The case for change
As Paul Black, the co-CEO at WCM Investment Management, noted this summer, asset management is ‘an industry that penalizes change.’ He writes:
Money management may be the only business where changing your process or belief system – because you’ve learned from your mistakes and want to get better – is frowned upon. Where else are you penalized for growing your knowledge base and making necessary improvements?
He goes on to explain how his firm originally invested in US large caps, with a focus on the size of moats, but today is better known for its international investing capabilities and focuses less on ‘elaborate’ discounted cash flow models and more on whether moats are growing or shrinking. The firm went from being on the brink of failure ($4bn in 2005 had turned to $900m in 2011) to having almost $100bn in assets today. Safe to say it hasn’t been too badly penalized for the change, but nor was it the kind of change that’s too common in the industry.
Per Black’s note, there was much more to the successful transformation than simply a change in process. But what the firm crucially did was recognize the need for a change (the firm was underperforming and losing money) and do something about it (it revamped its process, brought in new talent, and introduced a culture of greater accountability). It sounds simple in hindsight, but it’s something many organizations, not just asset managers, are slow to do: realize how you could perform better and adjust accordingly. The first part can be easy, it’s the second part that’s a struggle.
In their latest Consilient Observer paper, Michael Mauboussin and Dan Callahan note that ‘Philosophers discuss two sources of error in decision making. One is the result of limited knowledge. The second source of error is the failure to implement what is already known.’
The paper goes on to explain how sports teams, particularly those in the NBA, have begun to address the second form of error by making changes based on what they know but have essentially been ignoring. The clearest example of this being the shift to teams shooting more three pointers and fewer mid-range two pointers, as statistical analysis showed that this tactic resulted in more wins over the course of a season.
It sounds obvious today, but there are reasons teams were slow to make this change. The first, obviously, is that they needed the data – not an excuse fund managers can lean too heavily on. Other reasons Mauboussin and Callahan give for organizations’ slow pace of change are ‘status quo bias’ and ‘short-term time horizons,’ both of which money managers can far more justifiably relate to.
Another reason fund managers might be reluctant to make big changes is that it means admitting that something is wrong (whether their process, philosophy, or culture) and money management has never been the humblest of professions. As Black notes:
Most individuals attracted to investment management are exceptionally intelligent, have achieved a great deal academically, and (when successful) are highly compensated. Naturally, this bolsters the human ego, which makes it difficult for people to exhibit vulnerability about their mistakes and areas in which they need to improve.
And this barrier, or indeed any of the myriad others, means managers can be stuck making increasingly outlandish forecasts or missing out on the true driver of market returns, as we’ve covered here and here.
Don’t try this at work
Stocks generally go up. Stocks sometimes go down. Taken together, and mixed in with a third primary fact articulated below, these two statements encapsulate the riddle of investing.
There have been many attempts to capitalize on the former fact while trying to minimize the impact of the latter fact. One of the most persistent is the idea of ‘allocating’ to volatility strategies. The idea is to somehow add exposure to manufactured products that rise when markets become more volatile.
Over at The Capital Spectator, James Picerno argues for adding volatility-products exposure to a 60/40 portfolio. He ran an experiment using, as a proxy for this, the ProShares VIX Mid-Term Futures ETF (VIXM) – which he grants is non-ideal:
Let’s note up front that there are significant hazards to consider with vol ETFs, particularly in a buy-and-hold context. Given the tendency for the stock market to rise over time, VIX ETFs are destined to lose money. The longer you hold these funds, the deeper the loss (assuming a buy-and-hold strategy).
Except that isn’t quite right. The reason VIX ETFs lose money is more complicated and more interesting than Picerno makes out.
The VIXM strives to maintain consistent exposure to volatility futures expiring five months hence. In order to do this, the ETF ‘rolls positions from fourth-month contracts into seventh-month contracts.’
The only problem is the second law of thermodynamics. Put simply, the far future is more uncertain than the near future. So selling products exposed to expectations about the volatility of the nearer future in order to buy products exposed to the volatility expectations of the further future is generally a money-losing proposition. For that reason, the VIXM and its ilk lose money even when markets are flat; for instance, the VIXM fell about 15% in 2015.
But OK, let’s hear Picerno out. He doctors a standard 60/40 stocks/bonds portfolio by adding the VIXM to replace different-sized chunks of the bond exposure; he looks at 60/35/5% VIXM, as well as 60/30/10 and 60/20/20, and finds:
Although the standard 60/40 portfolio outperforms, the risk-management benefits of adding VIXM to the strategy isn’t trivial. Notably, Sharpe and Sortino ratios are higher in all three alternative portfolios and the maximum drawdowns are substantially softer. In other words, the reduction in return is arguably more than offset with lesser risk. Not too shabby when you consider that these alternative strategies require no forecasting or timing skills.
Here we have to bring in the third primary fact about investing: The market is the same for everyone, but every investor is different.
For most of who are actually committing money for a decade or longer, the fact that the 60/40 strategy suffered greater drawdowns during the Covid crash is more or less irrelevant. What matters is the returns. Unsurprisingly, these are worse the more to the VXIM you add, since the ETF has fallen about 90% over the past decade; according to Picerno, the 60/40 portfolio returned 10.9% per year, while the 60/20/20 portfolio returned 7.3%.
Does the investor who received the higher return care that on some days, his portfolio showed greater losses? We’ll have to ask him. And if he answers ‘yes,’ probably we should tell him to consider just cutting down on his equity holdings, instead of clinging to a negatively correlated ETF as it continues the slow march toward its asymptote of $0.