Another turning point, a fork stuck in the road   

Time grabs you by the wrist, directs you where to go

So make the best of this test and don’t ask why

It’s not a question, but a lesson learned in time 

It’s something unpredictable, but in the end is right

I hope you had the time of your life

— Good Riddance (Time of Your Life), by The Green Day

By Noah Solomon

Special to Financial Independence Hub

The Latin term sine qua non literally means “Without which, not.” It refers to something that is indispensable. With respect to investing, this term applies to risk management, which is essential for achieving better than average results over the long term. 

In this month’s commentary, I will discuss the advantages and drawbacks of the more commonly used approaches to reduce portfolio volatility. I will also explain why volatility management for its own sake is a value-destroying endeavour. Lastly, I will provide a contextual framework for measuring managers’ risk management skills. 

Macro Forecasting: Failing Conventionally

Ever since tariff-related concerns unsettled markets in April, I have been asked countless times what I think is going to happen and how investors should be positioned. Relatedly, to improve performance by predicting macro developments, you need the ability to:  

1. Consistently predict short-term developments, and
2. Make portfolio changes that produce results that are better than what would have been the case had you simply done nothing.  

By no means is this failure due to lack of effort, diligence, or intelligence. However, the simple fact is that interest rates, inflation, unemployment, and economic growth are all influenced by thousands of factors. Not only do these factors influence economic conditions on an individual level but also influence each other. In other words, millions of complex interactions affect macroeconomic conditions, thereby making forecasting a thankless endeavour.

How prices respond to events is not merely a function of the events themselves but also of the degree to which events are already discounted in prices before they occur (i.e. investor expectations). This observation explains why overly optimistic expectations can result in a company’s stock falling after it reports stellar results. Similarly, it also explains how excessively pessimistic expectations can result in price increases after disappointing news. 

In short, with respect to price movements and events, it’s not about whether an event is positive or negative, but rather about how the event compares with what was expected. Unfortunately, when it comes to gauging expectations, and by extension, how much of a given event is “baked in” to security prices, investors are by and large flying blind. There is no place where you can determine exactly what investors are expecting regarding inflation, GDP, or unemployment. Whereas asset prices offer some clues in this regard, they by no means offer any reasonable degree of precision. 

Finally, even if people could predict future events and accurately estimate broad-based expectations of such events, it is still unclear if such knowledge would lead to superior performance, as shorter-term price movements are largely a function of swings in investor psychology, which are impossible to predict. 

If I am correct in my assertion that basing one’s investment strategy, either in whole or in part, on forecasting future developments is at best impractical, then why does doing so remain popular? All I can offer in this regard is the following: 

1.) The proverbial “size of the prize” is so large that investors can’t resist the temptation, regardless of how poor the odds: if you could consistently profit from short-term market movements, your performance would make even Buffett’s look poor!

2.) Entertainment value: predicting economic trends can be intellectually engaging and even a “sport” for some.

3.) Following the herd: Managers may engage in forecasting for the simple reason that everyone else is doing it, and that it would therefore be irresponsible not to. According to John Maynard Keynes, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Volatility: Winning the Battle but Losing the War

Considered in isolation, portfolio volatility is undesirable. However, like almost anything desirable, volatility reduction comes at a price. All else being equal, the more you tilt your portfolio in favour of lower-volatility securities and strategies, the lower your returns will be. I suspect that most people who allocate a portion of their portfolios to lower-volatility assets have a reasonable appreciation for what they are getting. However, I also believe that they have little appreciation for what they are giving up in exchange for this benefit, or more specifically for the magnitude of this sacrifice. 

The aftermath of the late ’90s Tech Bubble involved a three-year decline in stocks. During this time, hedge funds weathered the storm relatively well, far outperforming their traditional, long-only peers. 

Predictably, the pain of those years in combination with an augmented appetite for stability prompted investors to pile into hedge funds, which caused assets to grow from several hundred billion dollars in 2000 to over $2 trillion by 2007 and to over $4 trillion today.

Just as Adam Smith’s theory of supply and demand would have predicted, the aftermath was far less rosy than hoped for. While the average hedge fund made good on its promise of stability, returns were sorely lacking, resulting in massive opportunity costs for their investors. Over the past 10 years, the HFRX Global Hedge Fund Index has delivered an annualized return of 1.87%, as compared to 9.8% for the MSCI All Country World Equity Index. Using these figures, a $10 million investment in the HRRX Index ten years ago would currently have a value of $12,035,470, while the same amount invested in global stocks would be worth $25,469,675.

Given this stark difference, investors should ask themselves whether their aversion to volatility is mostly financial or mostly emotional. By definition, the answer is the latter for those with long-term horizons. In such cases, the emotionally driven component of volatility aversion has proven, and likely will prove to be very costly indeed! 

Private Assets: See no Evil, Hear no Evil, Speak no Evil

Over the past decade or so, private assets have become increasingly viewed as a “you can have your cake and eat it too” panacea which can deliver strong returns while simultaneously shielding investors from high volatility and severe losses in challenging environments. These perceived attributes have led to explosive growth in private investment funds, with assets under management increasing from roughly $600 billion in 2000 to $7.6 trillion as of the end of 2022. 

There is good reason to be somewhat suspect of private asset funds’ low volatility and short-term, unrealized returns. While most funds may provide accurate asset values for their holdings, this may not always be the case. Although 2022 was a horrific year for both stocks and bonds, many private equity, private debt, and private real estate funds reported negligible losses.  Continue Reading…