Investors Doomed to Repeat the Past?

November 1, 2017

In most horror movies, a naïve and unsuspecting protagonist walks headlong into the closet, basement or cornfield in which her tormentor awaits. The viewer sees it coming. Cringing at the inevitable. But remains powerless to prevent the characters all-too-avoidable demise.
That scene is perfectly analogous to the one in which most investors find themselves today. Nearly nine years into a stock market recovery. With mean reversion laying in wait, somewhere, dead ahead.
Oh, the horror.
Twice over the first decade of the twenty-first century the stock market crashed. Two bear markets. Spanning four of the century's first nine years. Each eradicating more than 50 percent of the S&P 500 index's market capitalization.

First, a death-by-a-thousand-paper-cuts decline spanning 2000 to 2002. The next? Call it what you will. The Credit Crisis. The Great Recession. The Housing Bust. Regardless, the market lost 39 percent in 2008. Nearly 54 percent from October 2007 to March of 2009. The speed and ferocity of which continues to haunt.
Investors responded to the 2008 tumult in understandably human ways. Fight or flight mechanisms kicked in. Sending many to the cash only after having taken massive losses.
Then, presented with one of the greatest buying opportunities in a lifetime, 52 percent of the nation sat on the sidelines until 2015. Because fear, as someone said, imprisons us within the past, even as we despair about the future.
Much of the stock and bond markets were laid to waste. Yet, what market historians and other purveyors of hindsight lose sight of is the idea that investors were poorly prepared for market volatility. Let alone that of the magnitude experienced.
During both bears, some asset classes held up. Though few posted desirable returns. Desirable being a relative term.
In 2008, managed futures returned nearly 18 percent. Government bonds provided 12.39 percent. Mortgage-backed securities? 8.52 percent. Short-term Treasurys yielded 4.97 percent. International bonds gave 4.40 percent. Cash weighed in at 0.08 percent. And municipal bonds lost a respectable -2.47 percent.
Slices of consolation amid the destruction.
2008's massive equity-market losses were made all-the-more problematic by the lack of investor preparedness. Investors were woefully diversified. Having been lulled into a false sense of security, investors were over-allocated to risk assets. Particularly to the higher volatility areas of the global marketplace. Tethered to numerous asset classes that, like Icarus, flew too close to the sun.
So why were investors -- from the uninitiated to the most sophisticated -- so unprepared?
First, traditional sources of diversification were mercilessly tested during a 17-month period in which there were few places to hide. Stocks, corporate bonds, emerging markets, commodities, real estate, all depreciated in tandem.
Begging the question: did traditional portfolio diversification fail investors?
Traditional diversification -- the allocation of investment capital to stocks, bonds and cash, failed to decrease volatility and provide protection against the massive losses suffered by so many. More astute observers will question, however, the validity of focusing one's portfolio manage efforts on those three asset classes. An explanation for which we find after considering the relationship between Wall Street and Main Street.
Following the passage of the ERISA laws in the 1970s, many Americans who had never invested began doing so. The percentage of individuals seeking to place their hard-won retirement capital into the markets grew quickly. And Wall Street was there to dispense advice and sell product.
These days, Wall Street's bread is buttered through the accumulation of assets under management. Wall Street is nothing if not an efficient sales machine. Accordingly, Wall Street created a variety of investment products that enabled its advisors cum salesmen to spend time gathering new assets as opposed to managing what they had.
To keep the process simple and effective, Wall Street's minions focused on three primary asset classes: stocks, bonds and cash.
Leading up to the tech bubble, the belief that investors need only diversify between three primary asset classes had become commonplace. When the market fell apart in 2000, investors were scared. But the 2000 bear market was different than 2008. Because that downturn featured facets of the equity and fixed-income markets that continued to perform. Large cap value returned seven percent in 2000. Small caps remained buoyant in 2001. Fixed income essentially kicked off a long-term bull market. Returning 12, 8 and 10 percent during those three years.
The tech-bubble bear was really about the collapse of large cap growth and international stocks. With other asset classes posting gains and/or smaller losses. Leaving investors weary, but not shell-shocked. So, they quickly returned to investing when equities bottomed in 2002.
Why the focus on only stocks, bonds and cash?
In the 1970s, an investor could aptly diversify with 100 NYSE stocks. Since, the financial system has become more complicated. Correlations between stocks have risen appreciatively. Sometimes to the point of near-perfect correlation. Even stocks and bonds have increased in their propensity to mirror each other.
When U.S. stocks fall, foreign developed and emerging market stocks will often join in. And during periods of hyper volatility, corporate bonds may lose value. Leaving average investors with no place to hide. Punishing investors for assuming any risk whatsoever.
Nor did Wall Street help.
The Lords of Wall Street recognized that the tide was coming in. But they were making too much money to muster the effort required to educate investors. So, when the Credit Crisis occurred, investors -- especially those on Main Street America -- were wholly unprepared.
The knowledge gleaned from the 2008 tumult? Investors long-term diversification efforts require more than the traditional balanced allocation to stocks, bonds and cash.
In fact, among the few asset classes left standing in 2008 were certain bonds and alternatives. Like managed futures, which returned 17 percent. 10-year Treasuries returned 14 percent. Mortgage-backed securities returned 8 percent. Short-duration bonds returned six percent. Global macro hedge funds returned 4.7 percent. Municipal bonds provided 1.5 percent. And three-month Treasury bills returned just under two percent.
Interestingly, private equity trounced its public equity counterparts, losing only 15 percent compared to the S&P 500's 38-percent collapse.
True portfolio diversification, that which provides investors the opportunity to survive bear markets, must include low-correlation, alternative asset classes. As should any portfolio that aspires to more than simply tracking the ups and downs of market indexes.
When we speak before crowds at dinners or various events, we usually ask the audience, "What are you doing differently today because of what happened in 2008?"
Shockingly, most investors smirk and passively admit to not changing much. Ten years later, they're once again over-allocated to stocks, bonds and cash.
What constitutes an "alternative investment?" One residing beyond traditional stocks, bonds and cash. The benefit of which boil down to two primary ideas:
1) Alternative investment managers generally seek a net positive annual return. They don't track a benchmark index like the S&P 500 or the Barclay's Aggregate Bond Market. They don't exclaim victory when they beat the S&P 500 index by 1.3 percent even as the index lost 39 percent. They simply seek to deliver a positive return. Year in and year out. Doesn't always happen. But that's the objective.
2) Alternative investments can provide portfolio diversification while often reducing portfolio risk. Some are specifically designed to mitigate risk. While others do so by working alongside asset classes to which they have a low correlation. Enabling them to operate and perform independently of each other in any market environment.
The average investor may utilize ETFs, mutual funds or individual stocks. Regardless, he'll require the stock market to grow if his capital is to do the same. Occasionally, however, markets do not cooperate.
There have been 13 bear markets -- defined as declines of 20-percent or more lasting at least a month with no immediate recovery -- in the postwar era. The average bear lasts for 362 days.
Throughout each of these periods, long-stock-and-bond portfolios fared poorly. In the long run? Stocks recover. But that doesn't deride from the mental angst incurred during a market downturn. Let alone knowing that every 30 percent decline requires a 43 percent gain just to regain one's par value.
John Maynard Keynes said, "In the long run, we're all dead." But it was likely an alternative investment management who added, "Make sure the near term doesn't kill you first."
So, if an investor could utilize investments that enhance the probability for success throughout market cycles of five to seven years, what's the excuse not to do so?
Consider private equity, which has been the top-performing asset class over the last 25 years. Outperforming U.S. and foreign equities. Bonds. The Nasdaq. Small Caps. By a wide margin.
According to Cambridge Associates, private equity has outperformed the S&P 500 as well as the Russell 2000 small-cap index over the 5-, 10-, 15-, 20- and 25-year periods. In fact, the last quarter century has seen private equity return 13.4 percent per year, while small cap stocks delivered 10.6 percent, and the S&P 500 provided 9.9 percent. Moreover, private equity has done so with a negative correlation to the S&P 500. Meaning, private equity returns have been independent of the S&P 500 index.
Perhaps that has to do with the fact that 3,300 private equity firms can choose to invest in over 200,000 American companies with at least $10 million in revenues. While there are 16,000 institutional money managers chasing opportunities among a mere 3,700 publicly traded companies.
Fewer fisherman in a much bigger pond? Makes sense.
Performance itself, however, is hardly the point. Because many of the alternative investments can improve your long-term portfolio management endeavors simply by having a lack of correlation to traditional asset classes. So helping to lower volatility, or standard deviation, within the portfolio as a whole.
Rather like a general manager assembling a professional sports roster. Usually opting to take the component that most improves the team, as opposed to that with the most upside potential (and all its attendant risk).
Studies reveal that the addition of alternative investments to portfolios often improves performance while lowering volatility. That alone merits their consideration in any investment endeavor. Why else would some of the largest, smartest and most successfully managed pools of capital in the world allocate most of their assets to alternative asset classes like private equity, managed futures, hedge funds and real estate, among others?
Yale's endowment has made increasing allocations to alternative investments for 14 years. To such an extent that in 2015, domestic and foreign stocks amounted to only 19 percent of the Yale's portfolio. Whereas alternative investments, including absolute return strategies (hedge and debt funds) and private equity, comprised 51 percent of the portfolio.
Nor is Yale alone. The "endowment model" model, based upon large allocations to alternative and low-correlation asset classes, has been co-opted and increasingly utilized by endowments, pensions, foundations and other large pools of investment capital.
Of course, most investors believe that such opportunities lay well beyond their reach. Thinking that alternative investments are available only to institutions and wealthy individuals. Which was once true. But today, the alternative investments industry has become increasingly democratized. Our firm, for instance, has sought out relationships with a variety of opportunities available to all classes of investors. As we aspired to the opportunity diversify into these asset classes with not only wealthy clients, but with all clients whenever prudent and appropriate.
Do alternative investments represent a magic elixir? The remedy for all investment woes? Of course not. Like any investment, alternatives must also be scrutinized. They can be risky. Involve loss.
That said, the prospective risks of not incorporating such investments have been established. Two times in the last 15 years.
To move from the traditional investment methods -- long-only stocks, bonds and cash -- to a more modernized, nuanced approach, alternative thinking is required. That is, one must expand the toolbox with which we construct portfolios. Broadening from stocks and bonds to stocks, bonds, commodities, private equity, hedge funds and real estate -- depending upon individual requirements. Opening one's mind and portfolio to the spectrum of the investment universe.
Thus far, investors have been limited because Wall Street -- in its never-ending effort to gather additional assets without adding additional work -- has largely focused on stocks, bonds and cash. Even as the executives of the big banks and brokerages stuff their capital into private equity, hedge funds and managed futures.
Today, the opportunity set available to every investor has evolved.
We live in a world of 6.5 billion people. Each of them engaging in financial transactions of one sort or another. The sheer magnitude of today's interconnected global financial system means that we can no longer invest like we used to. We must develop more sophisticated approaches for dealing with and investing within a more complex world.
Hedge fund manager Ray Dalio has counseled, "I think the first thing you should have is a strategic asset allocation mix that assumes that you don't know what the future is going to hold."
Dalio's statement conveys the idea that no asset class will rise in perpetuity. Moreover, asset classes that are correlated will rise, and unfortunately fall, in unison. Sometime over extended periods. Leaving pragmatic investors, of all backgrounds and levels of affluence, to consider opportunities beyond stocks, bonds and cash. To climb outside of the little box in which Wall Street's brokerages have long kept them over all these years.
Market returns have been excellent for over eight years. Which means the only thing we can count on is mean reversion. At some point, stocks will drop. Perhaps precipitously. It's not a matter of if, but when.
Investors can better weather the inevitable storms if they're willing to think differently, and plan ahead.

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Alternative Investments offered as private placement securities are offered only to qualified accredited investors via confidential private placement memorandum. Income and returns are not guaranteed and there are no assurances investments will meet their stated objectives.

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