Elephants don’t do hills.
Elephants “studiously try to avoid sloped terrain” (“Elephant’s don’t do hills, scientists reveal”, 2006), which makes a ton of sense given their size. The calorie cost of every vertical meter climbed is around twenty-five hundred times the cost of level walking. Another way of thinking about this is that an elephant can climb a hill if there is no other choice, but the wise decision from a self-preservation perspective is to find a simpler path to follow.
Investors see their investment terrain differently. An investment I might define as a high-risk, you might view as the safe asset in your portfolio. As the old saying goes, “That’s what makes a market.” It is also where the concepts of portfolio diversity and liquidity come into play. Very few investors lock themselves into portfolios that are either pure risk or pure safety. However you define “safe” and “risky,” chances are that your portfolio is your ideal combination of risk calibrated to achieve a certain return over time.
That sounds easy. The goal? Avoid hills. We’d all love our portfolios return to be positive and predictable – and the bigger the number, the better! But alas, today’s perfect portfolio may be next year’s disaster. Ask a baby boomer whose mantra was/is “stocks only go up” – it worked really well for a while, and then 2008 happened. Ask a public pension fund with a target return of 8% –most of them have been waiting for the last 10 years to lock in higher interest rates and have been forced into all kinds of other investments to get there.
The market landscape changed rapidly into and out of the 2008 financial crisis. Falling yields and extremely aggressive easing by central banks have significantly altered the investment environment. In this paper, we will attempt to look at the growing imbalances in the liquid markets, the danger that liquidity itself may present and how correlations are likely to change over time. We will argue that the new world is one in which investors must rethink asset allocation along with the cash plays in their portfolio and seek out less liquid assets that are uncorrelated to the broad liquid markets.
Liquidity – The blessing and curse
Investors treasure liquidity based on the assumption that it always works in their favor. Investopedia.com defines “liquidity premium” as “a premium that investors will demand when any given security can not be easily converted into cash, and converted at the fair market value. When the liquidity premium is high, then the asset is said to be illiquid, which will cause prices to fall, and interest rates to rise.” This is a very scary sounding way of saying that a liquid security will have a higher price and a lower yield versus a similar illiquid security. In other words, there is a tradeoff between liquidity and price. The simplest way for a fixed-income portfolio manager to outperform an index is to own the least liquid form of every bond in the index. As long as the client never needs their money back, they will always out-yield the benchmark since the less liquid the bond, the more of a yield advantage it has over more liquid issues.
Obviously it isn’t always this easy – investors do need access to their cash, often on a known schedule and occasionally on short notice. The argument is that some percentage of your portfolio should be in liquid assets but that any long-term needs are often better met with illiquid assets that are held to maturity, or that have known exit strategies.
But what is a liquid asset? Cash certainly is – especially cash that you have in your mattress – but that isn’t always practical. In today’s world, I’d suggest that liquid assets are US Treasuries, German bunds and any equity that trades on a major exchange, whether it is an individual stock, mutual fund or ETF. If you believe this definition, many markets that used to be considered less liquid have been converted to liquid form, first by mutual funds and then by ETFs. Two of the better examples in fixed income are the high yield and bank loan markets, which historically were only investable by “specialists” and can now be traded by Joe Investor on demand.
But wait – let’s take a look back at that definition of liquidity premium for a moment. If an asset class was once illiquid and is now liquid, it has less yield by definition, as its liquidity premium must have fallen. In other words, while investors enjoy the liquidity of an investment, they are actually penalized for it through yield compression, unless they are actively trading the asset and monetizing the advantage that liquidity supposedly offers. I think the HYG chart tells the story pretty well – with more and more shares outstanding comes lower and lower yields.
How much of the broad markets have become liquid? According a recent IMF white paper, “The stock of globally traded financial assets (i.e. excluding real estate) has expanded sharply over recent decades, from US $7 trillion (71 percent of world GDP) to US $163 trillion (226% of world GDP) between 1980 and 2012” (Jones, 2015). That is a truly staggering figure if you believe that there is a cost to liquidity.
You are only as good as your last trade
Let’s assume that any cost to liquidity is 100% offset by the ability to trade the underlying asset. To be clear, I think that is complete nonsense, but we should explore the possibility.
I’m sure you’ve heard investors of various backgrounds converse with each other. It is very rare that you hear things like, “That allocation I made to bonds in 1980 really made the last 30 years easy for me.” In my experience, you’ll hear things like, “I bought my favorite stock when it was much lower in price and sold it when it was much higher.” That’s a much more exciting conversation to have, especially in the on-demand, instant gratification world in which we live and invest. How addicted are we to trading? As Vanguard founder John Bogle notes, “The average holding period for a U.S. equity mutual fund has declined from 16 years to around 3 years, while annual portfolio turnover has increased from 16 percent to more than 100%” (Jones, 2015).
The IMF paper I referenced earlier, “Asset Bubbles: Re-thinking Policy for the Age of Asset Management” lays out a very convincing argument that short-termism is a byproduct of the way asset managers are compensated (i.e. yearly) when investment time horizons should be much longer. This is nothing new. We saw the result in 2008 with banks that have the exact same problem of playing for the now. Jones points out, “It should perhaps serve as a shot across the bow that the rise of the institutional asset management industry – populated with what are presumably the most sophisticated and rational speculators in the world – has coincided with three of history’s largest bubbles in the last 25 years” (Jones, 2015).
Factually, that is correct, though I’m not sure that you can blame it as easily on asset managers. The truth is, most investors are, always have been and always will be overly emotional in the short term. Asset managers are not immune to this, and I’m not sure it would matter if they were compensated on a longer horizon.
There is another argument as to why there have been more “bubbles” recently. I actually don’t like that term – it gets thrown around any time any asset goes up in value a lot. I think that “bubble” is code for “I’m afraid that what went up a lot may go down a lot much more quickly.” But that’s not new information. According to Forbes, “Bull markets last on average about 97 months each and gain an average of 440 points in the Standard & Poor’s 500 stock index. By comparison bear markets since the 1930s have an average duration of only 18 months and an average loss in value of about 40 percent” (Lenzner, 2015).
Why then all this focus on bubbles? I think the world is moving more quickly. No one would really dispute this, but I’m not sure people have internalized what it means for investing. I’m simply suggesting that if you combine the age-old problem of short-termism, throw in social media, algorithmic trading, market-focused central banks and an increasing focus on liquefying capital markets, we are living through cycles much more rapidly than ever before. That means there will be more “bubbles,” if a bubble can only be identified by a sharp, bear market move that occurs in short order, as bear markets tend to anyway.
If this is true, investors should be seeking out non-tradable investments that compensate them for their lack of liquidity. The investment world is moving so quickly that liquidity simply isn’t the price that you pay for it.
Build the perfect portfolio
There is a broad market-timing solution to this problem that involves pulling money from the markets after a certain return is reached. In other words, I will invest in equities with a target of making some large return, say 20%, then pull that money and wait for a bear market before putting it back to work. The only problem is that if that money is pulled 3 years too early, or if the corrections are more shallow than usual, you are left with far too little return, especially with cash at 0%.
The more mainstream approach is to add diversity to a portfolio. Again, this is nothing new. Modern portfolio theory convinced us years ago that diversity was essential. Wall Street took it to a whole new level by offering literally thousands of different slices of markets – so now you can diversify yourself into oblivion if that is your desire.
While there is plenty of focus on the risks of the asset managers, what about the behavior of the largest pools of capital (away from central banks) – the pension funds? I took a look at the New York Public Employees pension fund as an example. In their 2014 annual report, they cited 65 equity funds across 13 different sub-categories. The 2004 statement lists 49 different managers across 8 sub-categories. I don’t mean to pick on New York – I don’t think they are different than any other large public pension fund – but the question is, are they more diverse now than they were in 2004?
Recently, this has worked out reasonably well in a world where correlations have been negative. The chart below uses the S&P 500 and long-bond futures to proxy fixed-income. It shows that since the financial crisis, there has been a diversifying effect from being in multiple asset classes. More interesting, and largely forgotten by investors, is the long period of time before the crisis where correlations were largely positive.
Historically, periods marked by negative correlations are followed by long stretches where the correlation turns positive. What could cause us to move to a world where assets are positively correlated? I’d argue there are many possibilities – inflation, central banks withdrawing liquidity, unsustainable sovereign debt levels – anything that makes investors in “liquid” markets rethink the strategies that have worked since correlations turned negative.
Avoiding the mountains ahead
Investors today are accepting record low yields across a growing pool of “liquid assets” in order to achieve their target return. With yields across the globe at or near all-time lows and equities in many place at all time-highs, it is time to lock in liquid gains and seek alternative places to invest funds.
Think about this scenario – S&Ps return -20% (not a massive correction in historic terms) and the ten-year treasury “normalizes” back to 4%, which would result in a roughly -16% return on a fixed-income portfolio. If correlations across markets turn positive, most other liquid investments will be marked down sharply as well. Investors can decide that such a move is unlikely, but historical correlations suggest otherwise.
To survive this type of move, investors need to seek true diversity. This does not mean buying European equities instead of US, or large cap instead of small – it means rethinking asset allocation from the highest level. Over the years since the financial crisis investors have crept out the risk spectrum to capture returns – and to a large extent that risk has been rewarded. On the other end of that spectrum is cash. Central banks keeping cash returns at zero (or below) have basically made cash a bad word. There is no way to survive whatever the next twist in the economy is without an increasing cash allocation. Increasing cash will reduce overall portfolio risk and provide ammunition for investing in assets when they do cheapen. This optionality in cash is undervalued in today’s world.
Diversity also comes from moving down in liquidity. There are plenty of interesting investments that reward investors with much higher yields than liquid markets in exchange for not being able to trade them. These investments create their own liquidity by spinning off cash flow and maturing over short periods of time and since they are not tradable, do not carry the same mark-to-market risk as liquid markets.
Short-termism compounds the problems caused by liquidity and correlation. While it is easy to blame asset managers, who are certainly complicit, the entire system is focused on what happens today as opposed to long-term growth and inflation levels that will drive investment returns. At the most important level, investors control the risk vs. reward calibration that drives investment return.
Investors, like elephants, try to avoid hills. We do so for similar reasons – very few people want to expend the energy it took to avoid the “hill” of 2008-2009 again. By thinking about these problems now, when markets are on solid ground, maybe we can learn from those large, lumbering mammals. They are the largest surviving terrestrial animals in the world for a reason – all we have to do is survive the next market cycle. That seems like relatively flat ground in the grand scheme of things.
Asset Bubbles: Re-thinking Policy for the Age of Asset Mangagment | IMF Working Paper 15/27 | Jones, Brad, 2015