November 2012
Flip My Portfolio?
Readers of a certain age may recall Flip Wilson, host of a 1970s
variety show, and the characters he created. For example,
Geraldine Jones became famous because of her catchphrases
such as “the devil made me do it!” and “what you see is what you
get,” the latter the source of the acronym WYSIWYG still used
in the computer industry. Investor behavior, however, reminds
us more of Wilson’s character Reverend Leroy, the avaricious
minister of The Church of What Is Happening Now.
Financial market participants and commentators seem always to be congregants of The
Church of What Is Happening Now. Perceptions of the market overwhelmingly are
influenced by current or recent events, regardless of underlying values or reality. A typical
example is a recent New York Times article, by a seasoned and respected journalist, on the
supposed failure of endowment investing by elite universities. The article criticized the
investment performance of leading endowments over the past few years because it lagged that
of an indexed portfolio invested 60 percent in stocks and 40 percent in bonds. Simple
enough, but the concepts jumbled together in the article and a missing sense of context make
the seemingly simple conclusion misleading.
First, active investment managers, as opposed to those following passive index investing, have
had a rough couple of years. Sigma is agnostic, or more precisely pragmatic, in the active
management/index debate – a significant percentage of our typical client account is placed
both with active managers and in index investments. Think of it this way -- two of the largest
mutual fund companies are Vanguard, emphasizing an indexing approach, and Fidelity,
emphasizing an active management approach. If either indexing or active management were
always “right,” or if the market were as all-fired efficient as claimed by proponents of
indexing, one of those firms should have gone out of business. A review of past performance
indicates that the relative lead of one approach over the other is cyclical, with neither having
an enduring advantage.
TACTICAL GLOBAL INDEPENDENT
For example, in the late 1990s, indexing beat active management as high-priced technology stocks,
shunned by reasonable managers, drove the market indexes. The more investors paid for tech stocks,
the greater the percentage of index value accounted for by the technology sector. When the tech
bubble burst in 2000, active managers did far better as tech stocks deflated. Value-oriented active
managers always are going to lag in momentum-driven markets. History tells us, though, that despite
results in the last couple of years, active managers will have their day in the sun again.
Second, the article seems guilty of a sin of omission in that
the index portfolio comparison seems devoid of foreign
holdings. As with indexing, foreign stock holdings have a
very time-specific effect on performance figures. Since foreign
-- Geraldine Jones (Flip Wilson)
market performance has trailed that of the U.S. market
recently, portfolios with foreign stocks (including the typical
major endowment), likely lagged a portfolio that doesn’t hold any foreign stocks over the past five
years. If you look at the period between 2002 and 2007, foreign stock performance dominated that
of the U.S. markets. Like active vs. passive investing, the performance of U.S. stocks versus foreign
stocks is cyclical. Current valuations in foreign stock markets are now significantly cheaper than
valuations in the U.S. stock market.
“When you’re hot, you’re hot;
when you’re not, you’re not.”
Third, the article criticizes the use by many endowments of hedge funds. We too are skeptical of
these “alternative” investments (see, for example, our February 2005 newsletter, archived on our
website). While hedge funds are no magic elixir, neither are they necessarily a poison. Our guess is
that in the next secular bull market, the distinction between hedge funds and traditional investments
virtually will disappear. You don’t need an “alternative” when “normal” is working.
Finally, most major endowments have an asset allocation more aggressive than the 60 percent stock,
40 percent bond portfolio used as a comparison in the article. In the flat to down equity markets of
the last twelve years, of course a more conservative allocation looks relatively good. In the buoyant
1990s, the more aggressive allocation would perform better. So what? The real question is whether
an allocation target is suitable for the portfolio. Since most endowments have a very long time
horizon, an aggressive equity target is completely appropriate, especially now with the 10-year U.S.
Treasury bond yielding around 1.6 percent, down from almost 16 percent in 1981. It would be
unwise to count on bonds being the performance enhancer they have been over the past decade.
In summary, the Times article, and most other market commentary we see, commits the same error
that plagues investors generally – extrapolating recent past performance, relying too much on The
Church of What Is Happening Now. The past few years have been hard on active managers, equities
generally and foreign stocks specifically, and therefore actively managed, high-equity portfolios with
foreign stocks (like most major endowments) have suffered. As the investment ads warn, though,
past performance is no guarantee of future results. In this case, the past performance relied upon in
the article may be a particularly misleading gauge of what the future will bring, a message applicable
to all investors, not just endowments – what you see is not what you will get. The devil of market
commentary, emphasizing the recent past, leads investors in the wrong direction.