Going New School?

Over the weekend as I was putting the finishing touches on an article for TSCM I stumbled across a concept that is probably not new, relative to this site, but that I did (by accident?) articulate a little differently.

Over the last eight or nine years one could argue that domestic indexing has not worked. Since the start of 2000 SPY is down about 10%. Since inception (mid 2000) iShares Russell 2000 (IWM) is up a hair under 40% which works out to about 5% annualized.

While very unlikely, what if indexing fails again over the next eight or nine years? Allocating too much to index funds that go nowhere for a decade and half creates a real headwind for reaching financial goals. As I find portfolio construction, and its evolution, to be an interesting topic…

What if indexing doesn’t work or more correctly what could you do if you think it might not work? One solution could be some sort of combo of absolute return/low volatility vehicles and potentially more volatile narrow themes. The ratio of absolute to narrow would depend on the investor but the combo chosen would need provide a chance for long term success and allow the investor to sleep. Putting it all into agriculture stocks would create too much volatility and putting it all into a carry trade ETF would not provide enough growth (at least I don’t think it would).

Unfortunately this would require a lot more work for folks who are accustomed to indexing but if indexing does not work then indexers need to do something different.

As an example, if a portfolio was constructed to have seven themes weighted at 4% each and then 72% in absolute/low volatility; the selecting of the themes would take a lot of work. It may not take long to come up with seven (or six or eight) ideas but it would take some work to study and make sure they are not too closely related and thus vulnerable to the same thing. For example it is a good bet that Vestas Wind (VWDRY) and Vietnam are not vulnerable to the same things but Potash (POT) and Monsanto (client and personal holding) probably are. To put it in Internet bubble terms having a B2B stock, a data farm stock and a search engine stock does not make for a diversified portfolio.

Examples of themes could be commodities (broad or narrow), emerging markets (broad funds, narrow funds, or individual stocks), certain parts of infrastructure, alternative energy (broad like GEX, narrow like FAN or individual stocks), agriculture, some big SPX sectors (like energy now or other things later), certain developed countries and there are plenty of others.

You could buy the ones you like with the hope of holding them forever but I think there needs to be a willingness to sell or at least reduce exposure when they go up a lot. There must also be a willingness to admit to yourself when you get one wrong and sell that as well.

Some examples of absolute/low volatility might include, long short equities, some of the managed futures funds, carry trade funds, other currency products, Canadian hydro funds, certain parts of infrastructure and maybe farmland stocks.

I actually think the theme portion would be easier to manage. You already know what sorts of things fit there (this comment has nothing to do with anyone’s ability to pick which themes to buy). It seems there are fewer categories to choose from and of course when there is a crisis the notion of absolute/low volatility may stop working for a while.

I’m not certain whether hydro funds belong in this conversation or not but during the crisis many of them got hit very hard (debt-intensive businesses) and they also got hit before that in the fall of 2006 when the change in the tax law was announced. The shock is in, the move down made and it is unlikely that they would be prone to yet another shock but if a shock does come I would expect them to go down a lot again.

I think that most of these sorts of things (those that are potentially in the absolute/low volatility category) will go down less than the market during bear cycles and up less than the market during bull cycles but every so often the will deviate from this expected behavior. As with themes it would be very important to spread the risk. Managed futures funds probably have different vulnerabilities than a Canadian income vehicle.

This post was obviously a theoretical exercise. Long time readers will know I work in a couple of these sorts of things into client portfolios because I think they help manage volatility.

Did you watch any of the UEFA Euro Championship yesterday? Wow that was a lot of Scottish broadcasting and only one of them was Scottish.

This will be the last Fenway picture for a while. Obviously this is the Red Sox dugout. Hopefully you have enjoyed them.

6 Comments

  1. Always enjoy your posts on theory and portfolio strategy. Thanks for today’s blog.

    Would you consider inflation to be a theme, as you use the term? Lots of smoke and maybe some fire out there. I’m thinking inflation-protected securities, precious metals, and maybe some miners would help me sleep better.

    Reply
  2. Inflation is complicated right now. Of course it looms as an issue so it makes sense as a theme for miners and metals but inflation protected securities would seem more like absolute/low vol.

    The complexity arises from the gov’t numbers appearing to miss some things and on a related note the notion that the rest of the world averages 5% or whatever and we are somehow so far below does seem odd.

    Add to that what might be deflation in asset prices. if food and gas costs you $200 more per month (which I think would overstate the problem) and your house is worth $30,000 and your 401k is down–well what matters more? the increase or the decline? complicated.

    Reply
  3. Inflation is complicated in that the US and UK governments are ignoring the things that are going up the fastest – food and energy. Life’s getting more and more expensive and wages aren’t going up accordingly, so we’re getting poorer in comparison. Unlike in other countries where inflation includes those commodities and interest rates are higher, somewhat protecting their currencies and incomes (compared to imports).

    It’s a great leveller over time. If it continues for any length our wages will be reduced to those of the emerging countries and we’ll all have the same quality of life. Some already say parts are like a third world country.

    Reply
  4. First off, my bias and actions reflect adherence to an indexing strategy. But I’m not evangelistic about it, and I’m always on the lookout for credible alternatives.

    So I read this proposal with interest and an open mind, but respectfully dismissed it on the basis that it assumes certain important things that have happened in the fairly recent past will generally persist into the future. But how can we know that with enough assurance to put hard money on the line? In my view, we can’t.

    Further, data shows that reported fund or manager returns (that reflect actual implemented strategies and position management) are far above actual investor returns, mostly because we investors usually fail to adhere to any strategy long enough to allow it to work. Or not.

    And finally, I rarely see where an investor’s target return is linked to a plan that is expected to produce some outcome, such as an ultimate stream of pension payments. Once you do this, asset allocation and its historical implications, modified by current valuations becomes an essential starting point.

    Reply
  5. What if indexing doesn’t work…?

    Didn’t happen. Ain’t gonna happen. Almost certainly can’t.

    The Russell 3000 index has done a SUPERB job of replicating the total dollars invested in US equities. That’s what it is designed to do, and would only NOT do it if companies were born and flamed out faster than Mr. Russell & Co. could get their monthly updates out, or if somehow all the gains were in IPOs that only active investors could buy. Or some other ridiculous scenario could cause it to not do its job.

    The only teensy mistake it makes is forgivable: by avoiding most of the non-deductible contributions made to financial intermediaries such as myself, friends of Mr Russell, Mssrs Standard & Poors and their ilk end up OUT-performing by roughly 0.50% to 1.00% per year.

    However, if your 20-20 hindsight leads you to conclude that you oughtn’t have been invested in US equities, you could sell an index fund (more cheaply and quickly than almost any other portfolio) and go to cash. So indexing works fine for market-timing geniuses, too. Even though the evidence on the average dollar invested thru active market timing is even harsher on the fine residents of Lake Woebegone, who are smarter than everybody else at the table.

    Finally, some of us think that by active equity selections, we can out-perform the returns on an index, or at least that it’s fun to try. Could well be true for some individuals — I’m pretty sure it is — but can’t be true in aggregate due to those nasty contributions.

    But that’s NOT what indexes ever claimed to do (despite their monstrous success in trumping those who think they’re not the mark at the table), so this conjecture can hardly be grounds to claim that the indexes aren’t working.

    Reply
  6. by working i meant delivering an average annual return that allows for growth sufficient to give investors a chance at having enough money for what ever their financial goal is.

    The Russell 3000 opened for business in 2000 at about 777. It closed today at 748. So maybe it eked out positive if there are any dividends.

    Another 8 years of that creates a lot of problems for investors. anyone who was 50 in 2000, in that scenario might have to save more than they earn–to take a bit of humor from a TD Ameritrade commercial.

    The point WAS NOT do index funds replicate the indexes they are supposed to.

    Reply

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Going New School?

Over the weekend as I was putting the finishing touches on an article for TSCM I stumbled across a concept that is probably not new, relative to this site, but that I did (by accident?) articulate a little differently.

Over the last eight or nine years one could argue that domestic indexing has not worked. Since the start of 2000 SPY is down about 10%. Since inception (mid 2000) iShares Russell 2000 (IWM) is up a hair under 40% which works out to about 5% annualized.

While very unlikely, what if indexing fails again over the next eight or nine years? Allocating too much to index funds that go nowhere for a decade and half creates a real headwind for reaching financial goals. As I find portfolio construction, and its evolution, to be an interesting topic…

What if indexing doesn’t work or more correctly what could you do if you think it might not work? One solution could be some sort of combo of absolute return/low volatility vehicles and potentially more volatile narrow themes. The ratio of absolute to narrow would depend on the investor but the combo chosen would need provide a chance for long term success and allow the investor to sleep. Putting it all into agriculture stocks would create too much volatility and putting it all into a carry trade ETF would not provide enough growth (at least I don’t think it would).

Unfortunately this would require a lot more work for folks who are accustomed to indexing but if indexing does not work then indexers need to do something different.

As an example, if a portfolio was constructed to have seven themes weighted at 4% each and then 72% in absolute/low volatility; the selecting of the themes would take a lot of work. It may not take long to come up with seven (or six or eight) ideas but it would take some work to study and make sure they are not too closely related and thus vulnerable to the same thing. For example it is a good bet that Vestas Wind (VWDRY) and Vietnam are not vulnerable to the same things but Potash (POT) and Monsanto (client and personal holding) probably are. To put it in Internet bubble terms having a B2B stock, a data farm stock and a search engine stock does not make for a diversified portfolio.

Examples of themes could be commodities (broad or narrow), emerging markets (broad funds, narrow funds, or individual stocks), certain parts of infrastructure, alternative energy (broad like GEX, narrow like FAN or individual stocks), agriculture, some big SPX sectors (like energy now or other things later), certain developed countries and there are plenty of others.

You could buy the ones you like with the hope of holding them forever but I think there needs to be a willingness to sell or at least reduce exposure when they go up a lot. There must also be a willingness to admit to yourself when you get one wrong and sell that as well.

Some examples of absolute/low volatility might include, long short equities, some of the managed futures funds, carry trade funds, other currency products, Canadian hydro funds, certain parts of infrastructure and maybe farmland stocks.

I actually think the theme portion would be easier to manage. You already know what sorts of things fit there (this comment has nothing to do with anyone’s ability to pick which themes to buy). It seems there are fewer categories to choose from and of course when there is a crisis the notion of absolute/low volatility may stop working for a while.

I’m not certain whether hydro funds belong in this conversation or not but during the crisis many of them got hit very hard (debt-intensive businesses) and they also got hit before that in the fall of 2006 when the change in the tax law was announced. The shock is in, the move down made and it is unlikely that they would be prone to yet another shock but if a shock does come I would expect them to go down a lot again.

I think that most of these sorts of things (those that are potentially in the absolute/low volatility category) will go down less than the market during bear cycles and up less than the market during bull cycles but every so often the will deviate from this expected behavior. As with themes it would be very important to spread the risk. Managed futures funds probably have different vulnerabilities than a Canadian income vehicle.

This post was obviously a theoretical exercise. Long time readers will know I work in a couple of these sorts of things into client portfolios because I think they help manage volatility.

Did you watch any of the UEFA Euro Championship yesterday? Wow that was a lot of Scottish broadcasting and only one of them was Scottish.

This will be the last Fenway picture for a while. Obviously this is the Red Sox dugout. Hopefully you have enjoyed them.

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