Is Knowing What You Own, and Why You Own It
What to Own
As we discussed last week, besides knowing what is priced in, the most important thing is knowing what you own, and why you own it. One of the most pernicious biases that adversely impacts investors' portfolios is status quo bias, which is the bias toward standing still, toward doing nothing.* It is pernicious because it is so subtle. Yet, it can be quite detrimental to your wealth. If you have a 'balanced' portfolio, 60% comprised of equity investments, and 40% comprised of fixed income investments, the majority of the return the portfolio generates will come from the equity allocation. This means that the equity allocation will grow faster than the fixed income allocation. If one never rebalances the portfolio--sells off a portion of the outperforming equities, and reinvests in fixed income--the portfolio will quickly grow to become entirely an equity portfolio. At that point, all the eggs will be in one factor basket.
So, rebalancing is certainly important, but more important still is knowing what you're invested in, and why you're invested in it. Many investors hold investment portfolios of multiple different funds, individual stocks, and individual bonds, but perhaps they don't understand why they hold stocks and bonds if bonds grow more slowly. The idiom about not placing all your eggs in one basket is easy enough to understand and communicates the necessity of diversifying one's sources of risk; however, few investors understand that the so-called 'balanced' portfolio depends for its return completely on the profitability of the companies on whose equity they own a claim--directly, as in the form of a stock, or indirectly, as in the form of a fund: a portfolio of 60% stocks and 40% bonds derives 97% of its risk from the stocks within it. A basket that should have only six out of ten eggs in it actually cradles 97% of them.
The purpose of holding different investments within an investment portfolio, then, is to diversify the sources of one's risk so that one's wealth isn't beholden to the fate of one source of risk--which, in the case of most investors, is the profitability of global corporations, as well as the market's combined expectations of future profitability. Corporate profitability is a derivative of global economic growth, but there are other means by which we can gain access to that growth that don't require owning claims on the residual economic profit these firms produce. For example, we can access this growth through sovereign fixed income. We can also harness this growth through investment in the various factors of production, things like copper or timber. Investing in a diversified array of asset classes allow us to capture the returns to economic growth with various leads and lags, and it is the spreading out of our bets across value chains that allows our portfolio to react with less sensitivity to the business cycle and its immediate derivative, corporate profitability.
Importantly, the truly balanced portfolio holds not only those assets that allow it to capture the return of economic growth, but also those assets that do not depend upon economic growth for their value. There are three primary factors that influence the pricing of financial assets: growth, inflation, and volatility. We will devote an entire missive in the near future to the third of these, volatility, as it is the most important but least represented factor within investor portfolios.
Our final missive of 2023 touched on the fact that diversification went terrifically unrewarded in the most recent equity bull market, as owning anything but the best-performing stocks in the S&P 500 led an investor to far underperform. So was the case in 2021. However, diversification--by which we mean diversification of the sources of risk--is always important for two reasons: the first is that it is impossible to time the market with any degree of precision, so you can't just decide to diversify just before equities go down in price; the second is that diversification not only exposes a portfolio to things that might be up when equities are down, but it also exposes a portfolio to things that might also be up when equities are up, too. Not only is risk as measured by volatility lower, but return is higher because the investor gets more shots on goal. And when one enjoys more shots on goal, then one must rely less on any single shot to win.
Now, not every asset class has equal expected return. You can't replace the expected return of equities with that of a long-duration inflation-linked bond. The expected return on equities is typically 10%, while that for inflation-linked long bonds is typically around 4%. However, by using the magic of portfolio finance, we can use leverage to increase our exposure to inflation-linked bonds, and thereby make what is traditionally thought of as a safe asset into a risk asset. By levering up these safe assets, we can lower the level of risk we take in equities by selecting equities with lower volatility and lower beta (sensitivity of price) to equity markets.
We had lunch with a good friend the other day who offered some very helpful feedback that we will incorporate today.** First, he recommended that we provide here a statement of what we do to make money, and for whom we work. Second, he recommended that we discuss how we use the diversification of the sources of risk to construct portfolios that feature more return for the level of risk we take than can be obtained simply by investing in the S&P 500.
As to the first, besides syndicating what we believe is the most compelling and well-written investment newsletter around, we are an investment advisor. We use quantitative methods to make investments on behalf of our clients in these risk-balanced portfolios and charge a 1% annual fee for doing so. Even though the largest hedge funds in the world also do what we do, they typically charge six-to-eight times what we charge for the same returns; and while they will invest you in a commingled vehicle alongside other investors, we invest our clients in their own separate accounts from which they can redeem or to which they can contribute whenever it suits them. This is because our investments are all completely liquid, meaning they are traded on public exchanges with tight bid-ask spreads that function in an orderly manner except in periods of extreme financial distress. Even then, our clients are able to redeem should they wish to do so.
As to the second, we manage these portfolios for anyone who thinks that our investment philosophy is a superior investment philosophy. We have no investment minimums, as our investment process and trading algorithms are completely volume insensitive. We manage both tax-advantaged and taxable accounts, and can target different levels of risk according to the client's ability and willingness to take risk. For larger or institutional investors, we offer the same portfolio of exposures, but also offer the same exposures via derivatives (futures and options) that allows for greater capital efficiency. These are provided at a fixed fee that is indexed to the idiosyncrasy of the risks that our portfolio is expected to accommodate, the frequency of trading and nature of implementation.
What We Own
Our portfolio begins with the Global Market Portfolio (GMP). This is the portfolio of all global assets that are investable: public and private; domestic and international; investment grade and high yield; developed, developing and frontier. Since we can't tell the future, we believe that the smart thing to do is to take what the market gives us and place a chip on every pocket.
We also run dynamic factor models (dynamic because their factor loadings change according to what's going on in the economy) that allow us to make forecasts about growth, inflation and volatility. After we determine what the market's expectations are for the economy, we use our proprietary valuation models to determine whether current market pricing makes sense.
For example, the market currently anticipates that the Federal Reserve will cut interest rates five times in 2024, beginning in March. The markets estimate that the Fed will cut rates by .25 percent in March with a 74% probability. The market also thinks there's a 20% probability that the Federal Reserve will hold rates where they are in March. Given the strength of the economy as measured by leading economic indicators and the pricing of assets, our models estimate that the likelihood of a cut is closer to 20% than it is to 74%, and so our estimate of the fair value of floating rate debt instruments is higher than the market's. Therefore, our portfolio remains overweight floating rate debt. Similarly, the GMP is dominated by US equity exposure, as these have grown terrifically over the past year in the same way the unwatched equity exposure did in the portfolio of the inattentive status quo investor of our earlier example. We believe that US earnings growth is overestimated, with the result that valuations of equities are too rich. We are therefore underweight equities. Recognizing that we could be wrong, we still maintain some allocation to US equities, but via lower-volatility, lower-beta exposures.
We'll use these and other variant perceptions to tilt the portfolio in one direction or another to keep just ahead of the market. However, if we determine that the market's price is the same as our estimate of fair value, our models will maintain a neutral weighting, and our holding as a percentage of portfolio value will equal that of the Global Market Portfolio's. We're not trying to beat the market, only to not throw our lot in with the market's when we don't adjudge it to be prudent, or the risk improperly priced.
The economy is currently in the Late Boom/Early Recession part of the business cycle, so our positioning is broadly consistent with these dynamics. We expect continued growth, albeit at rates lower than those just experienced during the end of the rapid expansion in the third quarter. Consumption has peaked or slightly fallen, debt growth has been arrested, capacity utilization is constrained, Investment has been high, inflation remains elevated, housing, construction and durables are declining, and employment is above capacity. The recent easing of financial conditions has delivered modest monetary loosening which will prevent conditions from becoming outrightly recessionary, but the path of the economy is now in the hands of the Federal Reserve, or some unpriced exogenous shock (broader regional war in the Middle East, a breakthrough in Ukraine, extremist electoral success in developed countries). Accordingly, we are underweight equities with a tilt toward defensive equities (utilities, health care, and consumer staples); we remain overweight floating rate fixed income and are slightly overweight commodities. Given that markets are all-in on rate cuts in the spring and the likelihood of a soft landing, we are happy to take some of what the market has given us and reinvest it in long volatility assets, which are inexpensive at the moment and particularly useful during cycle transitions.
Why We Own It
We won't go into too much detail here about our current valuations and signals, but rather offer a more general rationalization for why we own the assets--really, factor exposures--we do. For example, we view the pricing of assets as being driven by three primary factors: economic growth, inflation, and volatility. Different asset classes allow us to harness exposures to these factors in varying degrees at various times in the business cycle.
Equities represent claims on firm profitability. They are a derivative of global economic growth in the case of open, developed economies. Their excess return over bonds is due to idiosyncratic company risk and the supply and demand dynamics for their shares. We don't find much value in the S&P 500 at this time, as much firm profitability is baked into prices. We therefore look for cheaper equities and find them in Europe, where they are cheap for a reason. The region is beset by slowed export growth and hidebound regulatory environments, to say nothing of their poor demographics and reticence toward immigration. Still, the earnings yields on their markets are reasonable, though not cheap, and so we focus on this supergeography for the equity exposure we don't get from Japanese equities and US value and small capitalization stocks and defensives.
Developed Fixed Income
Fixed Income, like Equities, are derivatives of global economic growth, but also provide some additional risk features that are diversifying. Sovereign Debt provides exposure to economic growth, capped at the level of the interest rate the issues carry, but this exposure is attenuated by the government's powers of taxation. We always hold an allocation to both Nominal and Inflation-Linked Debt, though we moderate this exposure according to the difference between inflation expectations and economic activity. Corporate Debt represents these same exposures, plus credit and recovery risk. Both Sovereign and Corporate Debt include some duration risk, too. Since Corporate Debt is rarely issued with attractive terms, and the market for its issues so competitive, there is rarely adequate compensation to justify the risk/reward tradeoff. We therefore underweight Corporate Debt.
Although Investment Grade (highly rated) bonds are unattractive, High Yield Debt, or debt issued by less credit-worthy borrowers, is occasionally priced attractively. The market for these issues is less competitive, and its price action tends to mirror that of the equity markets. Therefore, High Yield is really equity in disguise. That said, this category can become mispriced. Now is not one of those times, as the extra compensation they offer for the risk they carry is not rewarded highly enough. We are currently overweight this asset class, as we are able to obtain this exposure alongside an exposure to credit default swaps that reduce the risk of holding these issues. The result is a fixed income exposure with Corporate Debt-like risk and high dividend-paying equity return.
Real Estate Investment Trusts
Our portfolio maintains a sizable allocation to Real Assets, as these are effective hedges against the risks that Financial Assets carry. They are diversifying because they have lower correlations with stocks and bonds, owing to their inherent characteristics.
The majority of investors carry substantial exposure to Real Estate, as they own an office or a home. These are highly idiosyncratic and illiquid investments, and exhibit features of both stocks and bonds. We obtain our exposure to Real Estate's peculiar dual nature via liquid, publicly traded Real Estate Investment Trusts (REITs). In addition to their dual nature of being somewhere in the middle between stocks and bonds, they also provide inflation protection. We don't have a preference for domestic versus international REITs, and we own both Residential as well as Commercial REITs. Commerical Real Estate has seen something of a clobbering as the world comes to terms with the twin impacts of internet retail and remote working. We don't feel that we know enough about this market to over- or under-weight it at this moment, though we would tend to think that the markdowns in Commercial Real Estate are probably overdone, since markets tend toward overshooting both to the high- as well as low-side. We maintain a neutral weighting toward all Real Estate.
Along the same lines as Real Estate, Commodities are important additions to a portfolio both because they are uncorrelated with Equities and Fixed Income, and because they are highly correlated with inflation. Many investors eschew a Commodities exposure because of their apparent volatility. It is true that Commodities themselves feature high volatility, often more than twice that of Equities. However, it is important to note that their high volatility is actually beneficial for a portfolio of stocks and bonds because of their low correlation: when commodities are up big, equities and fixed income tend to be down; when commodities are down, equities and fixed income tend to be up. This tends to be useful during periods of high inflation, as well as when exogenous shocks occur--especially as many of those shocks are commodity-related supply shocks. Given the strength of the global economy, our allocation to Commodities is higher than in normal periods, which is always higher than Commodities' weight in the Global Market Portfolio.
Emerging and Frontier Markets
We will use this space to discuss both Emerging and Frontier Market Equity and Fixed Income, as they are pretty much the same exposures for our purposes. Emerging Market and Frontier Market assets are different primarily in regard to their level of development. Frontier Markets represent the least-integrated economies in the world, whereas the Emerging Markets are more integrated and more developed. What we love about these investments is that their correlations with the developed markets are imperfect, allowing investors to capture Equity and Fixed Income returns off-schedule with Developed Markets. Also, they feature higher population growth rates, less expensive labor, and the ability to make comparatively large strides in productivity with smaller investments of capital than is the case for their Developed Market cousins. Further, while the impact of technological progress on Developed Markets is impressive, for Emerging and Frontier Markets, it is nothing less than astounding. So, these categories of investment represent extraordinary opportunities for harnessing growth. Their volatilities are quite a bit higher, but because these come off schedule, they are diversifying in the same way that Commodities' are.
We are currently overweight this category because we believe that global growth will be better than currently discounted, partly to do with the rearrangement of global supply chains in the wake of the COVID-19 pandemic, with a caveat: we are short China, for reasons we've discussed at length in the past and won't return to for the moment.
All investments except Gold are denominated in a currency. Because Currencies are traded on a daily basis--indeed, with a daily trading volume of $7 Trillion is the largest market in the world--their values change. These changes in value are uncorrelated with other sources of return, and so provide a diversifying benefit to the truly balanced portfolio. We are underweight the US dollar, and overweight Emerging Market currencies. We are slightly overweight other Developed Market currencies, as these tend to outperform the dollar during periods of economic expansion. We maintain slightly higher allocations to the Japanese Yen and Swiss Franc, as these tend to perform well during periods of economic crisis and so provide value as a crisis hedge or long volatility asset (to be discussed further below.)
Like REITS, Timberland is a dual nature asset: part Real Estate, part Commodity. It has Real Asset properties that hedge against inflation and diversify financial assets, but also growth characteristics as it is a primary construction input. It has zero storage costs, as lumber can be stored 'on the stump' in forests. We think it also has additional, unrealized sources of value as a carbon sink in a world that will soon be pricing carbon, as well as a construction material for a world that will soon be looking for alternatives to concrete. (Not for nothing is goodstead's logo a representation of the White Pine*** tree.) We are overweight Timberland.
Part of how goodstead diversifies its sources of risk is by investing in equities that look like bonds. Bonds have a role in a balanced portfolio because their defensive, contractual cash flows provide a floor to price. Infrastructure is similar in this way, however additionally benefits from a socially licensed monopoly that carries incumbency advantages and demand inelasticity. We are overweight infrastructure on a normal basis, and especially so at a moment when so much of our species' infrastructure must be upgraded or replaced to accommodate the new world that's coming with pan-governmental action on Climate Change and the New Energy Era that such a political regime change will necessitate.
Gold, the Anti-Asset, deserves the larger allocation it receives because it is an efficient way to access changes in real yields, shifting inflation expectations, fluctuations in economic sentiment, and the intermittent crises of faith we have in our financial markets. (Ironically, we access Gold exposure through a financial asset linked to its value.) Nonetheless, we're overweight gold because it is in good times a hedge against poor ones, and the combination of (eventually) falling interest and inflation rates suggest that its peculiar sheen is particularly lustrous at present.
Lastly, and most importantly, we maintain an allocation to Volatility. We say 'most importantly' because it is a key differentiator of our investment philosophy and financial portfolios. For volatility has unique properties that, along with a judicious allocation to the risk-free asset, make portfolios much more efficient over the long run. We obtain our exposure to Volatility a number of different ways that are mostly embedded in the Alternative Assets in which we invest; however, when Volatility is well priced, or our views on market pricing warrant it, we will take on dedicated Volatility exposure to enhance upside performance during periods of broader drawdowns, and to reduce overall portfolio volatility. Next week, we will dedicate an entire missive to just this factor and asset class alone. As aforementioned, we are currently overweight Volatility due to its low pricing and our predisposition always to be respectful of the unknown.
*Not to be confused with the Art of Life, which is "not having anything to do, to do something." - Henry David Thoreau
**Please send us feedback. It makes us better to know what we're doing wrong, what we're doing right, and how we can improve.
***"There is no finer tree." - Henry David Thoreau