Why bother?
What's the point of understanding economic cycles
I’ve said it before: I do this stuff for me, and I’m glad to have you along for the ride.
Why do I bother? I can give you millions of reasons.
Dyscalculia
As a multi-decade insider of billion dollar institutional portfolio management, I realize that the industry process is way off track. For an industry that is supposed to be good at math, the math didn’t add up.
Where the math really didn’t add up for me was in relation to institutional fund managers spending time, energy, and money in improving their investment process. If the industry did the math, they would see that there is significant incentive for them to be better - not just for their clients, but for themselves, too. However, the industry has chosen to ignore the math and ignore improving their offering. Instead, they have chosen to focus on being better marketers of their product. Sales! It’s all about sales.
For the investing client, they get:
an institutional asset management industry that is going increasingly ‘passive’ because of the poor track record of active managers relative to passive investing (i.e. they typically don’t add value but subtract it); and
told to “stay the course” during down markets (i.e. this is what markets do and we - the insto - don’t know how to avoid it).
These are both admissions that, as an industry, institutional-level fund managers add little value when it comes to protecting the wealth of investing clients during down markets.
Don’t get me wrong, there are some truly talented people out there. These are usually those with skill in stock picking. Eventually, such people start their own funds and do well for themselves and their investing clients. These are people who are talented in the area of identifying companies and industries with the right prospects to generate superior returns.
Where the industry really falls down and where there is, quite frankly, a black hole, is in the area of asset allocation. Asset allocation is selecting the mix of different funds, securities, and asset classes, e.g. stocks, bonds, property etc. and when to hold greater or lesser portions of each of these asset classes. This task usually falls to the Chief Investment Officer (CIO) and/or Investment Committee. These are senior people with many years of experience in financial markets. More often than not, these people have limited talent other than being institutional ‘movers & shakers’, i.e. good at corporate politics and climbing the corporate ladder. They know the words and the concepts, and sometimes even have some experience in portfolio management. But putting it all together across every asset class with a contextual understanding of the economy and identifying where in the cycle they are is beyond them. They are no different than the day traders you see on social media who get whipped by the market as they follow the price action.
That’s why the industry is going passive and why it hasn’t and can’t, add value. CIOs and Investment Committees fall back on the old adage, “you can’t beat the market”, which smacks of arrogance. Just because they can’t do it doesn’t mean it can’t be done. But because they chose the “it can’t be done” option, they close their minds to researching how it might be done.
You may or may not know that the majority of people invest in “Balanced” funds. These are also commonly referred to as “60/40” funds because they are 60% invested in stocks and 40% invested in bonds. Most diversified mutual funds are some derivative of this theme (e.g. 60% stocks, 30% bonds, 10% alternative investments like property). “Growth” investors - usually younger people who have the time to ride out market corrections - typically have 80% stocks and 20% bonds. “Conservative” investors - usually older people who aren’t looking for growth but are after more stable income - are typically 20-25% stocks and 75-80% bonds. That’s pretty much the industry in a nutshell. Basic recipes that charge a percentage every year on investors (mostly) growing wealth. And certainly, there must be a fee for service, but it’s that last sentence holds the key to my problem with the industry.
Incentives
Wealth ultimately grows when invested. Why then is the industry focused on better marketing to get new customers rather than growing client wealth? Institutional fund managers take a percentage of their clients wealth for their service. If they grow that wealth then they get more money. If they grow that wealth, then they get compounded growth of their income as well as their client’s wealth. Why then do they focus on linear growth through client acquisition rather than compound growth?
As I said above, the industry’s arrogance causes them to stay in ignorance.
Go long
When you invest for your retirement, you’re not just investing up until your retirement age, but for all years you will be retired, too. We could all do with extending our investment horizon.
The following chart shows a simple model. It invests 100% in stocks (mauve line). That’s considered an ‘aggressive’ portfolio being entirely in stocks. Over the course of 50+ years, an initial investment of $10,000 was turned into $350k.
IF that 100% stock portfolio was altered so that during recessions it invested 100% in bonds (just for the length of the recession) but was in stocks the rest of the time, that initial $10k would have turned into $2.534 million (purple line). That’s over 7 times greater for very little trading activity.
So you see, there is significant benefit in identifying cycles, researching asset allocation in relation to those cycles, and improving on investment process.
Just imagine the fees an institution would get on a portfolio full of clients with that amount of money each! Oh yes, and the client would be better off also.
So, when institutions tell clients to “stay the course” during large market drawdowns, it irritates me. I think institutions should be aiming to protect clients wealth while growing it, which would stabilize their business revenue also. It’s called alignment of interests. Quite frankly, institutions should “stay the course” and look to develop their business with a long-term mindset.
Let’s look at another scenario that offers even greater incentive to improve the investment process.
In the above chart, there are only 4 occasions where the portfolio goes 100% in bonds. The rest of the time it stays invested in stocks. The difference is almost 20 times in this scenario. An initial $10k becomes almost $7m.
I’ll admit, this scenario is extreme and unlikely. I simply picked the top month and bottom month of the 4 major down markets over the last 50+ years. I just wanted to illustrate the incentive that exists for an industry to lift its game and really try to develop some intellectual property.
I’ve already shown that recessions are reasonably easy to identify (e.g. like right now). So, the relative outperformance shown in the first chart above is well within reach. Especially when you consider that there are some asset classes that are more readily aligned to the business cycle and recessions, and that often offer superior returns to stocks. There is a lot of value available that is being passed over by a lazy (ignorant; short-sighted ???) industry. They do themselves and their investing clients a disservice.
You know what it really comes down to?
Most asset management institutions are run by managers (i.e. employees) and not owners who have their own wealth invested alongside their clients. Managers are subject to human traits and one of the primary ones for senior employees (e.g. the likes of CIOs and Investment Committee members etc.) is following the path of least regret. They won’t make decisions that have the potential to risk their position within the company or the company’s position within the industry. It’s cushy, carries status, and is well-paying. Why risk it? They also have a protection of running with the performance of the rest of the industry, which gives them the “but everyone else was doing it” defense should markets and investor returns fall. I shit you not! I’ve seen this first-hand, an active decision to try to be average on the performance rankings because clients stay passive (i.e. don’t get upset enough to leave) if institutions run with the pack. In the meantime, the institutions gets to charge fees.
Charts galore
I’m getting some interesting signals on my trading model.