Few days ago I had a meeting with a new potential client. He runs a family office in Switzerland and the conversation hovered around our asset allocation strategy for the current year. I spent quite a lot of time going through our preference for Asian and European equities, the rationale for low duration in fixed income and the opportunities we still see in EM corporate debt with a focus on Latam. I had several arguments to support an agnostic stance on currencies with the only exception of the old Swiss franc (mainly as a hedge). On top of that I explained in detail the strategy of writing covered calls on the GDX we have been implementing with decent results since the 3Q of 2016. I concluded my presentation with my usual final remarks (sounding a bit of a broken watch for regular readers).
I confessed I am optimist in life but that, at the moment, I am very worried
After so many years of loose monetary policy we might face the unintended consequences of huge misallocations of capital. The areas where I see the excesses are where investors pushed the “search for yield” in credit to extremes and in the US stock market where enthusiastic sentiment drove valuations to levels rarely seen in the past. Since these are huge asset classes in terms of size and positioning, I recommended some overall prudence and focus on liquidity of underlying assets in the portfolios. My guest listened quietly.
He then watched me in the eyes and asked frankly: “Giuseppe, do you really see so much euphoria around? I know so many people still flush with cash. I assume there is so much dry powder left on the sidelines. Also, whenever I talk to fund managers I always get some message of caution. This can push this market much higher, we are not in a bubble yet”. We talked for another while about this and other topics and then the meeting ended
However, his words continued to resonate in my head in the following days. Sir John Templeton once said “criticism is the fertilizer we grow in”. So, let’s be open and try to analyse his point of view in detail.
First there is the question of cash and generally prudent portfolio allocations. I do not find it surprising. Remember that events shape the persons and not viceversa. There is a generation of fund managers and private bankers (and clients) that has lived through 2000-2001 and 2007-2009. They still have some voice in decision making as far as portfolios are concerned. They are probably still fighting the last war and they might find out in the future that they have been deadly wrong. But this is not the issue here. The point is that I do not have a problem explaining the evidence of generally high cash levels among private and institutional portfolios during such a strong bull run. To be honest, I would not be shocked to see markets even much higher while most of the public sits on huge levels of cash. It is a collective behavioural bias at work. I believe it will take a couple of decades to eradicate it (i.e. a complete generational change). Let’s move on to the other point my client highlighted. If we are trading at, or close to, market highs, why there are so many fund managers advising cautiousness? I must admit this argument is quite tricky. We know that the majority of investors usually are trend followers. Only a minority have a value bias. We also know that with euphoric markets, contrarian investors should feel and be lonely.
Great investor Seth Klarman once said: “you do not go into value investing for the group hugs”. These days a good chunk of experienced active investors are aligned saying that we are trading at well above fair value compared to historical standards and that the sentiment indicators all suggest an overstretched market. If history is a guide, near a market top this view should be that of a small minority (often ridiculed), not the prevalent wisdom.
Following this line of reasoning, one should agree with my client and arrive at the conclusion that we have still a lot of room climbing the “wall of worry” before markets exhaust their inner strength. Possible, but something inside kept telling me there was a better explanation.
I found it looking at the main structural change the asset management industry is going through: the rise of passive investing. It is radically shifting the competitive position of active managers. Before the advent of ETFs, some active managers were aggressive and some were defensive. If you got the market right clients rewarded you with inflows. Today, there is a shift towards passive allocations.
Active investors are losing assets (even the ones outperforming). From a competitive point of view active investors have a choice between being offensive and defensive compared to the ETFs that are by definition 100% invested. People with some experience in the market know very well that it is extremely difficult to outperform a benchmark being 100% invested only from “pure alpha”.
Alternatively, aggressive investors could choose to push beta of portfolios above 1 but again this translates in higher recorded volatility and not much value added when adjusting for risk. Never forget that active investors traditionally have much higher fees than their passive counterparties.
The other alternative for active investors is being defensive. This means having some extra spare cash or a portfolio composition (and some hedges) that could prove of value in turbulent periods. The latter approach does not require extraordinary skills (found only in a small minority of managers). Therefore it is perfectly reasonable that, right or wrong, most active fund managers opt for defensiveness. It is a matter of survival against ETFs in a tough competitive environment. If this is generally true, it naturally follows that the prudent bias of active managers is the one more vocal in the world of finance. Active managers write, speak and interact with other human beings. On the contrary, I still have not seen an interview of an “ETF” on CNBC (but time will tell…). Finally, there is the point that “not being in a bubble” yet is a valid argument to invest now. Well, first of all I am happy we are not in a bubble because that means that there is still some rationality in the market and we do not necessarily have to face the consequences of the implosion of a bubble in the future. Secondly, bubbles, as market tops, are difficult to forecast or even to recognise. They appear clearly only with hindsight. Having said that, my thesis is that valuations well above fair value are a good enough reason to justify a prudent stance in portfolio allocation. It does not get more complicated than that.
In several occasions, markets had tremendous drawdowns from levels that did not imply any bubble (think 2007). Investors should position portfolios to match inflation after tax having in mind that the “fear of losing money” should always outweigh the “fear of missing out”.
CFA, Compass AM
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