This is a blog post with the conclusion first: Less wrong does not make things right. It is the time of the year when conferences, client-advisor meetings, and a batch of “hot-off-the-press” economic/investment outlooks make it topical to shape plans for future investing. Through our recent research, it appears that there is a significant conviction around two topics: 1) active asset management is dead, replaced with the rise of passive choices, especially “smart beta,” and 2) the U.S. remains, on a relative basis, the “best house on a bad block,” when it comes to allocating investment dollars – even though some pundits point to short-term challenges ahead
What is the value in challenging these majority convictions, considering that (admittedly) they have worked quite well in the recent past, not only individually, but also in combination? Using the near-30-year bull market in U.S. bonds as an example, a simple argument may be that what has worked so well in the past (e.g., buying 30-year Treasury bonds) may not continue to be the best solution going forward. With that stated, a real disconnect over market return expectations occurs between clients and their advisors. Based on a recent survey, investors are looking to achieve returns of 8.5% above inflation, whereas their advisors see a realistic chance of 5.9%. In other words, clients’ return expectations are nearly 45% greater than what their advisors are seeking, and current/future market conditions present a real challenge in this respect. Based on proprietary research, analyzing long-term (>5 years) Capital Market Assumptions (CMAs) published by major Wall Street and investment firms, returns near the 10% mark (when adding current inflation readings of 1.5% YoY) are nearly impossible to achieve, with two exceptions: Adjusting the investment horizon to 20 years out, and 2) “moving off” the high conviction positions mentioned in our opening paragraph.
The fact is that most investors – led by unrealistic return expectations or not – own the wrong assets to begin with, given where future returns are anticipated to be achieved. In equity markets, a regional shift away from the U.S. as “everyone’s darling” asset class is absolutely instrumental in positioning for more optimal future returns; further, emerging market equity markets, before developed international stocks, should produce significantly better outcomes. Using a “broad brush” of a statement, U.S. fixed income should be avoided or materially reduced, as total returns will hardly meet the rate of inflation (not even accounting for the risk of rates adjusting higher, as it relates to current holdings).
Recent capital flows support our analysis and our concerns about most investors’ inherent risk posturing. Although there appears to be positioning for higher volatility in U.S. equity markets, money continues to “pour” into U.S. fixed income. As discussed in our recent entry, Crexit, the domestic bond market is overvalued by unprecedented proportions. In fact, when applying a traditional Price/Earnings measure, the U.S. 10-year Treasury bond is 100+ percent more expensive than the average observed over the past 25 years; other than lack of imagination or understanding of the matter, there is no appropriate risk/reward argument to be made.
Focusing in on the risk argument, a related challenge to market expectations and future returns is that volatility (one “angle” of risk) has been suppressed through active central bank policy in recent years. Not only will forward-looking returns be lower across most asset classes, but investors will simultaneously have to accept higher volatility. While we may expect active management to be favored in such an environment, developments related to overall retail asset allocation choices have so far been counterintuitive, considering that passive market asset growth has outpaced that of the actively managed space since mid-2014 (passive increase of nearly $970 billion vs. active decrease of about $21 billion, and active management experiencing a trend of significant outflows since the end of 2012; source: Morningstar). Smart beta, the latest trend to promote the emergence of passive choices over actively managed solutions, is likely the last hurrah in supporting a world that has become hooked on the direction of central bank policy, rather than the value of an underlying asset.
It is time for “cleansing” conversations, starting with advisors and their clients. In an attempt to align communication and goals, it is instrumental for many of us to 1) reduce return expectations, and 2) avoid recency bias. The next 10 years will require a different approach to asset allocation compared to the previous 10 years, even though the financial industry wants to tell us otherwise through subtle hints of directional product creation. It is also important to review and state objectives around investing altogether: it is not important to “beat a number,” but rather to achieve personalized results, and financial planning remains a key element in this respect. With our suggested discipline in mind, investors have a chance to be almost right in their capitalistic pursuits, instead of being less wrong as a group and accepting collective failure akin to during the 2008 Financial Crisis.
For a lighter perspective on this topic, please also enjoy the Less Wrong Community.
Matthias Paul Kuhlmey is a partner and head of Global Investment Solutions (GIS) at HighTower Advisors. He serves as wealth manager to high net worth and ultra high net worth individuals, family offices and institutions.