Friday, November 17, 2017
The latest performance numbers of Ivy League endowments have been nicely displayed in the chart below along with the 60/40 stock/bond portfolio. Since the development of the "endowment" model associated with Yale and the attention on Harvard, the largest endowment, there has been an unusual focus on these funds. There is a fair amount of dispersion between the best and worst managers in the group.
Nevertheless, investors can compete against these more sophisticated funds by even just holding some variation on the 60/40 stock/bond mix. Three of the last ten years have seen the 60/40 mix at the top of the rankings. Twice the 60/40 mix has been at the bottom of the grouping.
A large portion of the Ivy endowments has been associated with illiquid private equity investments. The 60/40 stock/bond investment blend is a liquid portfolio. It is possible that adding liquid assets that have higher returns than bonds or further diversification characteristics can generate more competitive returns to a simple 60/40 mix. A liquid investment strategy approach can compete with more sophisticated managers.
Monday, November 13, 2017
Implied volatility is usually higher than realized volatility so there is a positive volatility risk premium, except when there is a crisis or volatility spike at which time the volatility premium turns negative. A recent CBOE seminar presented a chart on the volatility premium to illustrate the risk.
The numbers suggest that being short volatility gave you a positive premium in a stable world, but when the world is less stable, (higher realized volatility), you do not want to be a vol seller. The chart suggests that there can still be a positive risk premium when realized volatility is high, but the odds work against you. It is a way to get to a realized volatility of more than 20% at current levels, but that world can become a reality quickly if there is an equity sell-off.
It is important to measure your short volatility where you may have been picking up vol premium. If you have too much, now is the time to cut that exposure.
Saturday, November 11, 2017
Investors should be concerned about the unintended behavior from low volatility. Low volatility will lead to higher volatility in the future when investors become complacent about risk, the "Volatility Paradox". This paradox has been discussed by Richard Bookstaber as early as 2011 and recently referred to in a post on his blog, Our low risk (low volatility) world.
Low volatility is a variation on the prosperity argument used by Minksy to start the cycle of speculative excess. Low volatility lulls investors into thinking risk is actually lower than reality just like prosperity or no economic downturn will cause bankers to change lending practices. Because perceived risk is lower, there is a willingness to increase leverage and increase investment in riskier assets. Risky assets are bid higher which are then used as collateral for further leverage. This volatility argument is separate from the reach for yield because of low interest rates. Risk-taking on low volatility makes the financial system more fragile.
The problem of misperception by investors with respect to measured risk and actual risk is real. Investors may be placing too much stock in recent volatility and too much emphasis on standard deviation as the right proxy for risk. Low volatility today does not mean low volatility tomorrow. Low volatility today will create behaviors that will lead to more risk tomorrow. The smart investor should be looking for long vol or divergent strategies that will profit from an increase in volatility.
Friday, November 10, 2017
Dan Fuss, the Loomis Sayles bond guru, has been working in fixed income for decades. He has developed a set of four "P's" with central bank behavior for looking at the macro fixed income environment and his read is suggesting that caution should be applied to any forecast that believes bonds are safe.
Many of the P factors are longer-term and associated with shocks, so it may not be trade worthy, but for investors who are looking at longer-term asset allocation, this type of checklist is valuable. We have made our own assessment and believe the tilt is away from the credit sector and should be focused on global diversification or strategies that can perform better if there is a global economic shock.