You may have observed or read in the headlines recently that German 10-year government bonds now yield less than zero. They join approximately $30 trillion of other debt with negative yields. Many parts of the stock market, especially in the U.S., are priced at levels implying well below average returns and potentially big risks. Clearly these are not heavenly times for investors looking at what returns can be expected to flow from today’s prices.
Just as we can’t avoid gravity, we also can’t avoid that fact that asset prices will eventually adjust down to more normal levels. But when exactly is “eventually” and what does the timing of the adjustment mean for investors? In a recent commentary1, U.S. investment management firm Grantham Mayo van Otterloo (GMO) addressed this issue. They focused on two potential scenarios that could ensue from today’s lofty prices, giving them the names (only slightly tongue in cheek) of “purgatory” and “hell”.
Purgatory VS Hell
In GMO’s view, purgatory would be a quick, catastrophic decline in prices on the order of what happened in 1929, 1987 or 2008, followed by more normal returns from then on. This would be short-term pain for long-term gain. The hell scenario, on the other hand, would be a plodding, endless continuation of high asset prices and correspondingly low future returns until fundamentals catch up. For investors with return objectives to meet, hell is possibly the worse of the two because it means there will be no opportunity any time soon to put money to work in asset classes that are broadly priced for great returns. In hell we simply endure years of returns that are well below historic averages, effectively paying back the returns that were “earned” in the past but really were just borrowed from the future.
So what do we do?
So faced with an unknown future and the prospect of investment purgatory or investment hell, what do we do? I have three suggestions.
The first is simple: take less risk overall. The unavoidable fact is that today’s high asset prices mean greater risk of loss for investors. If purgatory (i.e. a quick move to lower prices) is what comes next, having a good amount of cash and low risk investments on hand will be a good idea.
My second suggestion is to embrace nuance. “Indexing” as an investment approach has gained popularity in recent years because it can accomplish instant diversification at low-cost. But it can also lead to large disadvantages especially in today’s markets as you own it all – the good, the bad and the ugly.
Diving into Indexing
In the bond world, indexing draws you into having the greatest weights in the most indebted entities. But why should an investor want a portfolio that is 20% Japan government bonds just because 20% of all the bonds in the world are issued by Japan? The bonds yield next to nothing and Japan has a debt/GDP ratio of 230%. Similarly, why would you want 50% of your equity investments in the U.S. just because 50% of the world’s market capitalization happens to be in the U.S. at the moment? Investors may have other needs or preferences. And there is far better value at the moment – with correspondingly higher expected returns – in many European and Asian companies’ shares, and the currencies in which a U.S. dollar based investor buys them are again at interesting levels.
I think simply following the best value to a number of areas outside the U.S. could lead to much improved return prospects for many investors, remembering that tomorrow’s returns are driven by today’s prices as surely as day follows night.
My last suggestion is to eliminate the high fee investments. This sounds like a no-brainer, but it is amazing how much of the investment landscape is still made up of vehicles like hedge funds charging well over 2% per year for exposures whose equivalents could be obtained far more cheaply in other ways.
Hedge Fund = High Fees
The world’s leading public pension funds are only now taking the knife to their hedge fund investments after spending the better part of a decade building up their allocations to them. Returns in this area have been disappointing and, more importantly, they are not expected to get better because high fees in aggregate eat up most if not all the value that the managers add. As the book The Hedge Fund Mirage by Simon Lack pointed out three years ago, successful hedge fund management is not infinitely scalable, and as returns inevitably tend towards mediocrity high fees turn into a deal breaker. There’s a reason Warren Buffett is winning his bet of the S&P 500 against a basket of professionally selected hedge funds.2
The world will eventually adjust, to purgatory or to hell, whichever comes next. Keeping overall risk lower than normal, paying attention to the value under the surface of financial markets – especially outside the U.S. – and ensuring fees are reasonable should help investors protect and grow their portfolios during this time, until the next period of rainbows and unicorns for investment returns arrives, whenever that might be.
1 “Is This Purgatory, Or Is It Hell?” Ben Inker, GMO Quarterly Letter, Third Quarter 2014
2 You can read a story about the wager here: http://fortune.com/2016/05/11/warren-buffett-hedge-fund-bet/