Why Didn’t Money Managers Protect Your Assets and Help Lead The Recovery?
On Oct 9, 2008, the flagship Fidelity Magellan fund closed below $50 a share, having lost more than 45% of its value in just under a year. If the fund returns 10% a year going forward, the market average, it will take more than six years to make up these losses, or more than ten if inflation is considered. Most other large mutual funds have suffered similar losses.
Now the money managers say it’s a time to buy. But what I believe most investors would like to know, is why should they trust their money to a market that’s so swift to destroy their hard-earned wealth, and to the money managers who have seemed so powerless to prevent economic ruin.
My response may shock you. In fact, the industry’s money managers and financial institutions knew about and had access to many strategies and tools that could have preserved your wealth, not just in this market downturn, but in all other downturns. They simply refused to offer them to you, leaving you completely exposed to the market’s meltdown.
Worthless Diversification
Money managers promise wealth preservation through the practice of broad diversification, in other words, buying lots of stocks. They purchase growth, value, large company, small company, international, energy, health care, and everything else they can find. The reasoning is that when some stocks fall, others will climb, offsetting losses and thereby reducing risk.
The problem is, diversification doesn’t work. For example, in September 2008, the monthly returns for those classes of stock are as follows: Growth -12%. Value -8%. Large companies -10%. Small companies -8%. Foreign -13%. Energy -14%. Health care -7%. All of the different investments that would have been in a portfolio fell by roughly the same amount.
What happens is that broad diversification turns a portfolio into a replica of the Vanguard Total Stock Market index, a reference portfolio based upon a cross-section of many different types of stocks. And this portfolio returned -9.5% in September 2008 and is down more than 40% from its peak last year. That’s the end result of stock diversification – a portfolio that is simply incapable of preserving wealth during poor market conditions.
Some money managers know that diversification within stocks is a fairy tale and encourage investments into other asset classes such as gold, REITs (real estate), or commodities. Even so, with such a rapid market decline, it’s obvious that a 10% or 20% alternative asset allocation wouldn’t have saved a portfolio. And these other investments haven’t raised either, they just haven’t fallen as much as the rest of the market.
The only way to effectively diversify is to select investments that don’t depend upon whether the market is up or down. Fortunately, these so-called “market-neutral” strategies are well known and relatively easy to engineer. Unfortunately, the overwhelming majority of money managers don’t bother, but instead just pretend that vast areas of financial theory, research, and innovation don’t exist.
Market Neutral
Let’s divide the companies in the S&P 500 into two groups. One group appears undervalued, so we will buy their shares. The other group looks overvalued, so we sell their shares short. As a result, we are invested only in the relative performance of one group of stocks in relation to others, but not the entire market, creating a “market-neutral” strategy that provides returns that are independent of those of the total stock market.
A skilled financial analyst could evaluate and rank all of the stocks by relative expected performance and then direct the portfolio manager to buy the top half and sell the bottom half. But there is an easier way. In the 1960s, Fama & French researched decades of stock market data and determined that small-cap and value stocks outperform their large-cap and growth counterparts.
This research is now taught to every first-year MBA student, however there is still no widely available investment that captures only the excess return produced by a long-short strategy focusing on these higher return stocks. The premium itself is easy to calculate and was +0.4% for the month of September, and +10% in 2008 YTD. Although it does fluctuate, providing negative returns in some months, clearly there is diversification potential there.
Not only have these two premiums held up for more than 40+ years, but others have also been found, including a momentum factor (stocks with clearly identifiable trends) and a volatility premium (a benefit of option sellers over buyers). Many of the factors are independent of or negatively correlated to the market, facilitating portfolio construction.
At this point, market-neutral strategies are primarily found in hedge funds. These unregulated investment vehicles have the freedom to select any investment strategy, but have high fees, are off-limits to all but the wealthiest investors, and can be very difficult to analyze. Still their popularity is ample evidence that the most knowledgeable and sophisticated investors are desperate for performance that is independent of the broader market.
For those without the opportunity to invest in hedge funds, a relatively small group of long-short funds is available from financial services firms. However, like hedge funds, their performance varies tremendously, and their general lack of transparency makes it impossible to determine why some have returned +10% in the past year while others are down 30% or 40%, essentially matching the losses of the broad market.
Portfolio Protection
Hedging is a financial transaction that protects an investor from a drop in the market value of an asset over a period of time. In the financial markets, this strategy is carried out through the purchase and sale of options, and more than 30 million contracts are traded every day. (Note: The hedge funds have nothing to do with hedging – it is an obsolete description of their business activities.)
However, very few money managers hedge their portfolios at all. Why not? Some view such a strategy as “betting against yourself”. Others don’t understand the options market and don’t know how to hedge, or believe it to be too expensive. But if we were to ask an investor if they would at least consider purchasing insurance against a 25% loss, the response would be overwhelming, especially after this month.
Also, variations in hedging costs convey market information that can be used for risk management. If the current price of a hedge is high, then the investment is risky, according to the market’s consensus. By combining this information across multiple investments, a money manager can develop a risk measure for the entire portfolio that helps to understand the potential outcomes of investment decisions.
And there are also times with the market outlook appears sunny and hedging costs fall rapidly. During these occasions, a cool-headed money manager could add tremendous value to a portfolio simply by taking some of the recent gains and purchasing long term portfolio protection, thereby reducing the amount of investor’s capital at risk.
Airlines hedge fuel prices. Farmers hedge crop prices. Gold mines hedge gold prices. Sports bookmakers hedge their books. Everyone hedges except, it seems, the professional who is responsible for ensuring that you have enough money to retire when you are too old to work.
Unmanaged Exposure
If an investment has been flat or falling for months or even years, how many investors would have the fortitude to not only hold on to it, but to add more money by selling shares of better performing investments? Very few, as it goes against human nature to abandon a winner and place a bet on a loser.
But studies show that rebalancing not only lowers risk in a portfolio, but in cyclical markets, can also provide better returns. And it’s not just good for investors, it’s good for the market. When investors take gains from rapidly rising investments, it helps to reallocate risk and reduce the speculative pressures that create bubbles.
Some money managers and investors do rebalance, and some don’t. But as we discussed in the section on diversification, selling a few small company shares and replacing them with those of larger companies won’t change a portfolio’s risk profile very much.
Where rebalancing is much more useful is if one of the assets in the portfolio is cash or short term bonds. In that case, rebalancing in a rapidly rising market takes money “off the table” and moves it to a more secure investment. Then when the market falls, rebalancing moves those same assets back into the market to take advantage of lower prices.
Otherwise, quite often investment gains remain in the portfolio, or even in the specific investment in which they were generated. Then at some point there is a sharp reversal, and the investor finds themselves dangerously overexposed. When that happens, the choice is between selling out and taking large losses, or holding on and facing total collapse – a dilemma that investors now are all too familiar with.
Going Forward
With millions of people planning to retire in the next several years, this stock market collapse could not have come at a worse time. Those Americans who did absolutely nothing wrong except to trust their retirement to money managers or mutual funds are now faced with trying to extend their working years in what are expected to be very poor economic conditions. The financial services industry has failed them.
Yet, somewhere right now, a money manager is meeting with a new client and showing them projections of how much money they will have in ten or twenty years based upon steady eight to ten percent growth. To meet the client’s goals, the initial investment will be divided between five or six different classes of stocks and a small allocation of bonds or commodities, leaving the client 80% exposed to the broad stock market.
And sometime in the future, the market will collapse, just as it did this year, and just as it did in 2002, and the investor will lose 40% of their money, or perhaps even more if their asset allocation is off. The money manager will encourage greater levels of investment to make up the difference, and will then try to find other clients to make up the lost asset management fees.
The industry needs to serve its clients better, and it needs to start right now while this market collapse is in the forefront of everyone’s mind. Otherwise in a few years investors will return to the market, lured back by slow and steady returns and a false sense of security, and will then put all of their money at risk just before the next extended downturn.
We need market-neutral funds that can manage hundreds of billions, or even trillions of dollars. Current long-short funds are poorly managed and have no transparency and the expense ratios are much too high. We can start by moving the technology from successful hedge funds into products suitable for and available to the average investor.
Next, individual investors must be given easy access to the hedging-related tools and information available in the options market. They need to know the current risk of a sharp portfolio decline and how much will it cost to hedge against that risk for a period of time. Also, “collared” investment products must be available that are incapable of rising or falling more than certain amount in a single year in order to help investors that are closer to retirement control their risk.
Finally, imagine if in the worst part of the next recession and market downturn, trillions of dollars of previous investment gains are moving out of cash equivalents and market-neutral investments and into the market, providing much-needed buying power and investment capital. This is possible with rebalancing, but it has to be automatic, and across not just stock funds, but also cash, bonds, and many other market-neutral investments.
This simple strategy if widely implemented could be a game changer, a tool for not only preserving investor capital, but also stimulating the economy during recessions and putting a floor under a falling market. The capital of money managers and their clients would no longer be at the mercy of recessions and market downturns, but would actually play a role in helping to lead the recovery.
Tristan Yates is the author of Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance and writes articles on index investing, options strategies, and leveraged portfolio management for Investopedia and Futures & Options Trader. He also helped lead the $1T Fannie Mae securities restatement. Yates has an MBA from INSEAD, a leading international business school.