Tag Archives: cullen-roche

Passive Investing – I Doth Protest Too Much

One of my favorite blogs, The Monevator blog , did a brief write-up on my new paper this weekend . If you don’t read their website you’re missing out because they consistently post some of the best financial content around. Anyhow, they had a very fair and objective view of the paper and approach to portfolio construction. However, one point that I seem to lose a lot of people on is my discussion of active and passive investing. So, I wanted to take this space to clarify a bit. Financial commentary doesn’t have a uniform definition for passive investing. Googling the term brings up the several different results: Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio. – Wikipedia Passive investing is an investment strategy involving limited ongoing buying and selling actions. – Investopedia The first definition is vague because there are limitless numbers of market cap weighted indexes these days, some of which are not well diversified and not low fee. Additionally, why should passive indexing be limited to market cap weighted index? Is it really correct to say, for instance, a fund like MORT , with 23 REIT holdings, reflects passive investing better than say, the equal weight S&P 500 ETF? An “index” is a rather arbitrary construct in a world where there are now tens of thousands of different indexes. The second definition is equally vague since an investor can hold a handful of stocks in a buy and hold strategy and limit ongoing buying and selling. Clearly, we shouldn’t call that passive investing in the sense that a low fee indexer would advocate. The new technologies such as ETFs have really muddled the discussion here as there’s now an index of anything and everything. So, as Andrew Lo notes: “Benchmark algorithms for high-performance computing blurred the line between passive and active.”¹ Along the traditional low fee indexing thinking I am tempted to define passive indexing as any low fee, diversified & systematic indexing strategy. But that could include all sorts of tactical asset allocation strategies that have systematic allocations. I don’t think it’s appropriate to call a tactical asset allocation strategy “passive”. So we’re back to a very blurry area in this discussion. In order to clarify this discussion I arrived at the following simple distinction: Active Investing – an asset allocation strategy with high relative frictions that attempts to “beat the market” return on a risk adjusted basis. Passive Investing – an asset allocation strategy with low relative frictions that attempts to take the market return on a risk adjusted basis. This definition has its own problem because we have to define “the market”. Is “the market” the USA, global stocks, global bonds, etc.? I’d argue that “the market” is the Global Financial Asset Portfolio, the one true benchmark of all outstanding financial assets. Therefore, anyone who deviates from this portfolio is making active decisions that essentially claim “the market” portfolio is wrong for them. This would mean that the only true “passive” strategy is following the GFAP. Obviously, not everyone does that and in fact, probably no one does it perfectly so that would mean we’re all basically active. Some people are active in silly ways (like day traders) and others are active in smart ways (diversified inactive indexers). Of course, I am a full blown supporter of low fee, low activity indexing. So please don’t confuse this as an attack on “passive indexing”. And yes, I am admittedly being overly precise. I certainly doth protest too much as Monevator says. But I am really just trying to establish a cohesive language here because I see too many people these days claiming they’re “passive” when they’re really being quite active. The worst offenders of this language problem are high fee asset managers who sell “passive” strategies cloaked as low fee platforms. I find that dishonest and extremely harmful. A little bit of clarity in this discussion is helpful in my opinion. ¹ – What is an Index? Lo, Andrew.

Why Stock Market Declines Are Good

James Bullard, the St Louis Fed President, gave an interview today discussing how the stock correction has been good because it has helped to prevent a bubble. He’s inferring that lower prices are bad in the short term and good in the long term. And he’s totally right. I’ll show you why. What happens when the stock market booms is that future returns get pulled into the present. Stock bubbles are dangerous because they pull so much of that future return into the present that they create an abnormal amount of temporal balance sheet instability. I’ve referred to this pricing change as a “price compression” in my book and elsewhere. It’s a fairly simple concept and can help us understand what happens to prices in the short term relative to the long term. In essence, when prices boom in the short term, we pull future returns into the present which often reduces future returns. For instance, imagine a zero coupon bond like a Treasury Bill yielding, for fun, 3%.¹ This Bill will sell at $97.09 and will mature at par plus your 3% in 1 year. Now, imagine that interest rates shoot higher to 6% right after you buy this Bill. The price of your Bill will fall to $94.34 for a 2.83% loss. But that’s just a short-term unrealized loss and not necessarily a realized loss. After all, if you hold the Bill for 1 year you will still get your $100 plus 3% in interest. So, what’s happening here? The price of the Bill has compressed as the market environment changed. Had you purchased another Bill immediately after the price decline you would have earned 5.99% on the second Bill. If you’d doubled down on the first Bill you would have earned an average return of 4.49% on both Bills thereby increasing your average return. The price decline was bad in the short term, but it was good in the long term! In other words, as prices compress positively (think bull market) in the short term they tend to pull future returns into the present thereby lowering future returns, whereas, when prices compress negatively (think, bear market), they push future returns higher. Stocks, while not perfectly analogous to bonds, are essentially coupon paying financial instruments. For instance, rolling mutli-year dividend payments from corporate America have been remarkably stable throughout history.² Now, the problem with the stock market is that the stock market has a very long and relatively imprecise duration³, but by my calculations it’s about 25 years at present. Of course, most people don’t have that kind of patience. But with a bit of clever analysis it’s not hard to build an asset allocation model that reduces that duration by mixing fixed income instruments with stocks making all of this much more precise. And in doing so, you’re essentially capturing that price compression concept in a very intelligent manner by realizing a few things: Price declines are bad in the short term, but good in the long term. Buying dips isn’t just for market timers. It’s for the savvy asset allocator who realizes that price declines will tend to boost future returns. The trick is making sure the duration of your asset allocation matches your overall investment time horizon! The problem with most of today’s stock market asset allocators is that they spend too much time judging a 25 year instrument inside of a short-term time horizon thereby resulting in faulty analysis, excessive activity and all sorts of behavioral biases that reduce future returns. ¹ – I know, I shouldn’t technically call a T-Bill a zero coupon bond, but that’s essentially what it is. And yes, 3% yielding T-Bills were the golden days! ² – See Robert Shiller in ” Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends? ” ³ – I like to think of Corporate America as one aggregate living entity. It doesn’t die. It just evolves over time and shifts a growing pool of profits from one legal entity to another to another (usually changing names or getting gobbled up over time) all adding up to higher profits in the aggregate, in the long run.

Assessing The Utility Of Wall Street’s Annual Forecasts

It’s that time of year when everyone starts preparing for the New Year and Wall Street makes its 2016 predictions. I’ll get right to the point here – these annual predictions are largely useless. But it’s still helpful to put these predictions in perspective, because it highlights a good deal of behavioral bias and some of the mistakes investors make when analyzing their portfolios. The 2016 annual stock market predictions are reliably bullish. Of the analysts that Barrons surveyed, they found no bears and an expected average return of 10%. This is pretty much what we should expect. After all, predicting a negative return is a fool’s errand given that the S&P 500 is positive about 80% of the time on an annual basis. And the S&P 500 has averaged about a 12.74% return in the post-war era. So, that 10% expected return isn’t far off from what a smart analyst might guess, if they’re at all familiar with probabilities. There is a chorus of boos (and some cheers) every year when this is done. No analyst will get the exact figure right, and there will tend to be many pundits who ridicule these predictions despite the fact that expecting a positive return of about 10% is the smart probabilistic prediction. In fact, if most investors actually listened to these analysts and their permabullish views, they’d have been far better off buying and holding stocks based on these predictions than most investors who constantly flip their portfolios in and out of stocks and bonds. But that’s the reason why these predictions exist in the first place. Because every year, investors perform their annual check-ups and evaluate the last 12 months’ performance before deciding to make changes. And of course, Wall Street encourages you to do exactly that, because turning over your portfolio means increasing the fees paid to the people who promote these annual predictions. But when we put this analysis in the right perspective, it becomes clear that this mentality is misleading at best and highly destructive at worst. Stocks and bonds are relatively long-term instruments. The average lifespan of a public company in the USA is about 15 years.¹ And the average effective maturity of the aggregate bond index is about 8 years.² This means an investor who holds a portfolio of balanced stocks and bonds holds instruments with a lifespan of about 11.5 years. When viewed through this lens, it becomes clear that evaluating a portfolio of long-term instruments on a 12-month basis makes very little sense. What we do on an annual basis with these portfolios is a lot like owning a 12-month CD that pays a one-time 1% coupon at maturity and getting mad that the CD hasn’t generated a return every month. But this annual perspective makes even less sense from a probabilistic perspective. As I’ve described previously , great investors think in terms of probabilities. When we look at the returns of the S&P 500, we know that returns tend to become more predictable as we extend time frames. And the probability of being able to predict the market’s returns increases as you increase the duration of the holding period. While the probability of positive returns becomes increasingly skewed as you extend the time frame, there is still far too much randomness inside of a 1-year return for us to place any faith in these predictions. The number of negative data points is only a bit lower than the number of positive data points, even though the average return is positively skewed: (click to enlarge) So, at what point do returns become reliably positive? If we look at the historical data, we don’t have reliably positive returns from the stock market until we look about 5 years into the future, when the average 5-year returns become positively skewed. A 50/50 stock/bond portfolio has a purely positive skew, with an average rolling return of 3 years. Interestingly, this stock market data is just as random even though it’s positively skewed. So, trying to pinpoint what the 5-year average returns will be is probably a fool’s errand (even though stocks will be reliably positive, on average, over a 5-year period). (click to enlarge) All of this provides us with some good insights into the relevancy of making forecasts about future returns. When it comes to stocks and bonds, we really shouldn’t bother listening to or analyzing predictions made inside of a 12-month period. The data is simply too random. As we extend our time horizons, the data becomes increasingly reliable with a positive skew. But it still remains a very imprecise science. The bottom line – If you’re going to hold stocks and bonds, it’s almost certainly best to plan on having at least a 3-5 year+ time horizon. Any analysis and prediction inside of this time horizon is likely to resemble gambling. As Blaise Pascal once said, “All of human unhappiness comes from a single thing: not knowing how to remain at rest in a room”. The urge to be excessively “active” in the financial markets is strong; however, the investor who can take a reasonable temporal perspective will very likely increase their odds of making smarter decisions, leading to higher odds of a happy ending. Sources: ¹ – Can a company live forever? ² – Vanguard Total Bond Market ETF, Morningstar