May 2022 IssueLong scroll reading

To Win Tomorrow: Question Everything

By Devesh Shah

There is a risk that 2022 is just the beginning of a treacherous investment decade. If so, it may be time to question what we know about conventional investment practices. In this article, I first highlight the so-called risk of a lost decade of real returns. Then, I raise 4 Questions we need to ask ourselves:

(1) what should be the mix between risky and riskless assets
(2) what about the active vs passive debate
(3) which assets work well during inflation
(4) which investment habits might we want to leave behind if the returns are slim.

After proposing some answers, I suggest “other” ideas that might work for some but are difficult to implement with consistency.

To be clear: I am not predicting “a lost decade,” a call that is speculative and at and far beyond my mortal skills. There are investment firms such as Research Affiliates who project a 10-year real return of 0.1% for a 60/40 portfolio, and even that is powered solely by its bond holdings since they project negative real returns from its stock allocation. So this is not my base case scenario for the next 10 years, but a theoretical exercise for how to structure the portfolio to prepare for the possibility of such a lost decade.

1. Existential threat for Real Returns of the 60/40 portfolio next decade

The performance of the 60/40 portfolio in the year 2022 so far, at -10 to -11%, is bad. But, according to many market strategists, this poor performance is just the beginning! They predict that we could suffer an entire decade of poor real returns. They have history on their side. Let me show you what they mean:

This table from MFO Search engine is various combinations of the S&P 500 and US Bond Total Return Index in the Decade of 1970s. It didn’t matter what combination one held, the annualized returns on average per year for the decade, was about +5.5% nominal.

Symbol Name Decade 1970’s
SP500 S&P 500 Monthly Reinvested Index 5.9
US9010 90/10 SP500/USBOND TR Index 5.8
US8020 80/20 SP500/USBOND TR Index 5.8
US7030 70/30 SP500/USBOND TR Index 5.7
US6040 60/40 SP500/USBOND TR Index 5.6
US5050 50/50 SP500/USBOND TR Index 5.6
US4060 40/60 SP500/USBOND TR Index 5.5
US3070 30/70 SP500/USBOND TR Index 5.5
US2080 20/80 SP500/USBOND TR Index 5.4
US1090 10/90 SP500/USBOND TR Index 5.3
USBOND Bloomberg U.S. Aggregate Bond TR (Modified) 5.3

Now, let’s look at inflation in the 1970s. The average year-on-year CPI was 7%.

“Real Returns” in the market parlance are defined as Nominal Returns (the APR from the MFO table) less the CPI, or, 5.5% – 7% = -1.5% per year!!

Comparatively, over the last 10 years, from 2012 to 2022, the 60/40 portfolio has earned an APR of 9.7% with an average CPI of under 2%. Investors blissfully earned a real return of +7.7% over the last 10 years (from 2012 to 2022).

The next decade, strategists predict, is far more likely to look like the 1970s and less likely to be the 10-years that just went by. In addition, investors pay taxes and fees and make mistakes, which means investors could be staring at a bleak picture, at least in inflation-adjusted terms, going forward.

Why do some strategists think stocks and bonds won’t provide adequate returns?

  1. Stocks are at a much higher valuation today than 10-years ago, a headwind.
  2. Interest rates on bonds are low compared to projected inflation, which will hurt bond returns going forward.

Why do they think inflation will be higher going forward? There are three broad reasons:

  1. Unwinding globalization
  2. Climate and ESG focus
  3. Labor and wage implications of unwinding historic racial economic inequalities

The reader can decide if corporate earnings will keep up, if capitalism will be resilient, if inflation is going to be higher, the reasons, and whether these strategists are correct.

I want to focus on what to do if they are right.

2. Rewinding the clock to the 1970s

I always like to start my process by putting myself in the past and asking, “Now that you have perfect hindsight, what would you have done differently?” Again, these are just mental frameworks for thinking and evaluating. There are at least 4 different questions and related ideas that come to mind.

A. Question the right allocation between Risky Assets and Riskless Assets going forward for YOU.

If any combination of Risky and Riskless gave the same low nominal return in the 1970s, then what’s the benefit of carrying (extra) Risky equities. In addition, if one is older, has less time until retirement, needs the funds, is considering a career switch, and is underfunded for retirement, then it would be better to not hold as much in stocks.

David Snowball has long recommended the Equity Light Portfolio as correct for him, and for many others. Question the traditional mix of 60/40, or 90/10, or any other mix.

There are a million investment statistics and portfolio choices but there is only one investor you need to care about – YOU.

How many Risky assets are correct for you if there will be increased volatility for every extra point of return gained.

B. Question the Passive vs Active Debate for Investing

There is no doubt that Passive and index-based investing in large-cap growth stocks have left Active investors in the dust, especially over the last 20-years. The high-fee fund manager lost the race. I am mostly passively invested.

Small cap, value, quality, international has suffered to large cap, growth, not-quality, and US stocks. This move exaggerated the victory of passive over active funds. But what kind of investing works when markets become treacherous?  

When the markets get tough, we need thoughtful fund managers. We want people who have seen risk and volatility and who will behave responsibly. We are grateful to Buffett and Munger for sailing the Berkshire ship well in tough times, but there are other investors who also know a thing or two about investing.

To that end, I invite every one of you to pour over the 137 Profiled Funds in the MFO Database. David Snowball has thoughtfully put together a collection of funds and investment managers who are willing to step aside and not be bullied into the index hugging. You will find gems in there.

David’s note on the Profiled Funds list: I appreciate Deveh’s faith. Thanks! I wrote most but not all of the profiles. Most are flagged “positive” because of our long-ago realization that we didn’t need to waste your time denouncing bad ideas that, by virtue of the industry’s dynamics, were going to die a quiet and obscure death anyway. We only warned about funds that risked being bad ideas that were still going to pull in assets.

You’ll find gems there, but also some ideas whose risk aversion led them to disappointing returns in a decade that rewarded imprudence.

Finally, many of the profiles are quite old, which reflects the inherent limits of a tiny team. If you see a profile that you do think warrants an update, let us know and we’ll make it happen!

C. Question the Asset Classes. Are US Stocks and US Bonds the only game in town?

The 2020s are not the 1970s. Financial markets are more sophisticated and new Asset Classes have developed. We now have access to some of these asset classes which we did not have back in the ‘70s, and we can access them in public markets at reasonable fees. Namely, there are at least 2 Assets that I believe will protect the portfolio in Real Returns:

      1. TIPS (Treasury Inflation Protected Securities)
      2. Equity REITS (Real Estate Investment Trusts)

These 2 assets perform favorably in inflationary times. I am re-linking my Feb MFO article on TIPS, which also has a link to a UPenn paper on Equity REITS performance during the 1970s.

D. Question the need and your ability to trade the market, to constantly pick successful stocks and bonds, and to engage in complex financial instruments.

Just because we can buy and sell from our smartphones in a fraction of a second, we don’t have to. There is no record of individual investors successfully trading the market year after year.

Picking a few good stocks over the lifetime is a gift each one of us should be granted. We should all be lucky enough to have bought a Walmart or an Apple and build inter-generational wealth. But we can’t expect to be lucky numerous times a month in finding great stocks.

Is it really important to trade levered and inverse ETFs? Do we really have to have an opinion on Oil and Copper every day? I know options trading is low risk (I co-invented the VIX Index!!) Precisely for that reason, I urge you to look at your cumulative options performance. Have you really made money?

If the investment landscape over the next decade will be choppy, we need to question everything we are doing today and decide how to improve going forward. We will need to minimize mistakes, keep our portfolios simple, and be incredibly humble.

Next, I would like to highlight a few other ideas. I am still evaluating these ideas and don’t know how to fit them into a holistic portfolio. I currently have some of these investments and some I have invested in the past. I will be candid that I don’t know if these solutions work. I am trying things, as I know, we all are in this world.  

    1. International Developed Market Stocks and Emerging Market Stocks:

We know good companies that live abroad. We know investing in them can be helpful and perhaps add a buffer to our US stocks portfolio. That’s the theory. But has it worked? Not really according to the data.

In a recent article, When Global Market Bets Went Wrong, Philip Cogan of the Financial Times quotes research by three London Business School economists. Here is the upshot:

While I own international assets, the high correlation with US stocks, and the underperformance has been disappointing. Within Emerging Markets, picking the right country is everything. I find picking the right Emerging market countries a difficult task and prone to luck. I believe David Snowball’s profiled EM funds can help here.

    1. Gold and Other Precious Metals:

Over millennia, gold had held its value. It is a commodity with no interest, no dividend, no rental income, and no guarantee of returns. But it’s worked. Why? I don’t know. Will it work in the future? I don’t know. There is no fundamental process to evaluate whether it will work or not. And should one hold it physically, in paper form, or through gold miners? Each one has its pros and cons.

Too many innovative products have failed in the last ten years. From concerns about commodity clearing houses failing to a disconnect between the paper value and the actual physical value of bullion, investors ought to be very skeptical.

Long-term capital gain taxes are punitive here. The bid offer for entering and exiting physical precious metals is even more expensive than buying and selling real estate. Gold commodity producers sometimes hedge, and sometimes the mines are appropriated by the national governments. The link between the commodity price and the commodity miners is not 1 to 1.

    1. Base Metals, Energy, Agricultural Commodities, niche commodities, and related companies:

This takes the gold problem to the next level. Presently, there is an enormous rush for all commodity-based hard assets. We saw a similar run-up in such hard assets during the 2002-2007 “rise of China” cycle. This time it feels different because the demand is global in nature and the supply is interrupted due to the Ukraine war, the pandemic, and the focus on climate change and ESG curbing mining and extraction. Inflation means the value of physical goods goes up. Commodities are physical. Ergo, invest. Hmm, ok, if you insist.

How does one participate in commodities? There are 2 ways:

      1. Futures or Futures Products (ETNs/ETFs/Levered/etc.): Commodities do not have a natural rate of return. They are mean-reverting assets. Eventually, supply always comes when the price is high enough. Impeccable market timing and market sophistication are required to participate in futures products AND KNOWING WHEN TO GET OUT.
      2. Companies that produce commodities: This may be easier to digest for individual investors. There are enough ETFs and Mutual Funds that allow one to participate. This is a safer mechanism for participating in some kind of a commodity bull run, but also extremely prone to volatility from:
        1. The commodity cycles
        2. The company management’s execution
        3. Informed fast money and insider trading
        4. Nationalization of assets
        5. Accidents in mines

We will often hear glorious stories of successful hedge fund managers and bank trading desks who “made a killing” in commodities. In physical assets, small changes at the margin have an abnormal impact on prices. These funds are close to the action. They know the shipping, mining, production, and demand numbers at the margin. They know how to take risk adjusted for the volatility of each commodity. Be careful trying to ape them. It’s not trivial.

    1. Crypto Currencies:

There will be inflation. #Bitcoin solves that!

There will be deflation. #Bitcoin solves that!

Nothing cryptocurrencies apparently cannot solve. Ok then. 

Your dear author does not have enough conviction about them to either recommend or not recommend them. I find the stories of stolen wallets and hacks too risky for my money. I don’t want to understand why a Bored Ape is the solution to every future problem!

I like reading Aaron Brown on this topic, who has held between 1% and 3% of his wealth in crypto. That’s a reasonable level of money to invest if one chooses to go down this route. Anyone who suggests investing more than that might be under the influence of some pretty good stuff I don’t have access to.  

    1. Infrastructure

This is actually very interesting if one knows how to do this right. Such assets have inflation-linked clauses that protect their earnings stream. The problem is that tolls, bridges, and ports are usually held by private companies and privately structured funds. It’s difficult to find public funds that directly own these assets and no other assets. David’s recently profiled infrastructure fund, First Sentier American Listed Infrastructure Fund (FLIAX) is an interesting starting point that needs more analysis. Master Limited Partnerships (MLPs) own energy assets, pay substantial cash flow, and may also work to protect the purchasing power of the portfolio in inflationary times. The volatility in MLPs, and the lopsided compensation structure for management, is a barrier for many.

    1. A General Problem with Adding Asset Classes:

One of the problems with investing in Other Asset Classes is knowing how much to invest in them. This is far from clear. With 60/40, the numbers are known. The moment we add other Asset Classes we have to make room for them from the 60/40. Moreover, the substitution of assets in and rebalancing out of these assets requires some pre-set levels of benchmark weight ranges.

It’s difficult enough to do this with 2 asset classes. When one adds esoteric products with leverage like Futures, Leverage ETNs/ETFs, and Options, the calculation becomes extremely challenging for all but a handful of truly sophisticated investors. Tread carefully.

E. Conclusion

The quest for proper and thoughtful investing is not finite. Far more important than the information on an asset class is gauging one’s own psychological makeup and potential reaction to losses. Long ago, I learnt that in trading and investing, the more one can visualize the potential outcomes, and be prepared for them in advance, the less difficult it gets.

This entry was posted in Mutual Fund Commentary on by .

About Devesh Shah

Hi, I’m Devesh Shah and I’m pleased to meet you. As a professional, I was a co-inventor of the CBOE VIX Volatility Index, an equities and derivatives trader, and Partner at Goldman Sachs. My passions now mostly involve writing, teaching about investments, practicing yoga, playing the piano, and volunteering with a non-profit, Sponsors for Educational Opportunities (SEO), that opens up career and college pathways for underprivileged students of color. I am an alum of SEO. My hope for the months ahead is that I might share a few things I have learnt about investing.