As the president has ramped up his tweeting about America’s trade deficit with China and is threatening a trade war, it is important to remember that running a trade deficit is not a terrible thing. As Warren Buffett noted at the recent Berkshire Hathaway shareholder meeting,
“When you think about it, it’s really not the worst thing in the world for someone to send you things you want and you hand them a piece of paper.”
This is especially true if you print the pieces of paper and the Chinese cannot effectively do anything with that paper besides buy US Treasuries with it. Obviously, there are other reasons that a country may want to produce some good/service domestically (instead of importing it), but eliminating a trade deficit in and of itself is not a great reason. Unfortunately, the word deficit has a negative connotation and so I do not expect this perennial political talking point to disappear anytime soon.
Like many Americans, I’ve been saddened and angered by the increasing number of mass shootings in our country. My wife and daughters even braved the rain and hit the streets to March For Our Lives a couple weekends ago. As the activism against assault weapons increases, so are calls to divest from assault weapon manufacturers and distributors. Thus, I believe now is as good a time as any to talk about “divestment.”
Definition: Divestment is the act of excluding a company, industry, or sector from an investment portfolio.
Reasons to Divest
Many (including myself) practice divestment as a way to align their portfolios with their values. Some investors would rather not receive any investment benefit from the sale of assault weapons (or cluster bombs, chemical weapons, and so on) and so choose not to own companies associated with these products.
There is also an argument that investing in risky or controversial businesses is risky because risks and/or controversy invites activism which can result in stricter regulations. Just ask tobacco companies or oil drillers.
However, investors should also understand what divestment will not do.
Reasons Not To Divest
Divestment reduces the supply of capital available to a company which increases its cost of capital. However, there are still plenty of investors willing to invest. So although divestment increases a firm’s cost of doing business, it also increases the returns to that firm’s investors. Cliff Asness of AQR recently summarized this concept in an aptly-titled piece: Virtue Is Its Own Reward: Or, One Mans Ceiling Is Another Man’s Floor.
Readers may point out that a higher cost of capital and weaker financials should result in weaker share prices and performance. Perhaps in theory, but I have not found the weight of empirical evidence compelling.¹
Divestment campaigns have not been shown to be effective historically, except to the extent that they are a means for social and/or political stigmatism. William MacAskill (a leader in the “effective altruism” movement) asks and answers the question: Does Divestment Work?
Not only is divestment unlikely to hurt a firm’s shareprice or investors, it is unlikely to benefit those who divest. Excluding a miniscule industry like firearms manufacturers will make no discernable difference to capitalization-weighted investor. Excluding larger industries or sectors may result in increased tracking error versus a benchmark, but is unlikely to make a material difference over a multi-decade timeframe as most sectors mean revert to the market over time.² I’ve found most arguments otherwise are timeframe dependant (ie. just changing the starting and ending dates results in different outcomes).
The upshot is that if divestment will not make a major difference to an investor’s portfolio, then investors can also capture market rate risk and returns without many (if any) tradeoffs.
Investors that own funds may find it expensive to divest if they have unrealized capital gains. Rather than divest and pay tax on the capital gains, it would arguably be more effective to donate an equivalent amount to an activism campaign.
Divestment is one of many tools that investors can utilize to align their portfolio with their values and/or effect change. Other options include:
Underweighting or otherwise optimize their exposure to objectionable companies, industries, and sectors. Kind of a “divestment-lite” approach.
Maintaining exposure to an industry or sector, but only invest with the most responsible or “best in class” firms (perhaps those that are pivoting away from the objectionable business).
Maintaining ownership of shares in order to engage with management through voting proxies and/or bringing shareholder resolutions. Sometimes having a seat at the table is the most effective way to effect change.
Invest in companies that counteract the problem or solutions.
Divestment can be a great tool to align portfolios and it is something that I personally practice. Like anything else though, investors should consider their goals and objectives to ensure that divestment is the right approach for them.
There’s been a lot of focus on short vol strategies this week and many questions about how long it can continue. For those that are curious, below is a brief explainer on how short vol has contributed to the selloff.
In short, this episode is a textbook example of forced selling. It can be tough for investors to see markets and prices move so quickly and irrationally, but it also creates opportunity as forced selling means that price action disconnects from fundamentals.
In this case, it was short vol positions that were crushed. Short positions started losing money because the VIX was ticking up. To limit losses, the shorts needed to go cover their short positions by buying VIX futures, which pushed those contracts and the underlying index even higher. This is called a short covering rally or a short squeeze. It is essentially buying that begets buying. Interestingly, in this case, the squeeze was in the VIX which moves inversely to the equity markets; thus, a rising VIX put downward pressure on the equity markets.
A major method of shorting volatility was to short futures linked to a volatility index. Futures have embedded leverage because investors only need to post a fraction of the notional value as collateral. When the position starts losing money, brokers will make margin calls demanding more collateral. If the investor cannot post more collateral, they’ll have to close out their position or liquidate other portfolio assets. Thus, they either had to buy and push the VIX higher or sell other risk assets which pushed their prices lower. Either way, equity markets moved down.
Once the troubled assets and players are identified, investors will begin pulling allocations. Exchanged-traded products, mutual funds, hedge funds, and so on will receive redemption requests. They will be forced to close out their short positions or liquidate other assets to meet redemptions. Again, this will further reinforce the price action.
Short covering, margin calls, and redemptions have exacerbated the recent market declines and they could continue. It is unclear how much exposure still needs to be unwound or what the leverage ratios are. Friday’s bounce may have been the bottom or there could be more pain to come this week. Investors should have a gameplan in place to take advantage of either scenario.
I inadvertently deleted my last post on 10 lessons we can learn from this latest round of exploding vol and the implosion of short vol strategies and products. With everything going on in markets right now, I have to focus on other things and let that post go. I still have the images, so I can give a brief recap of those at least!
AVOID shorting volatile assets and NEVER EVER short something that can spike up exponentially. It doesn’t matter how smart you are because you don’t know the future. History is littered with smart people that blew themselves up by shorting imprudently.
Looking at the below chart, it’s difficult for me to understand how anyone could short the VIX in January. You’re getting a low price on your short sale and it frequently explodes higher.
Unfortunately there’s a lot of perverse incentives and other bullshit in financial services. Sponsors and managers are incented to create products to generate management fees, brokers and custodians encourage trading to generate transaction fees, and it nobody cares if the products are beneficial or not. Some of them are dangerous. Below is the VelocityShares Daily Inverse VIX Short Term ETN (symbol: XIV). Went down 90+% overnight. Investors lost money, while the product sponsor, manager, and brokerages all made money and didn’t lose it when the thing crashed.
It’s not just retail investors that make mistakes though. Recently, a bunch of Wells Fargo advisors were fined for not understanding the above types of funds and making misguided recommendations to clients. Another team that manages a hedge fund and a public mutual fund (symbol LJMIX) made some serious errors causing their mutual fund investors to lose 80+%. This is a publicly-registered mutual fund with the word preservation in it’s name. Buyer beware indeed! Knowing what you own is much more important than knowing it’s history. The magnitude of adversity often trumps the probability of adversity.
This is not an “I told you so” post. The lesson is that investing is tough, so implement some risk management as guardrails and be discerning and skeptical. Retail and professional investors alike are susceptible to greed and complacency.
The great team at GapMinder has created Dollar Street, which is a very cool way of looking at the mundane all around the world. The photos are organized and standardized, so you can see what various aspects of life look like at similar income levels around the world. Check it out:
I was amped for the release of Blue Planet II today, but I think this was the best video release of the day.
My favorite thing about this talk is that Housel covers some of the most important investing issues without even talking about investing! Nobody is immune from the challenges and biases that Housel illustrates, so its a great watch for both professional and non-professional investors.
Following up on my previous post about the 2s10s spread, I should note that the 2s10s is just one of many spreads. Its a benchmark. But you could just as easily look at the 2s5s, 5s30s, 10s30s, and so on. Below are a couple of alternative ways to keep tabs on the shape of the yield curve.
I like the below chart because it allows one to see how various constant maturities move in relation to one another over time. As you can see, the curve flattened during the last two major tightening cycles and so I remain skeptical of those that are calling for long-rate rises to outpace those of short-rate rises.
Another common way to view the shape and history of the yield curve is to simply view it next to previous iterations of itself. See below for an example:
Fortunately for US taxpayers, the IRS provides income tax benefits for charitable donations and capital gains tax benefits if those donations are made with appreciated assets. See below:
Income Tax Deduction
Short-Term Appreciated Assets
(Held <1 year)
Long-Term Appreciated Assets
(Held >1 year)
(don’t donate these 😉 )
Obviously, the dual impacts of receiving an income tax deduction and avoiding capital gains tax are beneficial. Consequently, the above methods can be used to dispose of assets or reallocate/rebalance portfolios in a tax-efficient way. I should note that the above is a high-level overview and there are additional tax issues to consider, so donors should consult with their tax adviser before making any donations.
What assets can be donated?
Liquid securities suchs as stocks, bonds, mutual funds, ETFs, derivatives, and so on.
Illiquid assets such as insurance contracts, restricted stock, employer stock options, business interests
Real assets, such as real estate or commodities
Other complex and esoteric assets
Many organizations are setup to accept liquid securities, but most do not have the resources to accept illiquid and/or complex assets. Typically, these can only be donated to (larger) well-resourced organizations or contributed to a foundation or donor-advised fund before being granted out to the end charity. Future posts will cover various charitable vehicles and strategies.
Actively-Managed Bond Funds Underperform…
Given the nature of fixed-income markets (see here, here, and here), one might assume that the majority of active managers should be able to outperform. However, this claim does not hold up. The below chart indicates that although active managers occasionally beat the Bloomberg Barclays US Aggregate Bond index (or simply, “the agg”), most do not in most years.
The plot thickens in our next chart, which shows that active managers generally underperform the same index. However, these managers have bursts of outperformance which consistently coincides with an increase in interest rates.
And our final chart below smooths the above chart even more by extending the rolling performance period from 12 months to 60 months. Again, some episodes of outperformance, but those times are the exception rather than the rule.
…Because The Wrong Benchmarks Are Being Used
Besides implying that most intermediate-term bond managers underperform, the above charts also suggest that the actively managed universe of intermediate term bond funds consistently maintain both a lower duration and credit quality than the benchmark, which means that perhaps the wrong benchmark is being used. Vanguard has done much analysis on this topic and reaches similar conclusions (see: Active Bond-Fund Excess Returns: Is It Alpha…Or Beta?). Anecdotally, I can say that many fixed-income funds that I come across benchmark to “the agg,” despite no semblance of similar holdings or characteristics. The below chart does a good job of illustrating that many benchmarks are misspecified. Adjusting for a fund’s holdings reduces tracking error.
Of course, all of the above charts simply relate to intermediate-term bond funds and not other popular sectors such as high-yield/bank loans or any international bonds. However, the SPIVA data is not too supportive of active fixed-income managers’ value in these sectors and I was hard-pressed to find any supporting charts that showed anything different (at least for anything more than brief windows of time).
Many funds that I know and use are benchmarked to the agg, LIBOR + x spread, or some other arbitrary benchmark. When I ask fund sponsors what they benchmark to, they usually say something to the effect of, “Well we benchmark to the [you name your index]. It’s not a perfect fit or even a good one, but that’s what it is.” A huge number of intermediate bond funds are benchmarked to the agg, but are not trying to beat it or even hold similar assets. This is also true for many other bond funds and indices. Comparing funds to arbitrary indices is not a good way to select funds, as the comparison is meaningless and can easily be gamed.
What To Do?
Of course, if the agg outperforms various other sectors over time and thus represents an opportunity cost, then why not just invest in the agg? I think that is a fine choice for very long-term investors. However, since the agg and other high-quality benchmarks’ outperformance is neither universal nor consistent AND (as we saw in the last post) credit has periods of outperformance and underperformance AND returns can be approximated ahead of time, I believe investors can do better. To apply Klarman’s framework, bonds are better “trading sardines” than “eating sardines.” Even a brief glance at the below comparison of the agg and high-yield index shows that credit returns swing like a pendulum. Buy when attractive, avoid when not.
Several of the above charts above refer to the number of funds outperforming or underperforming, which ebbs and flows but generally more underperform. However, the data does not show how persistent outperformance or underperformance is for individual managers, nor does it show the degree of out/underperformance for individual managers. There are funds that have consistently beaten their stated benchmark and the agg over long periods of time, which means that some managers can outperform over multiple rolling periods with persistence. Even if the majority of active managers fail to beat their benchmark, there is a group that can beat their benchmark. I will not get into it here, but many of the funds that I have found have some common structural traits.
Lastly, in both order and importance, is that much of the data we have dates back to the early 1980s. Active managers outperform during periods of rising rates (see second chart) and rates have basically fallen for 35 years. This is not a prediction that the trend will reverse, but a recognition that passively managed funds have benefited from a tailwind that cannot be repeated to the same degree (rates only have 2-3% to fall until zero, not 15-20%).
The Bottom Line
So, what does this all mean?
Most fixed-income funds fail to beat their benchmark.
However, the benchmarks are often arbitrary and/or misspecified.
Fixed-income returns are both lumpy and predictable, so an active approach can add alpha relative to a benchmark.
One final thought is that the above all relates to relative performance. There is a lot of debate over whether to take an active or passive approach and performance metrics, but those are really secondary questions. Fixed-income is often used for an absolute return (ie. provide $x of income) or to simply diversify equity exposure. Investors should define the role of fixed-income in their portfolio before moving on to more complex and nuanced issues.
Perhaps the most important concept to understand about bonds is that they are debt. Debt is a loan and borrowers do not pay more than they are contractually obligated to. The implications is that even under ideal conditions, future returns are both known and limited. Below are several reference points that investors can use to predict future returns.
Starting yields have been a fairly good predictor of Treasury returns:
Within credit, starting spreads have been good predictors of future returns:
Spreads are also indicative of future excess returns:
The above charts convey an important message: be aggressive when future returns are high and defensive when future returns are low. Fortunately, fixed-income investors can get a sense of future returns in the present (as a point of comparison, this is very different from equity markets where expensive assets can get more expensive and cheap assets can get cheaper). Invest accordingly.