Short sharpe shock
It is human nature and a well-known fact that what gets measured tends to be what is easily measured. In the world of fund management, the two items that are most easily and frequently measured are fees and performance. Investors often overlook measuring risk entirely.
When it comes to active fund management, this approach to measurement has resulted in net capital outflows from active funds into passive investments. According to Morningstar, 2016 was one of the worst years for active management fund flows. US actively managed funds saw outflows of $340 billion for the year. Passive funds, dominated by Vanguard Group, the poster child for passives saw $505 billion of inflows in 2016.
The reasons for the shift in assets away from active and into passive are part structural, part cyclical and in no small part driven by performance versus fee evaluation.
The structural shift from active to passive can be explained, in part, by growth in assets and changing trends in global pension plan systems. In the US use of 401k plans continues to grow and many employers are opting to provide qualified default funds to relieve them of financial liability. According to ASFA, the Association of Superannuation Funds of Australia, Australian superannuation fund assets continue to grow, reaching 2.3 trillion AUD in March this year up 11.2% over 12 months. In Australia just under a third of superannuation fund assets are held in self-managed superannuation funds. In the UK, DC schemes are seeing rapid growth along with ISAs, SIPPs and LISAs – which could become the vehicle of choice for a new generation of savers.
From a cyclical standpoint, investors have experienced a sustained bull market in equities during which the average active manager has underperformed the main indices. Investors have felt that the performance offered by actively managed funds is not compelling when compared to passive indices, and that the fees charged are not justified by the results achieved. Active management is having a torrid time demonstrating its relevance.
All this leads to investors making the simple choice of opting for a cheap index fund that is generating good returns – but who is considering how to measure the risk that may be lurking in investors’ portfolios, and what the future may hold for index funds when markets turn?
Do the majority of investors have the tools, data or expertise to measure risk? Do they understand risk indicators such as the Sharpe ratio? Quite often they don’t, which brings us back to the point that what tends to get measured is what is easiest to measure.
Decisions by Default
The structural shift from active to passive can, in part, be explained by growth in assets and changing trends in global pension plan systems. People that contribute to long-term savings plans, often through a workplace pension, usually have a choice about how their money is invested and are able to choose from a variety of funds offered by their provider. However, certainly in the UK at least, many of these savers are quite happy with a default fund offered by their pension provider. With a default fund, the saver does not need to make a decision about how their savings are invested – they may choose this option because they would prefer to leave that decision to their pension provider, or because they don’t have the experience and/or interest to select from a range of options. According to MoneyWise, over 80% of UK savers opt for a predetermined mix of default funds.
Default funds are often modelled on the traditional and well-understood “balanced portfolio”; a combination of equities and bonds. A balanced portfolio has traditionally seen allocations anchored 60% to equities and 40% to bonds, with allocations increasing or decreasing to either asset class largely depending on one’s tolerance to risk and investment time horizon; the older or more risk averse one is, the greater the allocation to bonds.
The underlying assets of many default fund offerings comprise passive investments. Why? Because they are cheap. In the UK, a 0.5% fee cap is often applied to default funds. This 0.5% maximum fee includes management charges, custody and administration expenses. For most investors, this basic turnkey solution is simple to understand and easy to measure.
The majority of investors that choose default funds have neither the tools, data nor expertise to measure risk, which bring us back to a point made in my last note, that what tends to get measured is what is easiest to measure. The bad news for this new generation of passive savers is that risk needs to be given much more consideration. “Just because you can’t see the crocodiles, it does not mean that they are not there” – so goes the old African proverb. The same applies to risk: just because you can’t see it, it doesn’t mean that it is not there.
The Great Risk Premium Compression
For some time now, central bank policy and low market volatility have caused risk premiums to be compressed to multi-generation lows. When risk premiums are low, active managers struggle to outperform, driving many of their clients to seek cheaper passive investments. Savers allocating to passive strategies, or opting for passive balanced funds, may be setting themselves up for disappointment. Let’s go back 30 years.
Taking a sharpe’r look at history
The Sharpe ratio of an investment is a tool that investors use to assess the risk-adjusted rate of performance of their investment i.e. for every unit of risk that is taken, is the investor being adequately compensated? A Sharpe ratio in excess of one should be the aspiration of any investor.
Sharpe ratio = Percentage return of portfolio – Risk free rate
Volatility of portfolio
During Q1 and Q2 2017 the total return (including dividends) of the S&P 500 Index was +9.34%. Over the past eight years, since the beginning of the current bull market in equities starting in Q2 2009, the S&P 500 generated a total return over 290% and experienced only seven negative quarters. Over that time, the annualised total return and volatility of the S&P 500 was 18.1% and 13.0% respectively – generating a Sharpe ratio of 1.3. This ranks as the best eight-year period ever when looking at risk-adjusted performance for the S&P 500.
To explore this further we looked at the historic Sharpe ratio of a passive 60/40 equity bond balanced portfolio going back to 1988, taking the S&P 500 as a proxy for equities and Barclays US Government Bond Index as a proxy for bonds . The last 30 years have seen a phenomenal bull market in bonds and an equity market that has seen periods of very strong performance, occasionally interrupted by bone rattling-volatility – 1987, 2000, 2008.
Notwithstanding periods of volatility, this complementary combination of equities and bonds generated a satisfactory result for investors. Complementary, because bonds and equities have been fairly reliable in counteracting one another during turbulent markets. But, times are changing and this complementary relationship is beginning to break down.
We observed that, on a rolling four year basis, the Sharpe ratio of a 60/40 equity bond balanced portfolio has been greater than 1 since January 2013. The only other time in nearly 30 years when the Sharpe ratio of a balanced portfolio has been anywhere near close to this level was in the late 1990s just before the dotcom crash, when the Sharpe ratio was 0.9.
Sharpe ratio of a 60/40 equity bond balanced portfolio
The CBOE Volatility (VIX) index – often referred to as a “fear” gauge – is a measure of 30-day implied S&P volatility. Currently, the VIX is the lowest it has been since the index was formed, nearly 25 years ago. It is difficult to argue, in the absence of market volatility (or fear), that the continued upward march of equities seems inexorable.
CBOE Volatility Index (VIX)
A characteristic of markets that investors generally agree on is the concept of mean reversion, i.e. that over the long-term most instruments, markets and indices revert to their long-term average performance. The long-term Sharpe ratio for a balanced portfolio (60% S&P 500 / 40% Barclays US Government Bond Index since 1988) is approximately 0.51, substantially less than the level that is being enjoyed today, which was just under 1.2 in June this year. Mean reversion can occur gradually or sharply. Whilst gradual changes are always preferred, sharp ones are often experienced. Many investors holding passive investments may not be prepared for a reversion to the mean, particularly if this is sudden rather than gradual. Investors who are close to drawing down on long-term savings and pensions could be caught out and may face significant losses without the length of investment horizon required to see their savings recover over time.
Recently I have discussed the trend towards passive investments, the high Sharpe ratios enjoyed by traditional balanced portfolios in recent years and the hidden risk in passive balanced portfolios that many investors are not aware of.
Investors today are faced with a dilemma: is it sensible to maintain a high allocation to bonds on a forward-looking basis? To do so is to accept extraordinarily low yields in an interest rate environment that is arguably at an inflection point. Equally, is it sensible to maintain a large exposure to equities, given they have enjoyed one of the longest bull runs in living memory, which cannot go on forever?
So, what about the next 8 years – should we expect another 290% total return in equities and continued yield compression in bonds? Investors ought to be questioning whether now is a good time to continue to invest the same way as has been done for the past several decades.
As a group that focusses on absolute returns with an emphasis on low market correlation, Aurum is less concerned about the direction of either fixed income or equity markets. Aurum has observed many market cycles and abrupt turns over 23 years actively managing portfolios of hedge funds.
While Aurum is not in the business of predicting the top of the market, forecasting bear markets (or bull markets for that matter) or picking a fight with equities and bonds, it sees itself as challenging convention. It is at times like these, when equities and bonds are both looking somewhat precarious, that investors should challenge their own assumptions about the sustainability of a balanced portfolio. The simple mathematics of bonds gives an investor very little upside from this point in the cycle. The tenuous position of the global market equity indices means that it takes a bold investor to allocate a sizeable proportion of their retirement fund to equities. We encourage investors to take a careful look at the risk that may be accumulating in a supposedly benign balanced portfolio which, like a crocodile, may be lurking below the surface.
As my grandfather used to say “It is not how much money you make when everyone is making money, but how much you don’t lose when everyone is losing money”. We would argue that markets are at the point in the cycle where avoiding losses should be a sound starting point for investors – and that means questioning the prospects of a balanced portfolio.