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Generalists in Search of Specialists
The story of the quarter was all too familiar. The market declined 6% after a tariff-related tweet from President Trump only to fully rebound and then some when the Fed shifted course and signaled a rate cut. Bonds had a strong rally and global bond yields are now at 120-year lows. Some $15 trillion of euro- and yen-denominated bonds now have negative real and nominal yields. Yes, investors are contractually committing to an economic loss by owning those instruments—it’s only somewhat better in the U.S. where ten-year inflation bonds are yielding 0.3% per annum.
The love-hate relationship between the markets and the Fed continued into 2019 as equities staged a strong recovery following a particularly severe period in the capital markets. Just as the Q4 market collapse had a lot to do with Fed hawkishness at a time of slowing growth, the big reversal came after the Fed abruptly changed their stance on inflation to one of “patience” and more of a “whites of their eyes” approach.
The fourth quarter of 2018 was an extremely difficult period in the markets. A confluence of issues—including concerns about decelerating economic growth, Federal Reserve policies and political gridlock—significantly impacted investor sentiment. U.S. equities were down 14.3% and smaller capitalization stocks declined 20.2%. Non-U.S. equities fared only somewhat better, and oil was down 38%. The quarter had many “worsts,” including the worst December in U.S. equities since 1931.
The third quarter of 2018 saw a continuation of robust fundamentals in the U.S. but more fragile conditions in foreign markets. Foreign economies have been more affected as trade tensions have escalated and U.S. interest rates have risen. The dollar continued to rise during the quarter, as did U.S. bond yields which are at near fifteen-year record spreads versus those in Germany and Japan. U.S. equities ended the period up 10.6% for the year versus -1.4% for developed market equities and -7.7% for emerging market equities.
Few investments are immune to macro events and the risks posed by a trade war and an inflationary spike certainly could be in that category. Though most of our investments are selected through a “bottom up” process with a heavy reliance on fundamental analysis, a broader perspective on these risks and the market environment is important for understanding and managing overall portfolio risk.
The volatility experienced in February and March is striking, not because it was so elevated, but because markets had been so uncharacteristically calm, especially in 2017. The VIX index of volatility returned to where it was in early 2016, and not much higher than its median value since 1990. Of course, volatility itself is not risk, but it does correlate with an increased probability of future loss. To evaluate implications for portfolio risk going forward, one must understand the underlying causes of volatility.
The year 2017 was characterized throughout by rising markets against a backdrop of record low volatility. A solid world economy, robust earnings growth, continuing low bond yields and tame inflation together made for a Goldilocks market environment. All of this was the more remarkable given heightened geopolitical tensions and the fractured state of domestic politics.
Investing in Equities in Today’s Growth Environment
The high valuation of equity markets in recent years—especially U.S. equities—has been a constant point of vigilance for us, not because we have a distinct edge at the macro level, but because equity market exposure usually represents the most significant component of portfolio risk. Our major concern is with the potential for non-rational behavior to create excesses which may have systemic portfolio consequences.
The second quarter of 2017 saw a continuation of calm and rising markets against a backdrop of heightened political gridlock and uncertainty. Market volatility, which started the quarter at near historic lows, remained there with two brief exceptions: the first surrounding the French elections when markets feared a Brexit-like sentiment might lead to a surprise outcome, and the second corresponding to the firing of FBI Director Comey and his subsequent congressional testimony.
Equity market valuations are unambiguously high today. A Goldman Sachs study covering the last 40 years puts the S&P 500 index today in the 89th percentile of valuations and the median stock in the index at essentially all-time highs. This raises two questions: (1) why are equities priced so expensively and (2) what does it portend for future returns.
2016 was a year punctuated by outsized market reactions to pivotal political and other events—most notably the oil price shock, the Brexit vote, the U.S. election, and the Fed’s decision to raise interest rates.
Risk-averse behavior is normal. It drives investors to diversify their exposures and to demand compensation for bearing risk. Today, however, investors seem to be paying up very significantly for any sign of economic certainty and clarity. Bonds are a prime example. With yields hovering around all-time lows, investors are paying a tidy sum for a next-to-nothing—albeit certain—return. Austria just the other day issued a 70-year bond at a 1.5% yield and it was oversubscribed nearly 4:1.
We live in a difficult economic environment with few signs of improvement. Markets have continued to oscillate in a wide band, and bond yields are down sharply this year. Other economic metrics include corporate earnings, which have been in decline for at least the past 12 months, and GDP growth, which is sluggish.
It’s always dangerous to say that it is different this time but we absolutely live in an era that has little precedent. Most obvious is today’s low levels of interest rates and bond yields. Nominal interest rates have never been this low, except in the United States during the Great Depression and its aftermath. The world today is nowhere near as bleak as it was then (we’re absolutely not in the “sell everything” camp), but the combination of low rates, high valuations, high debt levels and high savings in the global economy is unparalleled.
The year 2015 was a perilous period for investing. Global equities ended down a modest -2.4% but this figure masks dramatic price swings, steep declines in emerging market equities and energy prices, and a marked deterioration in credit markets. It was also a difficult period for investing with a value bias. We will elaborate but suffice it to say that the market conditions of 2015 underscored the importance of maintaining a disciplined approach to risk control and patience in pursuit of return.
As the market began its precipitous decline, an important barometer of risk, the VIX index, more than
tripled and remained elevated for the remainder of the quarter. The VIX, which reflects the price that
market participants are paying for downside protection, is a well-known fear index—and for good reason. The chance of significant future loss in broad equities is much higher when the VIX is elevated.
The second quarter and first half of 2015 comprised periods of extended market calm interrupted sporadically by turbulence related among other things to China, Greece/Europe, and energy prices. Today’s macro conditions represent in many ways a continuation of what we experienced in the latter half of 2014.
Foreign equities had a much better quarter than U.S. equities. This is a rare exception to what has otherwise been a remarkably consistent pattern of U.S. outperformance since the end of the financial crisis. Over the last six years, U.S. equities have done better in both up and down markets, in volatile and calm, and when measured in local currency or not.
The questions from this historically unique period are at least several: Why did U.S. equities outperform? What impact did this have on the performance of institutional investors, especially in the U.S.? Are the prospective economic conditions similar to those experienced over this period such that this pattern might continue?
Asset Class Diversification: This Time Was Different, Again
Some two years ago, in a white paper titled “Asset Class Diversification: This Time Was Different,” we wrote about the notably poor performance of diversified portfolios since the financial crisis relative to a simple portfolio of U.S. stocks and bonds. Prior to 2008, investors were rewarded with higher returns as well as lower volatility by broadening into asset categories such as foreign equities, foreign bonds, real estate, and commodity-related areas. Since then, however, diversification away from U.S.-centric portfolios has not been a winning strategy; a finding that was even more pronounced in 2013-2014.
Safe Haven or Danger Zone? Crowding Risk in Low-Volatility Investments
Over the past decade, interest in low volatility strategies has surged with institutional and retail investors alike. With increasing popularity comes increased risk of crowding and the potential for lower returns in the future. Recent headlines discussing impending and violent underperformance of low volatility investing command further investigation into whether this investment approach has entered dangerous territory. After examining the state of low volatility investing through several lenses, we show that increased popularity has led to a more crowded trade, however we do not conclude that investors should immediately abandon these strategies. Instead, we believe avoiding this crowded trade can be achieved through more thoughtful approaches to implementation.
Home Runs and Strikeouts: Complexity Bias in Baseball and Investing
Investor interest in quantitative investing has surged while data availability, computing power, and quantitative talent have never been greater. Both allocators and quantitative investors face a daunting array of choices and investment options. We describe a bias which skews these decisions toward complexity and away from more simple and robust solutions—we call this Complexity Bias. It arises through a combination of three forces: external pressure from clients to innovate, internal pressure from researchers to contribute, and the tempting improvement in backtest performance that complexity inevitably brings. This performance improvement is illusory and failing to recognize and guard against this bias yields opaque investment processes with subpar out-of-sample performance. We utilize a more approachable subject, baseball, to illustrate these principles while demonstrating parallels to quantitative investing themes.
When and how the current environment may change for the worse is anyone’s guess. High on the list of suspects would be disappointing corporate earnings and an unanticipated shock to inflation and interest rates. Our main protection against earnings risk is to utilize managers with a strong value bias whose expertise lies in bottom-up security selection. However, protecting against an inflation or rate shock is much more difficult.
Beware the Dumb Money: Why Endowment Style Investing Matters Even More Today
Public market investing is a zero-sum game, and understanding who is on the other side of any trade is important when seeking to outperform. This paper lays out perspectives on alpha generation in a world where unsophisticated investors (“dumb money”) seek to become less exploitable. Indexing is one manifestation of such behavior; small order share executions is another. Both exemplify how capital market innovation can change the landscape of players—and their requisite skills—and consequently affect the opportunity set for generating alpha. Private market investing is less burdened by the zero-sum constraint and by free riding by others. While much costlier to pursue and no less subject to overheating than any market segment, it is an area in which skilled investors should be able to extract a disproportionate share of the gains for their efforts. Endowment style investing is well suited for the pursuit of alpha in today’s capital markets. It is a good match given the greater need for flexible, patient and opportunistic capital, as well as for the opportunity set provided by less liquid investments. The approach matters more today for alpha generation even as the bar is higher on the skills required to execute on this model successfully.
Risk Stabilization: Improving the Risk-Return Tradeoff
Any approach to asset allocation should be evaluated on at least two metrics: first, is it consistent with my tolerance for risk? Second, does it maximize my return given the amount of risk taken? We present an approach to satisfying these dual objectives which has proven effective over time and across many markets and cycles. We call this approach Risk Stabilization. In this white paper, we highlight the principles which underlie this approach, specifically that: (1) Market risks are dynamic, (2) Market risk today is a good predictor of future risk of loss, (3) Higher market risk today does not translate into higher expected return, and (4) Risk Stabilization adds value over time by allocating capital when and where the risk/reward tradeoff is most attractive.
Negative Real Interest Rates: The Conundrum for Investment and Spending Policies
U.S. real interest rates are negative today, which means that fixed income investments—which historically have earned almost 3% per annum over inflation—now offer a negative (real) return. Short of unusually strong equity market returns, a traditional portfolio such as 60/40 equities/bonds will not be able to support a 5% spending rate for endowments and foundations. In this environment, the onlyone way to achieve a 5% expected real return is through greater risk taking. Yet for many institutions still reeling from recent portfolio losses, higher allocations to risky asset classes are not an attractive option. Is there an alternative? While no solution is right for all institutions, the paper outlines four guiding principles on which to make decisions going forward—principles that, when prudently followed, can help endowments overcome the headwinds posed by today’s negative real yields without dramatically increasing their risk beyond their institution’s historical tolerances.
Asset Class Diversification: This Time Was Different
Diversification is the cornerstone of asset allocation—the only “free lunch” in investing. Over the last four decades, diversifying into assets such as foreign equities, real estate and commodities reduced portfolio risk while adding to return. But the years since the financial crisis stand in stark contrast as traditionally diversified portfolios have achieved lower returns with much greater volatility than a plain vanilla 60/40 U.S. stock/bond allocation. In this paper, HighVista examines the factors that led to this dramatic reversal, whether they are likely to continue, and draws several critical implications for investors.
Performance of the Large University Endowments: Can it be Replicated?
Large endowments have consistently outperformed the endowments of smaller institutions over much of the past decade, but the sources of this performance are not well understood. Do the significant advantages that large endowments possess in terms of resources and expertise give them an edge when it comes to generating true outperformance from active management? Is bigger simply better when it comes to an institution’s ability to identify, vet and gain access to talented hedge fund and private equity managers? Are smaller institutions up to the task of emulating their larger peers, or are they simply following a “paint by number” asset allocation approach that is destined to fall short? Using reported asset allocation and performance data since 2002, we evaluate the relative contributions of differences in portfolio risk levels, active strategies and asset allocation of endowments, concluding that the quest of many small institutions to match the success of large endowments is anything but a ‘David Beats Goliath’ story.
The Endowment Model of Investing: Still Worth Pursuing?
The investing climate of the last few years has been an unusually difficult one for large and small endowments. Dramatic swings in performance have caused Investment Committees to question virtually every principle of investing, from asset allocation and diversification to manager selection, liquidity management, and investment horizon. Against this backdrop, we examine whether portfolios with substantial allocations to hedge funds, private investments, real estate, commodities, and emerging markets, paired with minimal holdings of fixed income investments and cash, are appropriate for every institution. An update to a 2009 paper exploring the lessons of the 2008 financial crisis, this paper shines a spotlight on the implications for Investment Committees when they take on too much portfolio risk, don’t have the internal talent in place to continuously adapt risk exposures to changing market condition, and don’t conduct disciplined and rigorous due diligence when selecting external managers.
Home Runs and Strikeouts: Model Complexity and Backtest Success (Quantopian)
Chris Covington, a Principal in HighVista's Systematic Strategies team, discusses on Quantopian how the team utilized baseball data in conjunction with investment data to illustrate the practical challenges faced by quantitative investors today.
André Perold – Academic Practitioner (Capital Allocators, EP.02)
André Perold, HighVista’s CIO and Managing Partner, talks to Ted Seides about teaching at Harvard, then discusses the practice of investing: the active vs. passive debate, a risk-based approach to asset allocation, and what makes investing so hard.