Wednesday, September 3, 2014

The One Big Bet made by most buy-and-hold portfolios

Recently, there has been a lot written about active vs. passive investing and, as part of that debate, asset allocation. As an example, Barry Ritholz wrote about the effects of market timing and concluded that the "time" in market is more important than timing the market:
What of an ordinary investor who is a dollar-cost averager into broad indexes? He has a huge advantage over the world’s best market timer, in that he really exists. What he does is possible. The perfect market timer does not and cannot exist. There is no crystal ball or a magic formula that allows for perfect market timing. Instead, our dollar-cost averager simply makes regular contributions to his portfolio. It is a simple, powerful strategy that requires no special prescience into the future, and is a formula that actually exists.

What about risk?
There is a key underlying assumption behind the strategy of determining an asset mix and then buying and holding (with or without re-balancing) as an investment policy.

The assumption is that risk is mainly defined by portfolio volatility, which is the basic tenet of MPT. There is also an excellent discussion of the shortfalls of volatility as a measure of risk by Micah Spruill here, which is well worth reading.

There are other elements of risk for investors with long time horizons. When I write about the risk in an investment policy, I refer to:
  • Volatility, which is the metric most investment professionals focus on; and
  • The risk of the permanent loss of capital, which is split into the following two categories:
    1. The risk of loss from confiscation and conflict; and
    2. Legal framework uncertainty risk, otherwise known as, "How do you know you have a legal claim to what you own, or think you own?"

Confiscation and conflict risk
When investment professionals study past returns to determine future risk and return expectations, they often focus on US assets. As per the Credit Suisse Global Investment Yearbook 2014, here is a typical chart of US asset return considered by planners:

A survivorship bias problem
There are a number of serious problems with this analysis. First, it ignores the risk of confiscation and conflict. The above chart suffers from a severe case of survivorship bias. CS shows this chart of capitalization weights of global equity markets in 1899:

Here is the same pie chart in in 2013. The US went from a 15% market cap weight in 1899 to an astounding 48% in 2013. The UK market, which represented one of the dominant political powers of the early 20th Century, shrank from a 25% weight to 8% in 2013, France, another Great Power, went from 11% to 4%. Notwithstanding the fact that most investors invested in the bond market at the turn of the 20th Century instead of stocks, trying to project returns based on the US experience is like projecting returns based on AAPL`s returns since its 1980 IPO.

In 1899, which was 15 years before the start of World War I, the Major Powers were:
  • Britain
  • Germany
  • France
  • Austro-Hungary
  • Russia
The US was still a promising emerging market country, as was Argentina (how did those Argentine railway bonds work out?).

As per the Credit Suisse review, here are some of the returns of the markets of some major markets in the past 115 years. Here is the old Austro-Hungarian Empire, which has since broken up into modern-day Austria, Bosnia-Herzegovina, Croatia, Czech Republic, Hungary, Slovakia, Slovenia; large parts of Romania and Serbia; and small parts of Italy, Montenegro, Poland and Ukraine. (Bear in mind that, as the per above US asset real return chart, $1 invested in US equities in 1899 = $1,248 in inflation-adjusted dollars today).

What about Germany? That country underwent a couple of severe dislocations in the form of two World Wars in the past 115 years, the worst of which involved losses of over 90% if you invested in German equities.

The same pattern of 90% losses held true for Japan:

Of course, there is China, which has been a recent favorite among emerging market investors. The Shanghai market suffered a severe *ahem* dislocation in the wake of Mao Zedong's takeover Liberation of China and didn't turn around until the Deng Xiaopeng era.

The same kind of *ahem* dislocation occurred in Russia. In the cases of Russia and China, the personal experience of a resident of those countries as a capitalist investor likely paralleled that of most European Jews in World War II.

Legal framework risk
In addition, to the risk of permanent or severe loss of capital from confiscation and conflict, investors with long time horizons face the risk of legal framework uncertainty. Gold bugs will point to FDR`s Executive Order 6102, which effectively banned the private ownership of gold by individuals and companies in 1933.

A more modern example can been seen today in possible sanctions that have been proposed against Russia. FT Alphaville recently highlighted a Bloomberg article indicating proposals to cut Russia off from the western banking system, as the West did with Iran:
The U.K. will press European Union leaders to consider blocking Russian access to the SWIFT banking transaction system under an expansion of sanctions over the conflict in Ukraine, a British government official said.

The Society for Worldwide Interbank Financial Telecommunication, known as SWIFT, is one of Russia’s main connections to the international financial system. Prime Minister David Cameron’s government plans to put the topic on the agenda for a meeting of EU leaders in Brussels tomorrow, according to the official, who asked not to be named because the discussions are private.
Such a move could be devastating to the Russian economy:
The FT also reports that Swift is on the table, although it would be an “extreme measure”.

After all, if Europe did decide to press Belgium-based Swift, and thus financial globalisation itself, into service — it places Russia into a tricky spot this time round.

Swift doesn’t clear cross-border banking transactions itself. But it does open doors for relatively isolated banking markets (like Russia’s is, still) to connect to clearing systems such as Target2 or, in the US, Fedwire. The Kremlin has seen the risk coming and moved to create a local replacement. But as Reuters notes, less than 10 per cent of transactions involving Russian banks stay within Russia.

The model is Iran. EU sanctions in 2012 effectively obliged Swift to comply with disconnecting Iranian banks from its processes. The use of Swift allowed what’s become quite a familiar dynamic in US and European financial sanctions.
In other words, you may own those assets, but can you access them? If you are restricted from accessing them, what is their value (emphasis added)?
Some foreign investors might always stick with Russia as the assets are so cheap. Gazprom and Rosneft, two enormous companies with a combined enterprise value above $270bn (the Moscow bourse’s market cap is $560bn), are respectively trading 3 and 4 times forward earnings.

Sberbank, market cap $42bn, trades below book value despite a return on equity western banks would kill for, and having survived the financial crisis with barely a dent. Is it cheap even with Swift risk? Would any of these companies appeal to a minority shareholder, if the Russian state interest in them may mean they can also be tools of this ‘hybrid’ warfare?

Interesting questions, but the cheapness is almost irrelevant if the plumbing breaks. And then, there is what happens if Russian money flows home. That end-point presumably has to be factored into the sanctions strategy, and how the EU’s policymakers believe it would pressure Putin. Would it? Putin’s power rests partly on distributing resources at home to a selected elite group. Would returning capital change, weaken or strengthen this? What about the localised bank transfer systems which Russia would try to create — would it consolidate the Kremlin’s control?

A bet on World Peace
I began this post discussing the active vs. passive question, along with the asset allocation issue. Most investment professionals erroneously start with an asset allocation that is has a significant home bias (and therefore represents an active bet away from the global portfolio pictured below).

For most Americans, their portfolio allocations would be highly US-centric. For other developed market investors, their allocations will typically have a home-country bias. Such so-called "passive" allocations represent a big bet on continued world peace. For the foreseeable future, that appears to be a reasonable bet. JP Morgan Asset Management shows the effect of war in the world today (via FT Alphaville):
  • 11.7 per cent population
  • 9 per cent oil production
  • 3.8 per cent foreign direct investment
  • 3 per cent GDP
  • 2.6 per cent trade
  • 2.4 per cent gross capital formation
  • 0.8 per cent corporate profits
  • 0.7 per cent equity market capitalisation
  • 0.5 per cent interbank claims
  • 0.4 per cent portfolio investment inflows
Even though it involves 11.7% of global population, which is devastating to those involved, it only involves 3% of global GDP and 0.7% of equity market capitalization - which are not large figures that would overly disturb financial markets.

Doubling down on Pax Americana
In summary, most investment policies today are Big Bets on world peace. For Americans, they represent an even bigger bet - the continuation of Pax Americana. To illustrate my point, here is the CS chart of real returns on UK assets from 1899. Britain was a dominant global power at the dawn of the 20th Century. The sun never set on the British Empire as it had possessions around the world. The real return of $372 based on $1 in British equities in 1899 looks reasonably good, but it`s dwarfed by the 1,248 figure shown by US equities in the same period.

France, which was overrun by Germany in 1940, had an equity market that did much worse, though it did not suffer the 90% losses that the German and Japanese stock markets did.

If you wanted to project equity risk and return expectations, what figure would you use? The US 1,248 real return, the British 372 or the French 36 real return figure?

The history of the 20th Century has shown that previously dominant empires can fall. We don`t know what the future holds. Do investors with very long time horizons want to make an bet on the continuation of Pax Americana?


Caustic Pop said...

Isn't something like 30-40% of US corporate earnings now generated from offshore sources? So US equity markets are becoming more and more global rather than just reflecting the stateside economy. This perhaps justifies a significant portion of the greater relative size of the US market currently, no?

Cam Hui, CFA said...

Two things to keep in mind if you just invest in US companies:

1) Even if US companies get much of their sales from non-US sources, it doesn`t mean that they trade like international companies. KO is much more correlated to the S&P 500 than EAFE, for example.
2) You are also ignoring the other long-term risks that I wrote about, from war and confiscation and governance risk (being able to enforce your legal claims).


WimpyInvestor said...

Great blog post. The big reminder for me is to always watch out for survivor bias in all investment backtesting / historical analysis. Too many people use "after the fact" data, without factoring in the data available at the point of actual decision making.

Angel investors all want to find the next Facebook or Microsoft. So, if we are tempted to use "CEO who dropped out of Harvard" as one of the screening criteria. But, if I had invested in equal amounts on all Harvard undergrad drop-outs when Bill and Mark left school, I would probably be broke now.

wkevinw said...

I think the general progress of humanity (yes, contrary to many "news" reports), humans are much better off today than they were in the past- even just in the past few decades(- look up the Gates Foundation's and other assessments of well-being on the planet).

One of the main factors in well-being is law and order; part of which is avoiding violence, e.g. avoiding wars.

Wars tend to kill the poor- see ISIS, etc. If you look at the impact of war on the developed economies over history, including the past few decades, it has been declining.

If we had something like WWI or WWII in the developed world, you would have hundreds of millions of people killed.

Do you see that now? No, thus the continued reasonably good performance of financial markets and developed economies.

We should all feel good about that.

Thanks for your work on the blog.

Luke said...

Is the inflation adjustment using government figures, gold, or something else? Would have tremendous impact on returns.

I think its notable that in history there are wealthy families from industry, land and banking, but none (that I can think of) from equity investment. It is only in modern fiat money times that we have super wealthy equity investors - we'll have to wait and see if this is a long-term opportunity or a half century blip in history.

Stumbled upon your blog from Pettis' writings, enjoying your work.

james brownn said...

I wish more authors of this type of conent would take the you did to research and write so well. I am very impressed with your vision and insight.