Montier On Portfolio Construction

James Montier, via Barry Ritholtz, knocked it out of the park with a lengthy commentary that explains why benchmarking is the wrong way go, picks apart various strategies including Yale’s, offers some interesting numbers and gives an opinion about how to think about portfolio construction.

There are some things he mentions that I agree with, and implement, and other things I don’t agree with.

The first idea I wanted to comment on was Montier’s belief that benchmarking is a bad way to navigate through with a portfolio. He feels that benchmarking results in “mis-measurement of risk and indifference to valuation.” He goes on in great detail why he feels this way and backs it up with some numbers and some logic.

Benchmarking, like anything, has pluses and minuses. The building block here, IMO, is that equities have averaged 9 or 10% in annual returns over long periods of time. A normal and suitable allocation and a healthy savings rate gives people a decent shot of having enough money. This building block is being question after a very long round trip to nowhere for the US equity market and quite a few other major markets.

Of course while we were on a long round trip to nowhere there were many other foreign markets that had very good decades. While I have been consistent in doubting whether the US will have “normal” returns I have been just as consistent in saying there will be plenty of countries that will have “normal” returns and there are ETFs to cover many of them.

A big theme throughout the commentary is that risk and volatility are not the same thing. This is a point I have made often. Part of the mis-measurement he mentions is that many people do not realize the two are different. He notes that volatility, we can see this on a chart of VIX, was lower in 2007 with the SPX above 1500 and it was sky high when the SPX was below 800. If volatility equaled risk then the VIX would have been sky high in late 2007.

Indifference to valuation means buying at any price and then staying fully invested. He was very critical of staying full invested when risk, not volatility, increases. To paraphrase; if risk is greater doesn’t it makes sense to reduce exposure?

This resonated with me in how I talk, almost to tedious length, about having some sort of trigger point for defensive action in a portfolio. The way I frame it is that when demand for equities is not healthy it makes sense take defensive action.

One concept I write about a lot in the context of defensive action is avoiding the full brunt of down a lot. He would likely tear into me for believing in going down 15% in a down 30% world is a good result. I don’t know if Montier bet big on treasuries and gold in 2008 but narrow bets in a portfolio create the potential for “permanently impairing capital.” Gold obviously can be very volatile and volatility when it goes the wrong way on you moves much closer to being risk than the commentary frames it and buying treasuries in 2008 was clearly a good trade, especially at the end of the year, but people buying then were buying high.

Concentrated bets increase risk and potential volatility (the bad kind).

All I’ll sale about Yale is that he believes the endowments are mostly chasing heat, you can read the commentary to see why.

The last thing I want to get to here is a point about asset allocation. A few times in the past I have referenced an observation from a past colleague that for some period of time one could have shorted Nikkei futures, kept 98% in cash and about equaled the return of the US stock market. As I always include when mentioning this, the accuracy of the observation is not important. What is important is what the example says about risk adjusted returns and volatility budgeting.

Montier notes that if the 60/40 stocks bonds allocation was built around volatility it would result in 13% in equities and 87% in bonds. I’m not sure what volatility numbers he is using but giving him the benefit of the doubt, the interesting thing is that 13/87 would have averaged 9% per year from 1980-2009 compared to 11% for the 60/40 mix.

That is a fascinating result. Obviously it takes in a colossal 30 year, and counting, bull run in bonds that would seem to be impossible to recreate. Despite that unrepeatable tailwind for bonds it makes an interesting point that a little can go a long way in terms of return.

The big takeaway from Montier seems to be to not worry about what the market is doing. When the risk/reward for an asset class is not attractive then get out of the asset class. It was not clear to me that he was advocating a long term outlook so I will add that in. I’ve mentioned countless times what markets like Brazil, Chile and Norway did over the entire decade despite occasional big declines.

I would also reiterate the diligence required in saving money. It is likely that in this decade or the next there will be a large run up in equities over a period of quite a few years. If the market ever triples in six or seven years, even if we are talking about foreign markets, then the “extra” savings will obviously result in your having more money. If (global) markets do not have that kind of run then the “extra” savings will have turned out not to be so extra. By the way if the markets do have that kind of run then everyone will love equities, they will always work and of course that will be the time to permanently lighten up.

Congratulations to the Tufts Jumbos for winning the D3 Lacrosse Championship yesterday 9-6 over Salisbury. Look at those unis. Brown with Tar Heel-blue lettering? I am repulsed but I can’t look away.

8 Comments

  1. Thanks for the post, Roger.

    Reply
  2. “The big takeaway from Montier seems to be to not worry about what the market is doing. When the risk/reward for an asset class is not attractive then get out of the asset class.”

    easy to say

    I’ll stick with analyzing market trends

    Reply
  3. what is the 200 DMA if not a market trend?

    Reply
  4. Roger,

    I was not criticizing you, I agree you follow market trends. But, determining when the risk/reward for an asset class is not attractive as proposed by Montier is much, much easier to say than to implement.

    Your approach is simple to implement

    Reply
  5. Taking a moment to express gratitude for our military on Memorial Day.

    The wounds we experience from time to time investing are paltry in the big picture of all that is asked of our service men and women.

    They are the “stimulus” that benefit all of us.

    T

    Reply
  6. A good article and a helpful post. Thanks, Roger.

    If I’m tracking with Montier’s logic, wouldn’t he advocate buying at the 200 dma (or some suitable trigger) rather than selling, because equities are a better value than they were?

    Happy Memorial Day.

    Reply
  7. that could be the case but from what i know of him from past writings he would be more of a blood on the street buyer. when spx breaches its 200 dma there is no blood on the street. that may or may not come but if there is to be a large decline then the breach occurs somewhat early on.

    Reply
  8. Montier first states risk is loss of principal not volatility. Anyone taking income off of a portfolio quickly learns that taking a fixed amount out will crash your portfolio if you have downside volatility. Return averages may come back to historical norms but it will be too late if volatility is too high.
    As for Yale chasing heat…well that’s stupid. However, rising correlations for global markets means MVO models need to include different asset classes especially the kind that have low correlations during crisis. Montier is making a cognitive error. Ironically, it is the one that Yale made only in reverse. Policy benchmarks may not have been great recently but it’s still the only way to go for any serious investor. Savings rates are the bigger issue anyway.
    IMO rising country correlations have peaked and will fall in the future as more specialization occurs because of globalization. Countries will have lopsided sector positioning and less diversified economies and we are all it in together.
    JB – Hi Roger

    Reply

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Montier On Portfolio Construction

James Montier, via Barry Ritholtz, knocked it out of the park with a lengthy commentary that explains why benchmarking is the wrong way go, picks apart various strategies including Yale’s, offers some interesting numbers and gives an opinion about how to think about portfolio construction.

There are some things he mentions that I agree with, and implement, and other things I don’t agree with.

The first idea I wanted to comment on was Montier’s belief that benchmarking is a bad way to navigate through with a portfolio. He feels that benchmarking results in “mis-measurement of risk and indifference to valuation.” He goes on in great detail why he feels this way and backs it up with some numbers and some logic.

Benchmarking, like anything, has pluses and minuses. The building block here, IMO, is that equities have averaged 9 or 10% in annual returns over long periods of time. A normal and suitable allocation and a healthy savings rate gives people a decent shot of having enough money. This building block is being question after a very long round trip to nowhere for the US equity market and quite a few other major markets.

Of course while we were on a long round trip to nowhere there were many other foreign markets that had very good decades. While I have been consistent in doubting whether the US will have “normal” returns I have been just as consistent in saying there will be plenty of countries that will have “normal” returns and there are ETFs to cover many of them.

A big theme throughout the commentary is that risk and volatility are not the same thing. This is a point I have made often. Part of the mis-measurement he mentions is that many people do not realize the two are different. He notes that volatility, we can see this on a chart of VIX, was lower in 2007 with the SPX above 1500 and it was sky high when the SPX was below 800. If volatility equaled risk then the VIX would have been sky high in late 2007.

Indifference to valuation means buying at any price and then staying fully invested. He was very critical of staying full invested when risk, not volatility, increases. To paraphrase; if risk is greater doesn’t it makes sense to reduce exposure?

This resonated with me in how I talk, almost to tedious length, about having some sort of trigger point for defensive action in a portfolio. The way I frame it is that when demand for equities is not healthy it makes sense take defensive action.

One concept I write about a lot in the context of defensive action is avoiding the full brunt of down a lot. He would likely tear into me for believing in going down 15% in a down 30% world is a good result. I don’t know if Montier bet big on treasuries and gold in 2008 but narrow bets in a portfolio create the potential for “permanently impairing capital.” Gold obviously can be very volatile and volatility when it goes the wrong way on you moves much closer to being risk than the commentary frames it and buying treasuries in 2008 was clearly a good trade, especially at the end of the year, but people buying then were buying high.

Concentrated bets increase risk and potential volatility (the bad kind).

All I’ll sale about Yale is that he believes the endowments are mostly chasing heat, you can read the commentary to see why.

The last thing I want to get to here is a point about asset allocation. A few times in the past I have referenced an observation from a past colleague that for some period of time one could have shorted Nikkei futures, kept 98% in cash and about equaled the return of the US stock market. As I always include when mentioning this, the accuracy of the observation is not important. What is important is what the example says about risk adjusted returns and volatility budgeting.

Montier notes that if the 60/40 stocks bonds allocation was built around volatility it would result in 13% in equities and 87% in bonds. I’m not sure what volatility numbers he is using but giving him the benefit of the doubt, the interesting thing is that 13/87 would have averaged 9% per year from 1980-2009 compared to 11% for the 60/40 mix.

That is a fascinating result. Obviously it takes in a colossal 30 year, and counting, bull run in bonds that would seem to be impossible to recreate. Despite that unrepeatable tailwind for bonds it makes an interesting point that a little can go a long way in terms of return.

The big takeaway from Montier seems to be to not worry about what the market is doing. When the risk/reward for an asset class is not attractive then get out of the asset class. It was not clear to me that he was advocating a long term outlook so I will add that in. I’ve mentioned countless times what markets like Brazil, Chile and Norway did over the entire decade despite occasional big declines.

I would also reiterate the diligence required in saving money. It is likely that in this decade or the next there will be a large run up in equities over a period of quite a few years. If the market ever triples in six or seven years, even if we are talking about foreign markets, then the “extra” savings will obviously result in your having more money. If (global) markets do not have that kind of run then the “extra” savings will have turned out not to be so extra. By the way if the markets do have that kind of run then everyone will love equities, they will always work and of course that will be the time to permanently lighten up.

Congratulations to the Tufts Jumbos for winning the D3 Lacrosse Championship yesterday 9-6 over Salisbury. Look at those unis. Brown with Tar Heel-blue lettering? I am repulsed but I can’t look away.

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