Editor’s note: This article was originally published at: http://go.mta.org/3793 and is reprinted here with the permission of the author.
Relative versus Absolute Return? Conventional investment strategies and managers seek to beat a pre-defined benchmark or basket of market indices across one or more asset classes and hence they measure themselves relative to this benchmark or index. This is true of most mutual funds and financial advisors and planners. Thus, if the benchmark, say the S&P 500 index is down 39% as it was in 2008, the manager or strategy is considered successful if it “beat” the market, even if they generated a 35% loss that year. A relative return manager, hence, has a built in excuse for not performing well with your investment, i.e. the markets were at fault.
Absolute Return Strategies: In contrast to relative return strategies, an Absolute Return strategy seeks to generate a positive return over a predefined period independent of whether an index or benchmark with similar risk characteristics is positive or negative over the same predefined period. Also called “alternative” strategies, Absolute Return strategies can use fundamental, technical, or macro-economic indicators or a combination of these to determine investment positions or portfolio allocations that are adjusted with changing market conditions as represented by these indicators or otherwise. Absolute Return strategies are almost as diverse as their developers and managers, and are not all created equal. They can be simple or sophisticated, include one or more underlying strategies and risk management approaches, use instruments other than stocks or bonds (like options, futures, etc.) to hedge existing positions or enhance leverage, can take both long and short positions in different markets (i.e. align the investment with direction of prices), have different trading frequencies, and most importantly can perform differently with different degrees of risk. In choosing Absolute Return strategies, the diligent investor will seek to gain an understanding of the underlying strategies, risks, and their performance before investing funds.
Why not “time-tested” Buy and hold Long-term Investing?
There are 5 reasons why we believe Buy and hold as an investment strategy for retirement is actually harmful for your portfolio, and that the right tactical Absolute Return strategies need to be a key part of your mainstream solution for retirement. Given the extraordinary misinformation distributed by the financial industry on the subject, we strongly recommend your reading through these points or calling us. The five reasons are:
1. Buy and hold has RARELY worked historically: We all know that investing in the stock market has not exactly been a winning proposition since 2000 where real dividend re-invested return (adjusted for inflation) for the S&P500 has been -3.4% annualized (thru the end of 2009) or a total real decrease in the purchasing power of a hypothetical portfolio invested in the S&P500 of 29%. But even if we assume a longer-term investment horizon, the story from the last 140 years is not pretty as shown in Figure 1 below which charts the 30 year annualized returns for the inflation-adjusted dividend-reinvested S&P Composite index which does not account for any investment fees. Only in 27% of the last 120 years did the long-term real-returns from US equities go
over 5%.
Traditional investment strategies and conventional wisdom promoted by Wall Street and embraced by most of the financial establishment (including possibly your very own financial adviser or planner) have ignored this reality and have foisted the idea upon us that 10% pre-inflation returns are obtainable from the stock market in the “long-term”, no matter what environment we begin investing in if we simply 1) Invest in a diversified portfolio of equities, bonds, commodities, real estate, etc. and 2) Hold-on through thick and thin for the long-haul with the quarterly or annual rebalancing. Let us test this idea using the above chart. The long-term rate of inflation which “everyone” knows is 4%, which means the claimed long-term real rate of return available from US equities is 6% if one re-invests dividends, right?
The red-dashed line in the chart above is drawn at the 6% level. The 30 year real annualized dividend reinvested returns for the S&P Composite index rise above 6% in only 14% of the 120 years from 1901 to 2010. We are coming off a brief 13 year period in which long-term investors have succeeded in garnering a >6% return but that is the exception rather than the norm historically. In fact, the average 30 Year US equity market real dividend reinvested returns for investors who retired between 1901 and 2010 was 3.6% on an annualized basis.
2. Buy and hold is a matter of luck: Markets are cyclical and have historically alternated between secular (long-term) bull and bear markets as is shown in Figure 2 below. Actually secular bear markets have lasted for at least 15 years (to 19 years) whereas the two secular bull markets in the early 20th century were 9 years long and the two since 1948 have been 18 years long each.
Since 1880, Secular Bull markets have roughly been in force 41% of the time while Secular Bear markets have been in force for 59% of the time. Stocks have grown (in real terms) at a 12.8% annual rate during the secular bull markets since 1900 but have lost investors -3% annually (in real terms) in the secular bear markets in the same period. Average real loss during any of these secular bear markets over the 15 to 19 year period was 42%.
Figure 3 below dramatically illustrates the cyclical nature of the long-term returns available from buying and holding the market. We will somewhat arbitrarily call a long-term real return above 4% as being “good” and below 4% as being “poor”. The green shaded regions are the “good” years to retire in and the red shaded regions are the “poor” years to retire in. These green and red shaded areas correspond to secular bull and bear markets respectively shown in Figure 2 (except being shifted forward by a few years as one would expect since we are looking back 10 yr to 30 yr to calculate returns). So whether a long-term investor’s net return, after adjusting for inflation, was positive or negative, was mostly a matter of when he started and when he stopped investing, i.e. whether he was born at the right time and/or retired at the right time or even made his investable money at the right times. Most people today are rapidly falling into the “unlucky” category. If these cycles continue to hold, we should see a further deterioration in longterm returns in the 2nd decade of the 21st century as the cyclical pattern indicates. Looks like a bad decade or more to retire in for committed buy and holders, which a significant part of the population will be.
3. Buy and hold is not worth the risk or the heartache: buy and hold as a strategy has no risk management built into it. You buy, and then you hope for the best. If the markets start dropping, you keep holding, hoping that the market will eventually recover, hopefully sooner rather than later. In fact you are encouraged by your financial advisor, if you have one, to keep holding no matter what the draw-down (a technical term for the peak-to-trough drop in the value of your portfolio). Using the same real dividend reinvested S&P Composite data we have been using, Figure 4 shows the drawdown reached subsequent to each preceding portfolio peak. This is the “heartache” or “lurching stomach” factor which your financial advisors may not have prepared you adequately for when they try to sell you their services. Are you prepared to grit your way through a 50% drawdown? What if you plan to retire in 10 years … or 5?
Another way to look at this is to compare a Buy and hold strategy with other investments or strategies in terms of the risk-to-reward. Figure 1 above in the light red shaded area shows the risk-spread for investing in equities, i.e. the amount of excess 30-Year real return available from investing in the US stock market compared to the 30 Year real return from holding the 1-year T-Bills. The average 30 Year Real return for our Long-term stock market investor for the last 110 years has been 3.6%, only 1.62% higher than the 30 Year Real return for our Long-term 1-year T-Bill investor. Our stock market investor had to risk about $2 for each dollar of gain, to get a 1.62% higher yield than the almost no-risk T-Bills. And our hypothetical retirees obtained a risk-spread greater than 4% for investing in equities relative to the 1-year T-Bill in only 14% of the years since 1901. Is the possible gain worth the pain?
4. THIS TIME it IS very DIFFERENT: Many Wall Street firms and investment professionals are continuing to recommend holding stocks, sometimes albeit defensive ones, through this economy and are refusing to learn from the full historical record. The underlying assumption they are making about this downturn is that it is fundamentally not different from other post-40’s recessions. In September of 2010, there is still a very large camp of investment advice givers who continue to argue that double-dip recessions are extremely rare and that we will not see one after the 2008/2009 experience. In other words, business is as usual and the “make us whole” long-term bull market is right around the corner.
Reinhart and Rogoff, leading economists, in a comprehensive investigation of global financial crises going back 800 years compiled in their 2009 book titled “This Time is Different”, have this to say in the preface – “If there is one common theme to the vast range of crises …, it is that excessive debt accumulation, whether it is by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.
Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are. Such large-scale debt build-ups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short-term and needs to be constantly re-financed. Debt fueled booms all too often provide false affirmation of a government’s policies, a financial institution’s ability to make outsized profits, or a country’s standard of living. Most of these booms end badly.” In other words, this crisis is not made of the same cloth as other post-World War II recessions.
The Great Depression of the 1930’s was a crisis similar to this one in that it was also caused by excessive debt accumulation, rather than inventory corrections or inflation which have been the cause for other post-40’s recessions. For an investor who invested in the stock market in the late 1920’s, it would have taken 25 years before their account values were back to break-even. Hope does not preserve capital. Can you afford to wait?
5. Theories underlying buy and hold are full of holes: Buy and hold and the idea of building a diversified and static portfolio using domestic and global stocks and bonds according to one’s risk tolerance or investment goals, is built on the foundation of the Efficient Market Hypothesis (EMH), Modern Portfolio Theory (MPT), and the idea that markets follow a “Random Walk” rather than exhibiting any systematic structure. EMH is the idea that security prices are rationally determined, reflect all available information, and seek equilibrium. MPT, which resulted in a shared Nobel Prize in 1990 for its founder Harry Markowitz, puts forward the concept of diversification and the thesis that a portfolio can be constructed on the “Efficient Frontier” that optimally balances risk and reward from an “uncorrelated” selection of investments. The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk per the bell curve or Gaussian distribution and thus the prices of the stock market cannot be predicted.
Some significant facts that fly against these hypotheses are:
- Warren Buffett and successful market timers who have gotten lucky for a very long time (if these hypotheses are true)
- Structure that exists in the markets in terms of clear trends and repeatable patterns which manifests itself as fat tails in price statistics where EMH expects a normal Gaussian distribution.
- Large discrepancies between price and fundamental valuation of assets seen frequently over large time periods or during bear markets like 2008, and
- A correlation in global markets and asset classes seen most strongly since 2008 where most asset classes (stocks, bonds,
commodities, real estate, etc.), have generally dropped and then risen together, some more than others.
Until recently, theorists lacked exposure to a persistent, years long downtrend, so the belief in the Efficient Market Hypothesis (EMH) and the impossibility of a fully diversified crash persisted. According to this hypothesis, investors cannot consistently beat the markets because markets move in a random fashion and adjust instantly and rationally to the news. The only path to higher returns is to bear greater risk, however the theory goes on to propose that the risk can be reduced by remaining fully diversified at all times. Modern Portfolio Theory (MPT) builds off these tenets to propose an “efficient frontier” where risk is supposedly minimized and return maximized.
Counterarguments began surfacing in the media after the 2008/2009 market beating. A Feb 14th, 2009 headline from Barron’s proclaimed “Modern Portfolio Theory Ages Badly: The Death of Buy and Hold”. People are questioning the standard fifty year definition of “long-term” and calling for 100-300 years of data which provides a better perspective to understand the decline in 2009 and the subsequent market rally. Research that contradicts these modern financial theories from the budding field of behavioral finance and from top universities has also been emerging. Prechter and Wagner compile this research in a June 2007 paper published in the Journal of Behavioral Finance titled “The Financial/Economic Dichotomy in Social Behavioral Dynamics – The Socionomic Perspective”, in which they also propose an entirely new model based on the new concept of socionomics to better explain the workings of financial markets.
The most commonly held out explanation for these times by EMH practitioners is that 2008 was a “black swan” event, i.e. something that happens very rarely, and that things will happily get back on the “random walk” track and efficient markets will return for the long haul … so please go on buying and holding through this discontinuity, and in fact buy some more if you will, thank you. The scientific method would state that the exceptions render the entire theory untrustworthy, especially since there is no way to objectively determine when the theory would work and when it would not. Benoit Mandelbrot, the late Professor Emeritus of Mathematics at Yale and the author of The Fractal Geometry of Nature and The (Mis)behavior of Markets wrote in a 2006 Financial Times article that “The problem is that measures of uncertainty using the bell curve simply disregard the possibility
of sharp jumps or discontinuities and, therefore, have no meaning or consequence. Using them is like focusing on the grass and missing out on the (gigantic) trees. In fact, while the occasional and unpredictable large deviations are rare, they cannot be dismissed as “outliers” because, cumulatively, their impact in the long term is so dramatic … One can safely disregard the odds of running into someone several miles tall, or someone who weighs several million kilograms, but similar excessive observations can never be ruled out in other areas of life … Despite the shortcomings of the bell curve, reliance on it is accelerating, and widening the gap between reality and standard tools of measurement. The consensus seems to be that any number is better than no number – even if it is wrong. Finance academia is too entrenched in the paradigm to stop calling it ‘an acceptable approximation’.” Clearly, there is a massive disconnect between market behavior and economic reality and the rational behavior of investors. The pillars of modern financial theory may actually have been made of sand rather than stone. Do you want to build your financial house on these?
Though traditional investment approaches and their underlying theoretical bases cannot be “proved” wrong, the markets and those who understand them, and the buying power of a general investor’s portfolio values tell a different story. Progress was unleashed on the world after Kepler and Copernicus rang the death knell of the “Flat Earth” hypothesis in the 1500’s. Our goal is to manage portfolios based on theories that better align with market price and economic history, and which use tactical investment strategies and sophisticated risk management that seeks to preserve your capital, expose your portfolios to less risk for higher potential returns, and provide absolute returns independent of market direction.
The Absolute Return Opportunity
It becomes apparent after a quick study of a long-term price chart, like the chart shown above above, that markets tend to trend – either upwards, or sideways-to-downwards and are not random. If an investor had purchased stocks at the bottom of each of the secular bull markets since 1900 and sold them at the top of the bull market, then the investor would have earned an annualized real dividend re-invested return of 5.1% versus 3.2% if they had simply bought and held stocks for the entire century. If the investor had shorted stocks during the secular bear markets, the investor’s real return would have increased to 6.9%. But it is impossible to time the markets this way, you may be thinking. To be this accurate, maybe not, however there are trend-following and trend forecasting techniques that have been shown to capture 25% to 50% or more of a trend and/or keep one’s portfolio out of trouble.
To illustrate this, a simple trend-following system constructed from a 45-day moving average is shown along with its profitability from January 2008 to August 2010 in the next figure. A buy signal is given when the S&P 500 crosses above the moving average line and a sell signal is given when the S&P 500 crosses below the moving average line. There is some filtering that has been included to reduce false signals. This simple trend-following system has provided an annualized return from January 2008 through August 2010 of 21.8% compared to an annualized 14.3% loss for the S&P 500 buy and hold investor. In addition, the maximum drawdown of this strategy was 13% versus 56% for the buy and hold strategy using the S&P 500. The green bars on the top graph show the growth of the initial $100,000 to $165,000.
There are other trending degrees, for example primary trends which last for 1 to 5 years, and secondary or intermediate term trends which last a few months to 2 years, and shorter trends all the way down to intra-day trends. We have determined that timing short-to-intermediate-term trends provides the best returns at the lowest risk for our trend forecasting and trend following methodologies. We believe contrary to popular opinion that returns are not a matter of “time in the markets” but of “timing the markets”, i.e. of using robust methodologies that are designed to harness the inherent structure in the markets and to align the direction of your portfolio and capture significant portions of these inevitable trends while controlling risk through active money management.
