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!
Did you know that less than 32% of Americans have or use a budget, according to a recent Gallup poll? To us that is shocking!
Even more shocking is just 30% of Americans have a long-term financial plan according to that same 2013 Gallup poll.
Luckily our clients do not have to struggle with budgeting or financial plans. Our eMoney client portal provides one of the simplest methods to track their finances and keep a budget that known to man!
Let us explain.
Over the past year, we have invited all our clients to set up a free eMoney personal client page, like the one below for this fictitious client.
Not only does this portal allow them to track their assets and spending but it allows us to work with that information and other adviser provided assumptions to help our clients with a long-term financial plan that is constantly updated, can be reviewed in real time and makes it easy to track progress (see InTrust Advisors Rolls Out eMoney for more information).
Once the client sets up the portal to pull in their account information from wherever they have a log-in and password, it will start to track and pull in their spending transactions automatically. That is right automatically!
It will also pull in account balances and activity automatically on such things as investments, savings, trades, and of course spending.
The client can then easily set up line item budgets to track their spending.
There are no receipts to input. There are no daily, weekly or monthly downloads. It all flows into eMoney automatically and without a cost to our clients.
If a client clicks on the client portfolio Spending or Budget sections they are taken to detail pages like these pages (below), where they can see in greater detail where they are spending their funds.
It is just that easy! A budget in as little as 30 minutes!
The great philosopher Dave Ramsey (sarcasm) famously said “You must gain control over your money or the lack of it will forever control you.”
Here is a great simple tool to do just that!
Interested in getting started? We offer the client portal to both clients and non-clients without charge. Give us a call or click here to get started.
My good friend, Rob Robbins at Franklin Templeton Investments, sent me the Real Return Forecast below from GMO. At first blush it is pretty negative!
What is obvious is that investors are going to have to accept higher volatility in such asset classes as international or emerging markets if they expect to get any kind of positive return over the next 7 years if GMO is correct.
This forecast however has two glaring weaknesses in our opinion. Those weaknesses are that it assumes: 1) that returns are stable over that 7 year period, and 2) that you are a "buy and hold" investor.
So let me address each weakness separately.
First, when investors think about forecasts like this they tend to assume that the return stream will be stable, i.e., the same every year. However, the truth is that markets are volatile and returns are likewise volatile.
We can see that returns are volatile, below, in this chart of annual S&P 500 performance courtesy of Macrotrends.net.
If we take it one step further and overlay GMO's expected returns for U.S. Large (dotted red line) over this chart, you can see that there will likely be up and down years throughout the forecast period.
Pick a period of time, like the one I highlighted in the blue box, and you can see there are years you will make money and likely years you will give back returns.
This Forecast Is For Buy and Hold Investors
The second point I would like to make is the GMO returns assume that you are buying and holding your investments during this forecast period. However, if you are a client of ours that is not what you will be doing.
So lets assume for a moment that we have a replay of the 2008 - 2014 period.
What would that possibly look like for a client with an actively managed account assuming a 5% loss in 2008 while getting out of the markets post a bear market signal, a 12% return in 2009 due to a late signal to get back in the market and only 80% the returns of the S&P 500 in the balance of the years due to excess Central Bank intervention? Sound familiar?
Here is what that looks like:
Historical S&P 500 Index Returns (Buy and Hold) vs. Hypothetical Actively Managed Account Returns
A phenomena called "Recency Bias" has most investors up in arms about actively managed strategies, but if we include 2008 in this hypothetical analysis, you can see that if we can avoid the big down period (which if you are honest with yourselves you know is coming), that even with earning less return in 2009 - 2014 years you still come out ahead in terms of an annual return (10.75% vs. 5.74%).
Now let take a SWAG (scientific wild a_s guess) at what market returns may look like in the next seven years under GMO's forecast. Bear in mind this is just a hypothetical guess and it is possible that big down years are replaced by a series of smaller loss years or the big loss year is pushed farther out by even more Central Bank intervention.
Hypothetical S&P 500 Index Returns (Buy and Hold) vs. Hypothetical Actively Managed Account Returns
What we see here in this SWAG is that while the buy and hold investor did realize a negative seven year return in the S&P 500, the actively managed account did much better because he/she avoided the hypothetical big draw downs in 2017 and 2018. The actively managed account was slow to respond to a rally in 2019 and made only 80% of what the buy and hold investor did in 2020 - 2023 period but still came out substantially ahead.
The Moral Of This Story
The moral of this story is that even if you are one of the many persons out there looking feverishly for positive returns and are turned off by forecasts like GMO's showing the next 5-10 years will be low return years, there is hope!
The solution is not what has been working so well since the 2009 bottom (buying and holding and indexes), but what has not been working half as well and that is an actively managed approach. Investing is cyclical and every type investment strategy has its day in the sun. You have to figure that the buying and holding of index is probably in the 8th or 9th inning if it were a baseball game.
In the years to come, the key will be to avoid the big down periods and just do "ok" in the up markets. The result will be positive returns. Maybe not what we have seen in the past but "ok" positive returns.
If we then get smart and add exposure in the areas of the market highlighted by GMO as potential outperforming asset classes maybe that return profile improves further.
This is NOT the time to go chase some other investment options such as direct lending or commercial bridge loans or even the next tulip mania, this is the time to change how you approach the markets because the cycle has to be near an end.
I certainly don't want to disparage diversifying, but right now in this market everything is in bubble territory and the more you stretch for return, the more likely are you to get your head handed to you on a platter when this market finally hits the skids.
So let us know if we can help you position for what is likely coming. We offer a Free Second Opinion - click here to sign up.
Past performance is not an indication of future performance.
The S&P 500 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.