The level of dissatisfaction with wrap programs offered by the largest TAMPS has reached a new zenith. Underperformance has been remarkably broad, consistent, and durable. Many factors have contributed to this underperformance, but two stand out, the inability of the average mutual fund to beat a simple index ETF or ETN and “Buy & Hold’s” inability to perform ever since the 18-year bull market of 1982-2000 ended.
I addressed the challenge of mutual fund underperformance in my August 27th RIA Central article entitled “The Death of Mutual Fund Wrap”.Therefore, let’s turn here to the second of these two sources of underperformance, i.e., Buy & Hold strategies (hereafter referred to as B&H).To begin this dialogue, we must first describe B&H’s underlying “logic.” B&H is based on a series of beliefs about how the investment world operates. These include:
- Asset categories have inherent, fundamental defining properties. These properties are stable and dependable. For example, stocks will deliver an average 10% per year with a 20% standard deviation. The prices of securities and asset categories follow a Random Walk.
- Markets are efficiently priced and reflect all currently available information.
- Investors are logical and sensible. Collectively, investors correctly process all available information in a consistent and stable fashion. Collectively, investor preferences are stable over time.
If these beliefs are correct, then how is it possible for large cap domestic equities to deliver a 0% real return for 17 years running, and then earn a 12% real return for the subsequent 17 years? Or for U.S. Treasuries to earn a 0% real return for 29 years followed by a 7% real return for the subsequent 29 years? Or for commodities to earn 0% real return for 30 years followed by a 5% real return over the subsequent 30-year period ?
In other words, B&H is based on a series of assumptions that don’t hold in reality. Nevertheless, it had become the accepted wisdom by March 2000, the beginning of the tech-wreck. This is not surprising, in that during the eighteen years leading up to the year-2000 collapse, large cap, small cap, treasuries, corporates, and real estate, essentially all went straight up – creating an environment that made B&H look like it actually worked. So if B&H has no long-lasting basis in real world market behavior, what are its origins? It started in academia and was then reinforced by industry behavior. Academics developed the now famous “Efficient Market Hypothesis”  and the related“Random Walk Theory” . As is academics want, they had the need to apply their theories to the real world and to thereby draw conclusions about how the real world must work if their theories are correct. The investment industry encouraged this line of thinking through its very robust propensity to build investment products that target non-performance based objectives . This industry behavior left beta as the only source of return. In other words, active investment decisions don’t add value, so one may as well just buy and hold.
Unfortunately, asset class performance varies considerably from episodic era to episodic era. Each era is driven by a surprisingly different and distinct set of drivers. These drivers change from one period to the next. The eighteen-year bull market for U.S. equities spanning 1982 through 2000 was driven by the restructuring of U.S. business after the malaise and dysfunction of the 1970s in combination with a rapid expansion of global trade, relaxation of regulation, and the unprecedented leveraging of both the domestic and global economies. The current U.S. equity era (post-2000) is defined by once-in-a-lifetime deleveraging, the loss of U.S. global competitiveness, regulation and regulatory uncertainty, and the consequences of federal, state, and local governments reaching (or exceeding) their abilities to take on ever increasing implicit and explicit levels of debt and liabilities. These are profoundly different eras, driven by altogether different forces, generating fundamentally different investment behaviors for U.S. equities.
B&H makes no sense. However, to the extent that we can understand the nature of our current episodic era and its primary drivers, then we are able to construct investment portfolios that are in alignment and harmony with these long-duration forces. This has nothing to do with market timing. Instead it is about understanding the winners and losers for the era within which we find ourselves. It requires a highly opportunistic approach tempered with diligent patience that considers the entire range of all possible traditional and non-traditional asset categories located within any geography or asset niche. For a U.S.-based investor, the following four drivers might define the current episodic era:
Clean Up. The Great Recession was a once-in-a-lifetime event. It takes many years to complete the clean up following such an economic debacle. The deleveraging process has begun and has now proceeded for almost four years. Historically, such deleveraging processes have never been completed in less than ten years. We have many more to go. We face profound and widespread non-economic behavior by governments, banks, and the institutions that they control, regulate, or influence. Finally, capital markets are littered with orphaned securities and abandoned security market niches.
Governmental Limits. State and local governments have reached the limits of their ability to take on much less service debt and implicit or explicit liabilities. As a consequence, they are now unable to maintain existing public services and public infrastructure, nor can they satisfy existing promised pension and healthcare entitlements. This will eventually resulting in privatizations and out-sourcings.
Global Evolution. A powerful, multi-decade development of an emerging middle class is unfolding across the global emerging countries. Indonesia, Turkey, and Mexico provide outstanding examples of this trend in the three primary geographic regions. The depth, breadth, and regulatory oversight of emerging country security markets and private investment opportunities continue to improve at a rapid pace. A global race has begun to lock up key natural resource deposits and related capabilities. The age of entitlements is coming to an end in the U.S. and other old-iron European nations. Those countries around the world that remain unlevered, have positive currency reserves, and are experiencing rapidly growing middle classes are in a unique position to dominate and thrive for the next decade. In contrast, the U.S. continues to struggle and find a pathway by which it can regain an ability to effectively compete on a global basis.
Housing. The data on the U.S. housing market strongly supports a conclusion that the downtrend has ended for single-family dwellings across the nation. An end to this unprecedented decline bodes well for the U.S. economy for two reasons. First, housing is one of the largest industries. Second, and more important, a turnaround in housing has the potential to quite strongly improve both consumer and business confidence – encouraging both segments to begin spending again.
B&H never really had a basis in the real world. Asset categories never had the behavioral stability required for B&H to make sense. But thankfully, if we can identify and understand the durable primary drivers of our current episodic era, then we will be able to assemble an asset mix far superior to anything that B&H could identify.