain distributions. Cash distributions can have a material
impact on the percentage displayed. This
has been a source of confusion for several clients.
Low-cost Versus High-cost Funds
Competitive forces have driven down the cost of investing
in equities and bonds considerably.
However, if a fund’s expense ratio was the sole attribute in deciding
whether or not to include a particular fund in a prudently diversified
portfolio, it would be fairly easy to use that filter. We are not suggesting that costs do not
matter, but that they must be taken into context with the fund’s overall
strategy and size. Factors to consider:
that provide exposure to more liquid1 markets (i.e. large U.S. multinational companies, Treasury bonds, etc.) will
generally be less expensive than less liquid markets (i.e. small and/or
international and emerging market companies).
funds (large amounts of invested dollars) will generally be less expensive than
smaller funds (i.e. economies of scale).
that are managed more or less by a computer using algorithms with little to no
human intervention will generally be less expensive than those that are not.
funds, which represent a much smaller subset of mutual funds in existence, are
much pricier than funds that allocate to traditional investments such as stocks
and bonds. In many cases, alternative
funds contain strategies that traditionally have existed only in the hedge fund
space. While these funds are more
expensive on a relative basis, they are less than their hedge fund
We research and conclude on what we believe is
worth paying for and what is not with no conflict of interest to influence our
All fundamental research we have reviewed
suggests that developed2 market equities are overvalued with U.S. equities being substantially
overvalued. We included a chart from
Star Capital that uses two data points on valuation to demonstrate how various
countries or regions compare from a valuation perspective.
If we looked at the valuation of the S&P 500
as measured by the cyclically adjusted price-to-earnings ratio (CAPE)3 and divided all of the historical data into 10 deciles from most undervalued to
most overvalued, the current valuation of the market is in the most expensive
10% of all measurable periods since 1928.
The most expensive decile is represented by the 90-100% in the table
below. This table illustrates the average
prospective returns from 1 to 10 years out.
Historically, the most expensive decile averaged 3.1% annualized over a
10-year basis, and was basically flat over a 5-year basis.
This is not to suggest that a
positive 10-year return is not possible.
The next two tables illustrate the best and worst returns from 1-10
years at each respective decile of valuation.
Professional Dilemma – Do I Protect My Career At The Expense Of My Clients?
Investment advisors/managers have always had to deal with the fear of being wrong, in isolation. It is always better to be wrong with a lot of company, than to be wrong alone (in the near term).
James Montier4of GMO, a well-respected member of the investment community, explains why professional investors continue to hold overvalued stocks:
“This is what I’ve described as this kind of cynical bubble (in the U.S.) where people (professional investors) know they shouldn’t be investing and they say, “Yes, we agree. U.S. equities are expensive.” I had a bizarre meeting earlier this year on the West Coast of the States with a well-known endowment, and we spent 20 minutes running through all the valuations and they were nodding away and I was like, “Oh, this meeting is going really quite well.” And then we go to the end where we talk about, “What are you going to do? So, how are your positions?” They’re like, “Well, our Chief Investment Officer is screaming at us because we got 6% cash and meant to have 3. So we’re going to go and buy S&P 500 futures.” And this was not some individual investor who had no idea. This was a very sophisticated endowment and here they were behaving in exactly the way that we talked about here was cynical.
So I think this is a very fragile market where you have this cynical career risk dominated behavior where everyone is saying, “I’m gonna own equities, either because I think they’re going up more or because…” And this is, I think, a big influence on a lot of the professional investors, “I don’t want to look wrong in the short term. It’s not that we don’t think they are over-valued, we do. It’s just that all of my peers are holding this stuff and if I’m the only one who isn’t, and they do well again, I’m gonna look really stupid and I’d get fired.” And that’s why we often talk about career risk being such a dominant force in market behavior because it is one of those things that forces people to do strange things like owning overvalued equities, which they know they’re doing, but they’re doing it because the fear of missing out is just so great. And that makes me nervous because it’s in essence you’re playing a greater fool game. You know, you abandoned the principles of investment. You should no longer call yourself an investor. You’re welcome to call yourself a speculator.” (Meb Faber Research May 23, 2018)
We have always taken a hard stance in this area. Our job is to make sure you reach your goals,
which mainly consists of helping you create or build toward a sustainable cash
flow stream. Investing an outsized
portion of a portfolio into richly valued stocks, which has historically
punished investors severely, is not something we could do in good
conscious. We would rather have the
uncomfortable conversation of not participating in an expensive market that
gets more expensive than risk your sustainable livelihood. This investment management discipline is
precisely what we get paid to do.
We can all easily understand risk unrelated to investing. There is the risk of dying young, the risk of
being disabled, the risk of someone getting hurt on our property, the risk of
losing our job, etc. However, from an
investment standpoint, risk is a nebulous concept. The financial community uses risk
interchangeably with the statistical measure known as standard deviation, which
is basically a measure of variability around the average return of an
investment. What exactly does that
mean? We all know that returns do not
happen evenly. For example, if an
investment earns an 8% annualized return over a 10-year period that will not
mean that the yearly return was 8% every year.
There will be years where the return is well over 8% (i.e. 25%) and
years where the return will be well under 8% (i.e. -15%). The greater the magnitude of returns both up
and down, the greater the risk (standard deviation). In other words, if you graphed two
investments that had the same returns, the lower risk investment would have
smaller peaks and valleys. What are the
implications? Below are the results of a
simulation of 2 portfolios with the same return, same withdrawal rate, but
different risk levels:
Portfolio 1: 6%
return, 14% standard deviation
Portfolio 2: 6%
return, 10% standard deviation
portfolio experiences a 4% annual withdrawal, adjusted for inflation, to meet
cash flow needs.
chart shows the probability of success (balance not going to $0) over a 30-year
time frame for each portfolio.
The effect of building a portfolio that has
lower peaks and valleys increases the success rate of a sustainable cash flow
stream. Keep in mind that an investor
must be willing to give up some years of high performance in return for less
significant declines. There is no silver
bullet that allows one to participate in the peaks and not the valleys.
A Portfolio That Acts Differently From Your Neighbors
We hope that we have made the case as to why it
makes sense to allocate to alternative investments other than stocks and bonds:
valuation concerns and minimizing portfolio risk (peaks and valleys). What are alternatives? Alternatives are a catch-all bucket for
anything that does not fit neatly into the stock or bond category. Our primary criteria for choosing
alternative investments is that they perform independently of economic and
interest rate risk, both of which are key drivers of returns for stocks and
bonds. Additionally, there must be a solid
fundamental reason why these strategies make money over time. The Stone Ridge All Asset Risk Premium Fund
(AVRPX), Stone Ridge Reinsurance Interval Fund (SRRIX) and both merger
arbitrage funds meet this criteria.
These investments will not track anything you see on TV or read about in
financial publications. Including these
strategies in your portfolio will undoubtedly cause you some performance envy
from lack of upside participation in environments where stocks and bonds are
doing well. However, once you realize
that including alternatives increases the odds of a sustainable cash flow
stream, this envy can be kept in perspective.
The last negative year for bonds was 2013 with
a return of -2.02%. In that year, the
return from merger arbitration strategies, as represented by the Barclay Merger
Arbitrage Index, was +3.91%. Merger
arbitrage, with its low risk profile, is the exposure we use as an alternative
The last negative year for the stocks, as
represented by the S&P 500 index, was 2008 when in the midst of the
financial crisis the index declined 37%.
In that year, catastrophe bonds, as represented by the Swiss Re Global
Cat Bond Index retuned a positive 2.45%.
Creating a sustainable cash flow stream
requires that an investor pay attention to both return and risk. Minimization of risk requires adding assets
that do not correlate or “track” each other.
Although the inclusion of these assets can cause discomfort when
traditional assets are performing well, the benefit of reducing large portfolio
declines is worth it. Given a 40-year
declining interest rate environment in combination with lofty stock valuations
across the globe, we do not believe that traditional asset classes (stocks and
bonds) will provide a sufficient risk/return tradeoff necessary for most to
achieve their retirement goals.
The concepts presented here are of such
importance that we want to make sure that all clients understand them. In order for us to be confident that this
material was understood, we are asking all of you to contact us by phone or
email to confirm your understanding. We will reach out to anyone we have not
heard from in the affirmative in the coming weeks.
We continue to work daily to earn your trust and confidence.
Vincent A. Schiavi, CFP®, CPA/ PFS Ravi P. Dattani, CFP®, CPA
President Vice President
1A liquid market is a market with many bids and offers, low spreads, and low volatility. In a liquid market, it is easy to execute a trade quickly and at a desirable price because there are numerous buyers and sellers. In a liquid market, changes in supply and demand have a relatively small impact on price . (Investopedia)
3The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. (Investopedia)
4James Montier. James is a member of GMO’s Asset
Allocation team. Prior to joining GMO in 2009, he was co-head of Global
Strategy at Société Générale. He is the author of several books including
“Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance”;
“Value Investing: Tools and Techniques for Intelligent Investment”; and “The
Little Book of Behavioural Investing”.
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