Many of you have never heard of recency bias, but it all around us today. According to DaveManual.com, "Recency bias" is the phenomenon of a person most easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.
In every day life we all experience recency bias! Just think for a moment about the best movie you have ever seen. I bet the mental process is affected by a recency bias because quite frankly it is simpler to remember the Star Wars Sequel you just saw (Rogue One) over the original Star Wars you may have seen in 1978, like me.
So how does recency bias affect investing and capital preservation?
Simple, as investors we tend to chase what has been working best in a search for higher returns. When we do this we inevitably rush to the same side of the boat as other investors as I talked about in my post entitled "Is the Market for Passive Strategies Really Just Load Shifting?" because this is the popular trade.
For many of us who, if not for bad luck, we would have no luck at all, we shift just at that moment in time that popular investment or trade is losing its advantage. What happens next is a reversion to the mean or average that then costs us money.
Today, I am going to share with you a number of graphs that clearly show both a recency bias by market participants and the growing possibility of a reversion to the mean.
Let's first start with a graph showing what investors are seeing today.
This is a graph of the S&P 500 Total Return Index versus both the SG CTA Trend Following Sub-Index (an active strategy index of commodity trading advisors) and a portfolio that is 50% active (the SG CTA Trend) and 50% passive (the S&P 500 Total Return Index on a cumulative return basis assuming a $10,000 initial investment for each.
Clearly, the S&P 500 Total Return has been the place to be over the past six years! As a result investors are piling into index based investments pulling investment dollars from active managers, like the trend followers that make up the SG CTA Trend Sub-Index.
However, let's now pull back a bit and get a greater perspective by looking at those same returns since 1990, below.
Now what do you see?
Here clearly the active managers are the historical winners, except for the last 6 years or so. Also note how well the 50% active / 50% passive portfolio did during this period both in terms of return and the smoothness of the return stream (more on this later).
So is it possible, assuming the world has not changed measurably, that investors have lost sight of what has worked historically to chase returns in the here and now?
I mentioned reversion to the mean earlier. Which charts below are the the most susceptible to a reversion to the mean (the mean is represented by the red linear trend line)?
If you answered the S&P 500 Total Return Index, you are correct.
Of the two charts, it appears the SG CTA Trend following index could be primed to rebound towards or even above its linear red line. The S&P 500 one would figure is most susceptible to a move towards or below the linear red line or mean.
Obviously, I have no idea on the timing and the S&P 500 could continue higher, but it stands to reason it will eventually have to turn lower and towards its mean.
So let's say the S&P 500 and markets in general do turn lower, how do you best position oneself for that eventuality?
We believe the answer is to have both passive (index) and active managers, specifically trend following managers.
Here is the why?
When that down market for the S&P 500 comes, trend followers generally do well (see boxes in red). Despite their reputation, the Equity Long/Short hedge funds (represented here by the HFRI Equity Hedged Index, still lose money but not as much as the pure, passive S&P 500 Total Return Index.
The trend followers are the only ones that have an almost zero correlation (i.e. the degree to which two securities move in relation to each other) with the S&P 500 index and they bring down the overall portfolio beta (or volatility vs. the benchmark S&P 500 Index). You can see this below in the chart of beta. Notice how the beta of the 50% active / 50% passive portfolio is lower than holding just the S&P 500 Total Return Index or for that matter the HFRI Equity Hedge Index.
So the moral of this whole story is simple! Don't throw out the active managers from your portfolio just because they have under performed.
In fact, it is probably time to allocate even more dollars in this direction as a contrarian play on the likely reversion to the mean that is sure to come. Remember this current bull market is already the 3rd longest advance on record. What are the odds it continues much longer?
If we can help you with portfolio construction or one of our many unique active or passive investment strategies, please feel free to reach out to us.
Past performance is not an indication of future performance and there can be no assurance that the above indexes will achieve results in line with historical results. This blog post is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
The S&P 500 Total Return is a capitalization weighted index of the 500 leading companies from leading industries of the U.S. economy. It represents a broad cross-section of the U.S. equity market, including stocks traded on the NYSE, Amex and Nasdaq. In this particular index dividends are reinvested and added to the index returns.
The SG CTA Trend Sub-Index is designed to track the largest trend following CTAs and be representative of the trend followers in the managed futures space. The index is comprised of the 10 largest managers in terms of assets under management, equally weighted, rebalanced and reconstituted annually. These managers must be open to new investment and report daily returns.
The HFRI Equity Hedge Index is an index of Investment Managers who maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH managers would typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities, both long and short.
A 50% active / 50% passive portfolio is just a simple portfolio that is 50% the historical returns of the SG CTA Trend Sub-Index and 50% the returns of the S&P 500 Total Return Index.
#1 Take Losses in 2016 and Defer Gains till 2017
This one is our number one idea just because it is time sensitive. You need to take those losses now in the last few days of 2016 to realize the ability to offset any gains that may be taxed at higher rates for the year.
In 2017, our hope is that President Elect Trump will get his tax rate reductions through Congress and deferred gains taken in the new year will be potentially taxed at lower rates, thereby making 2017 a better year to take any gains, especially short-term, from the sale of assets. At least that is the plan!
#2 Consider a Roth IRA Conversion in 2017
Likewise our next planning idea for 2017 is tax driven. If President Elect Trump can lower rates, the investor in me says what are the odds that such rates can go lower?
With rising national debt levels at just about $20 trillion and the Tax Policy Center predicting Mr. Trump's proposed policies will raise the national debt by another $7.2 trillion, what are the odds that somewhere along the line the next administration will have to raise taxes to cover the debt service on the rising national debt?
My guess is pretty good!
We know for certain it will be hard for Washington to stop spending our hard earned tax dollars. So barring the "unbelievable" growth that Mr. Trump promises, at some point taxes will have to go back up.
That could make this point in history, post Trump's tax reforms, the likely low point for tax rates. With that the case, it may be the best tiime to convert taxable IRAs to Roth IRAs that defer tax free if held for 5 years and to age 59 1/2 or more.
The key here is Mr. Trump's tax reform proposals must be come law first before you go this route.
#3 The 30 Year Interest Rate Cycle Has Turned
If you have a bond portfolio, you may have already noticed that something is up in bond land. The thing that is up is rates.
As you can see in the chart below, the 30+ year bull market in 10 year bond yields is up. Remember lower bond yields equal higher bond prices and vice versa.
Notice how recent rate increases have broken the dotted red downtrend lines to the upside?
The trend is now up for bond yields!
Don't panic however, this trend is just beginning and, just like the road down for rates, the path up will be filled with ups and downs.
In fact, I believe rates could retrace some of the recent rise before they make another move higher in 2017. However, the buy and hold game with bonds is probably over unless you are holding to absolute maturity!
It is important that you find an advisor that understands how to manage bonds or bond alternatives in a rising rate environment. May we suggest that if your advisor seems clueless, it's time to change advisors.
FYI - this likely also applies to high income securities like utilities, REITs and other income generators that will be in someway affected by rising rates.
#4 Active Managers Will Outperform
Ok, I know this seems a bit self serving, but it is not. So many folks have shifted to the passive side of the boat that we believe it is likely time for active investments to shine (see Is the Market for Passive Strategies Really Just Load Shifting?"). They certainly have been out of favor the longest period of time I have ever seen!
The rational here is that the Federal Reserve is attempting to raise rates in a period of tepped growth so they have ammunition to fight the next economic downtown. In our opinion, they are a day late and a dollar short!
In other words, their actions will bring about the next possible recession here in the U.S. When recession comes, markets will fall and this is typically when active managers outperform.
When the recession ends, we believe Central Banks will have once again eased into the recession and will have very little impact on the following up cycle. This will likewise be good for active managers as Central Bank intervention has been the bane of such strategies since in 2009 lows.
Our suggestion is that you diversify with both passive (buy and hold) and active strategies in your porfolios. We don't know the exact timing obvously, but 2017-2018 will likely see a move back toward active manager outperformance and you will be prepared for such a move.
Remember that both active and passive managers have been around for hundreds of years and it is not uncommon for one or the other to have periods of outperformance and then periods of underperformance!
#5 Maximize Income in or Through a Business
Here is another idea that is totally Trump dependent. Make sure you are capturing as much of your income via corporate entities as possible.
President Elect Trump has proposed lowering the corporate tax rates for all types of entities including S-Corporations, partnerships and C-Corporations to 15% tax rates. For many this would mean their corporate tax rate could be lower than than there personal tax rate.
So now may be the time to rearrange your affairs to take advantage of this possible windfall for corporate entities and their partners, members or shareholders.
Just like #2 above, our best advice is to wait until it's clear Congress is going to pass this proposed tax measure. However, if they do, there could be a clear path to lower tax rates.
Well that is our Top Five Key Investment and Planning Ideas or themes for the upcoming year. Let us know your thoughts below in the comment section or if we missed another possible investment or planning idea, please feel free to share it!
Have a Prosperous New Year!
It seems a day doesn’t pass where I don’t see an article about some family or firm dumping their active manager or hedge funds for passive, buy and hold investments.
In fact through July 2016, hedge funds had seen seven years of under performance and a record $200 billion+ in outflows so far in 2016.
According to Bank of America’s Savita Subramanian, “over the last several years, we have observed an accelerating trend of flows out of active funds into passive vehicles. Price sensitivity of investors to fees, coupled with poor performance trends, have conspired against active funds, and year-to-date flows out of active have reached a post-crisis high.”
Now as many of you know, we are mostly an active shop. We have strategies that are passive in nature, but even those strategies have active overlays.
There is also no doubt that the last seven+ years have been a challenge for us and others as repeated interventions in the markets by Central Bankers have dampened volatility and wreaked havoc with active manager models and technical signals.
However, what I see now from investors is more of a full scale stampede into passive strategies. They believe they are doing the right thing to reduce management fees and while maximizing returns in this managed market.
However, I believe this to be the equivalent of an entire ship load full of passengers shifting to the same side of the boat and not expecting the boat to capsize into the cold blue ocean.
This “load shifting” as it is called in the transportation industry has actually increased risk and put them all on the same side of a dangerous trade.
This type of investor behavior has a name. It is called “Recency Bias.
According to DaveManual.com, Recency Bias is the phenomenon of a person most easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.
In our case, investors have forgotten the Bear Markets of 2000 – 2003 and 2007 – 2008 and instead focused on the pain of under performance in recent years and are therefore setting themselves up for disappointment.
The average bull market length since 1937 has been 39 months or less than four years. This current bull is now the third longest in history at 91 months.
What are the odds this one continues significantly longer? I would say slim to none given the slowdown in growth we are already seeing globally.
Most astute investors would agree that we are in one of the greatest market bubbles of all time. The last time we had such a bubble in 2007-2008, stock markets dropped by some 39% as measured by the S&P 500 index.
It is therefore likely, that this next Bear Market could be at least as big. Wouldn’t you agree?
Finally, most active managers do substantially better than passive managers in a bear market. We are trend followers here by nature and that is the only strategy that tends to not-correlate with traditional market strategies.
In English this means a pure trend following strategy should make money when others lose money in a bear market. I use the word “pure” because very few of our strategies are “pure” trend following and therefore our expectation is just to sidestep losses not necessary to make money in a bear market.
However, in either case, the bear market is the equalizer. In a bear market, passive strategies will get hammered and active strategies should do relatively better. This relative out performance should equalize the active vs. passive long-term performance.
So now turning back to seismic shift to passive strategies, my belief is these investors are throwing in the towel at the wrong time. They will likely look back and realize later they under performed for years in active strategies and then shifted to passive strategies just in time to lose 30-50% of their money in the next bear market.
What a nightmare!
A Final Note on the Next Bear Market
In September, I posted that GMO had forecast 7 year asset class real returns and many of those asset class returns were negative. I likewise showed how active strategies could enhance returns during such a period in my post entitled “Return Forecasts Don't Always Tell The Whole Story.”
Now GMO is out with another commentary on the next bear market. According to its letter to investors, GMO built the case that when the market bubble pops, it could be more of a slow whimper than a loud pop.
In a rather long 37 point thesis, GMO lays out the reasons for the former conclusion including the fact that most classic bubbles have taken at least 3 ½ years or more to decline and were actually quite orderly as you can see below.
For us this was quite exciting because our models are much more effective in a slow moving decline, like in Japan above, than a bubble that pops and results in massive, very short term declines.
So bring on the bear!