In some cases, we know the odds of an event occurring with certainty. The classic example is that we can calculate the odds of rolling any particular number on a pair of dice. Because of demographic data, we can make a good estimate of the odds that a 65-year-old couple will have at least one spouse live beyond 90. We cannot know the odds precisely because there may be future advances in medical science, extending life expectancy. Conversely, new diseases may arise, shortening it. This illustrates the concept of risk. Compare that with examples of uncertainty: the odds of an oil embargo (1973), the odds of an event such as the attacks of Sept. 11, 2001, the odds of Iran blocking the straits of Hormuz, or the odds of a trade war with China. For investors, it is critical to understand the important difference between these two concepts—risk and uncertainty. While investors much prefer to deal with risk, where they know the odds or can at least estimate them with a high degree of certainty, investing is generally much closer to uncertainty. And since there are no investment crystal balls, how should investors go about designing portfolios—what are the principles that should be followed? One strategy is to hire active managers, those legendary gurus who can protect you from bad things happening to your portfolio. Unfortunately, the research, including the Eugene Fama and Kenneth French study, “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” has found that fewer active managers (about 2 percent) are able to outperform their three-factor (market beta, size and value) model benchmark than would be expected by chance. And that is even before considering taxes. Adding to the bad news, there is no evidence that active managers add value in bear markets, just when they are needed most. That was the finding of a Vanguard study which appeared in the Spring/Summer 2009 issue of Vanguard Investment Perspectives. Defining a bear market as a loss of at least 10 percent, the study covered the period 1970-2008, which included seven bear markets in the U.S. and six in Europe. Once adjusting for risk (exposure to different asset classes), Vanguard reached the conclusion:
Risk is present when future events occur with measurable probability. Uncertainty is present when the likelihood of future events is indefinite or incalculable.
They also confirmed that “Past success in overcoming this hurdle does not ensure future success.” Vanguard was able to reach this conclusion despite the fact that the data was biased in favor of active managers because it contained survivorship bias. (For more on the challenges active investors face, read my December 2018 post.) It is likely evidence such as this that led William Bernstein, author of “The Investor’s Manifesto,” to declare: “The reason that ‘guru’ is such a popular word is because ‘charlatan’ is so hard to spell.” Either that, or as Peter Drucker stated, “Charlatan is too long to use in a headline.” Even highly regarded mutual fund manager Ralph Wanger, in his book “A Zebra in Lion Country,” stated:
Whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection, and market-timing proves a difficult hurdle to overcome.
The problem with active management is that the industry is focused on trying to manage returns—a losing proposition. So what’s the alternative? Perhaps it’s the strategy most likely to allow you to achieve your life and financial goals.
For professional investors like myself, a sense of humor is essential. We are very aware that we are competing not only against the market averages but also against one another. It’s an intense rivalry. We are each claiming that, ‘The stocks in my fund today will perform better than what you own in your fund.’ That implies we think we can predict the future, which is the occupation of charlatans. If you believe you or anyone else has a system that can predict the future of the stock market, the joke is on you.
The Prudent Strategy in a World of UncertaintyThe prudent strategy is to focus not on managing returns, but on managing risk. How should an investor go about doing that? The following are the foundational premises of what I believe to be the most prudent approach to managing risk. The first premise is to assume that markets, while not perfectly efficient, are highly efficient. Thus, after implementation costs, active management is a loser’s game, where the odds of winning are so poor that it’s not prudent to try. Just like the loser’s game of craps in Las Vegas, the surest way to win is to not play. In investing, not playing means using passive strategies that do not seek alpha, only beta (exposure to a factor or asset class, a unique source of risk and return). If you believe that markets are highly efficient, you should also believe that all diversified sources of systematic risk (unique sources of risk and return), such as major asset classes and factor exposures like size, value, momentum, quality, profitability and carry should have the same expected risk-adjusted return. That leads to the conclusion that we should invest in strategies that broadly diversify across an entire asset class (or factor) instead of trying to determine which individual investments are likely to outperform. In other words, investors should be beta (unique sources of risk) seekers, not alpha seekers. That brings us to the third foundational premise. Because diversification across unique sources of risk is a free lunch, providing a higher expected risk-adjusted return, the prudent strategy is to identify as many unique sources of risk and return as you can that meet the criteria you establish for investment. In “Your Complete Guide to Factor-Based Investing” my co-author, Andrew
- Persistent—It holds across long periods of time and different economic regimes.
- Pervasive—It holds across countries, regions, sectors and even asset classes.
- Robust—It holds for various definitions. For example, there is a value premium, whether it is measured by price-to-book, earnings, cash flow or sales.
- Investable—It holds up after considering trading and other costs.
Typical Portfolio: 60% Stocks/40% BondsInstead of thinking of exposures as percentages, we need to think about them in terms of how much risk is involved. While volatility is not the only type of risk (skewness, kurtosis and liquidity are other types of risk), it’s a good one. Thus, we will use it to calculate the amount of risk points each investment brings to the portfolio. A typical well-diversified equity portfolio has a volatility of about 20 percent. Since equities have an allocation of 60 percent, they bring 1,200 (20 x 60) risk points to the portfolio. If we assume the 40 percent invested in bonds is in a five-year Treasury bond portfolio, it has a volatility of about 5 percent. Thus, the bonds bring 200 (40 x 5) risk points to the portfolio. The total number of risk points in the portfolio is 1,400, of which 1,200, or 86 percent, are in equities. Which raises the question: If we can identify other unique sources of risk, each of which has about the same expected risk-adjusted return as the stocks and safe bonds we are holding, why would we not want to include them, increasing the portfolio’s diversification and creating a more efficient portfolio? Why do we want to own a portfolio in which one risk factor—market beta—comprises almost 90 percent of the risk? That brings us to the concept of a risk-parity portfolio. The risk-parity approach to portfolio construction seeks to allocate capital in a portfolio based on a risk-weighted basis. This approach attempts to avoid the risks and skewness of traditional portfolio diversification by considering the volatility of the assets included in the portfolio. In addition, the risk-parity portfolio is the most efficient portfolio when allocating to systematic assets and factors that have similar expected returns per unit of risk. One way to approach risk parity is to increase exposure to equities with higher than market expected returns. For example, small value stocks have historically outperformed the market portfolio. Thus, owning more small value stocks than the market portfolio allows us to lower the portfolio’s exposure to market beta without lowering its expected return (because the stocks we own have a higher than market expected return). That lowers our exposure to market beta while increasing exposure to the size and value factors. In addition, the lower exposure to market beta allows us to hold more safe bonds, increasing our exposure to the term premium. These changes move us toward more of a risk-parity portfolio. Consider the following example of two hypothetical portfolios, A and B, that illustrate how to move a portfolio toward risk parity. The period is April 1993 through December 2018. The start date was chosen because it was the inception date of the DFA U.S. Small Cap Value Fund used in the example. I chose that fund because it has the longest record of any passively managed U.S. small value fund (the inception date of Vanguard U.S. Small-Cap Value Index Fund is April 1998).
- Portfolio A: 60% Vanguard Total (U.S.) Stock Market Index Fund (VTSMX)/ 40% Vanguard Intermediate-Term Treasury Fund (VFITX)
- Portfolio B: 40% DFA U.S. Small Cap Value Fund (DFSVX)/60% Vanguard Intermediate-Term Treasury Fund (VFITX)
- The two portfolios had similar returns and exhibited similar volatility.
- While Portfolio A had exposure to only two factors (beta and term), and its risk was dominated by the beta exposure, Portfolio B was more diversified across other factors, including greater exposure to the term premium. Thus, Portfolio B was more of a risk-parity portfolio.
- Portfolio B benefited from its greater diversification across factors. It produced a slightly higher return while exhibiting slightly lower volatility. In addition, it produced a much smaller worst-case annual loss, while its best annual gain was not that much smaller than Portfolio A’s.