Climbing the Mountain
May Market Report

 

The S&P 500 gained 1.16% in May, bringing its YTD return to 7.73% and 8.66% with dividends. The S&P SmallCap 600 posted a broad -2.25% decline in May. The loss pushed the index into the red YTD with a -0.67% loss, while one-year gains stood at an impressive 18.01%, thanks to the index’s 33.02% 2016 gain. 

 

International Developed Markets added 3.33% in May, bringing their YTD return to 12.72% with dividends. The one-year return was up 15.75%.

 

Emerging markets added 1.44% in May and were up 14.66% YTD; the one-year return was up 22.54%.

 

Interest rates ticked down in May. The 10-year U.S. Treasury Bond closed at 2.25%, down from last month’s 2.28% and 2.45% at year-end 2016. The 30-year U.S. Treasury Bond closed at 2.92%, down from last month’s 2.95% and 3.07% at year-end 2016. 

 

Gold closed at $1,268.30 per ounce, up from $1,152.00 at 2016 year-end. Oil closed the month at $49.49, slightly up from last month’s $49.21 and $53.89 at year-end 2016. VIX, “the fear Index,” continued down, closing at 9.90, as it traded as low as 9.56—its lowest level since December 2006. 

 

 

There’s always a next new thing in investing. That’s how Wall Street lines its pockets and active investment advisors rake in high fees. Liquid alternative strategies promise to turbo-charge the benefits of diversification. And quantitative strategies use proprietary models to try and beat the market. There are shortcuts to the mountaintop, if you believe the Wall Street marketing machine. 

 

Can investors really reap more using these new strategies? The evidence so far says “no.” Still, it can be hard to resist the siren call of sexy solutions that promise to alleviate investor insecurities about missed opportunities to reduce risk or capture higher returns. Here’s a closer look at these products and the research that casts doubts on their claims.  

 

Liquid alternatives, a catch-all category for hedge fund strategies packaged as mutual funds, sell investors on the promise of positive returns—with a twist. In pursuit of these gains, liquid alternatives attempt to capture positive returns that are uncorrelated with the market. 

 

They start with the global stock and bond markets to which all investors have inexpensive access, then depart from traditional strategies by selecting, weighting and sometimes shorting securities, using leverage and illiquid derivatives. 

 

Investors are apparently buying the pitch: An April 6 WSJ article reports that money flowing into these funds soared from $72 billion at the end of 2010 to $360 billion by the end of 2014. The same article warns: “Some investors may be surprised by how some of these funds perform in turbulent markets.” That’s because unlike hedge funds, liquid alternatives may be forced to sell quickly into illiquid markets during a market slide in order to meet redemptions, with nasty results for investors. 

 

Of equal importance is how these funds correlate with the market. A DFA study by Marlena Lee found that in aggregate, the liquid alternatives had high correlations of 0.91 with US and global equities. While the difference in correlations between the 10th to 90th percentile varied dramatically, swinging from 0.01 to 0.93 due to the wide range of fund strategies, the average fund was correlated about 0.55 with equities, implying that the diversification benefit may be overstated. 

 

How have the strategies performed over a full market cycle? The results so far are unimpressive. According to DFA’s Marlena Lee, “From June 2006 to December 2015, these funds in aggregate returned 49 basis points annualized, which was half the return on one-month US Treasury bills and with far more volatility. These funds also fell far short of broad equity and fixed income indices. Some of this underwhelming performance is likely due to high turnover and fees. With an average expense ratio of 1.38%, the benefit to the fund managers was almost three times as large as that to the investor.” 

 

As is often the case, liquid alternative fund advisors are clever about playing to expectations that there is a free lunch for those smart enough to have a seat at the table. But they’re not the ones taking the risks, they’re simply collecting the hefty fees. Many Investors who believe they’re getting more for their money are going to be disappointed. 

 

Research has demonstrated that equity, size, value and profitability premiums persist across markets over long stretches of time. But here’s the rub: These premiums are not always reliably positive. Sometimes they dip. Sometimes they rise. If mean reversion exists and highs are followed by lows and vice versa, there’s money to be made. But you would have to be able to accurately predict when to move in and out of equity markets or between asset classes. That’s the nut quantitative models hope to crack.  

 

Jim Davis at DFA ran extensive research to study this issue. The questions he looked at included how long it takes a pattern to unfold—three years, five years, longer? And should one expect to return to the same level as when returns deviated, or does the mean shift over time? He researched 15 different markets around the world, including the US, examining different premiums and return differences within those markets and testing different trading rules. In the end he had 780 test results. Some showed strongly positive returns, but because there were so many results this may have been the result of random chance. Another issue: the high returns were most often due to a single year of data, meaning they may not persist over time. The conclusion: “One cannot rule out the existence of mean reversion in security prices but after looking at 780 tests the research doesn’t show evidence that mean reversion is strong enough to produce profitable trading strategies.”

 

Another DFA study by Wei Dai examined whether premiums could be predicted using popular aggregate valuation ratios such as earnings-to-price and book-to-market. The short answer: “Going through all of the 680 simulation results reveals that not a single timing rule consistently outperformed the simple buy-and-hold strategy.”

 

Putting aside doubt for a moment, let’s assume quant-driven strategies can deliver higher returns for investors on a back-tested basis. There’s an infinite number of quant strategies, and if you search long and hard enough you’ll surely find something that worked. But just because it worked in the past doesn’t mean it will work in the future; it’s entirely possible fundamental shifts have occurred that make a back-tested model irrelevant. 

 

I can’t offer shortcuts to your goals. Instead I encourage you to capture what the market returns, control the risks you can control, and stick with a proven strategy.   

 

Passive investors understand the benefits of diversification better than most. In fact, it’s been called “the only free lunch in investing” because it can temper risk without hurting returns, and boost returns without adding risk. We know that it works based on decades of research. 

 

But some investors want more. They feel they deserve more. Smart, financially savvy people are not immune to this kind of thinking. Warren Buffett estimates that at least $100 billion has been lost to pension funds, endowments and wealthy individuals over the last decade due to sky-high hedge fund fees (NYT, Andrew Ross Sorkin, 27-February 2017). Their money, they feel, should buy them something superior compared to the market return.  

 

Most of my clients know better. Even so, I regularly get emails asking about alternative strategies as a means to mitigate risk or capture excess return. This is when I advise people to use reason. Conduct a careful analysis of what has to happen for any given strategy to succeed. How does this new strategy work? Many new financial products exude a sort of intellectual sexiness. And the people selling them are so competent, smart and convincing that it’s hard to resist. That’s what the powerful marketing of Wall Street does to us. 

 

Resist. Be skeptical. It may get harder. We’re entering an era in which the promise and power of artificial intelligence encourage us to believe that markets don’t really behave the way we know they behave. Wouldn’t it be fantastic if we could move in and out of premiums, capturing all the upside with none of the downside? There is no holy grail. Unicorns don’t exist. 

 

Bottom line, it’s important to place trust in the collective wisdom of markets and to accept the reality that markets are unpredictable. You will have to withstand periods of underperformance when markets and your strategy aren’t doing well. And at those times it’s especially important to stick with a strategy based on solid research that is well accepted in the academic community. An opaque strategy requires blind trust which can quickly erode. An evidence-based strategy helps foster the discipline needed for better long-term financial outcomes. Ignore the clever promises and take the safe pathway to the mountaintop.