Gold, Risk & Leverage: ReSolve Visits the Meb Faber Podcast
- Why asset allocation drives performance;
- Why mistaking capital allocation with risk attribution is a grave error;
- How leverage can be both a return amplifier, or risk mitigator; and
- Why sequence of returns risk can ruin your retirement dreams.
Of course, this is just a small sample. We strongly suggest you take the time to listen to the show. It was a trip!
Why Asset Allocation Drives Performance
Meb: So why don’t you guys start with talking about how you think about top-down investing in general…
Adam: The fundamental recognition is that asset allocation completely dominates long-term portfolio outcomes. There’s a pile of research out there, most of it is really misunderstood. For instance, Brinson’s a perfect example where the original research claimed that 90% of returns were explained by asset allocation, then everybody came aboard and said that asset allocation is responsible for 90% of performance. Then some notables like Ibbotson and Kaplan came out and blasted a bunch of those myths.
Regardless of the exact number, asset allocation is the dominant theme, whether it’s 50% or 2/3rds or 90%, whatever. Asset allocation is what matters to long-term portfolio outcomes. So that was number one. Once of you realized that, then it’s “Okay, well, how do you effectively focus on asset allocation?”
Once you start really digging into some of the more advanced asset allocation techniques and realizing that 60/40 works really, really well in some economic environments but really struggles in others, then you start to want to broaden your scope and think more globally. That was really the starting point for our journey.
Why Mistaking Capital Allocation with Risk Attribution is a Grave Error
Meb: Can you explain a little bit about Risk Parity and how you construct these portfolios, for listeners who may not be familiar?
Rodrigo: Going back to the Global Market Portfolio, the first thing you have to do is say, “Okay, this is a passive benchmark. Any deviation away from this is an active bet.” So how do we best make those active bets? Well, in a 50/50 portfolio, stock and bonds may seem like they’re contributing the same amount of risk to the client’s portfolio. But in reality we know that the equity side of that dominates the volatility of the entire portfolio.
In fact, when you measure it, the equity side represents 90% to 98% of the volatility of that portfolio. The bond side of the equation offers very little in terms of diversification benefits. The Global Market Portfolio, the first thing that it does is it allows you to get exposure to a broad array of risk premium, global asset classes that will do well in different market environments.
A strategic risk parity methodology looks at long-term estimates of correlations and volatilities and gives a higher weighting to those with lower volatility and greater diversification benefits, and less weight to riskier asset classes like equities. So if you look at a traditional stock/bond portfolio and if you wanted to risk balance that, the portfolio would be something along the lines of 80% bonds and 20% equities.
The Two Faces of Leverage: Return Amplifier, or Risk Mitigator
Adam: The thing about leverage is that it just allows you to scale risk. And so the fundamental shift that a person goes through when they begin to think in terms of risk parity, is they begin to think in terms of risk allocation instead of capital allocation…You want to have an allocation to a wide variety of different global risk premia that behave differently in different economic environments.
So you’ve always got something that’s killing it in your portfolio because it’s perfectly aligned with the current economic environment. And, you’ve always got something that’s killing you in the portfolio because it’s exactly the opposite of what would thrive in the current economic environment. But on balance, the overall portfolio is chugging along normally as if nothing’s irregular. You get this sort of steady performance through thick and thin.
But the problem is that all these different asset classes have very different risk characters. So if you think about them on an equal capital allocation basis, then what ends up happening is that the more volatile assets, that by the way also tend to be more highly correlated with one another, end up completely dominating the risk of the portfolio. So the portfolio ends up being completely susceptible to the economic environment that, for example, equities do well in.
The other asset classes that do well in different regimes have no opportunity to exert their benefits when those regimes actually manifest. So it’s this risk interpretation instead of a capital interpretation that really defines that transition to risk parity.
Michael: I think that also, one of the things that everybody is told is about the avoidance of leverage. Which is strange, because you can own the S&P 500 which has got a debt-to-equity of 2 to 3 and that’s okay, but God forbid, you lever a well-diversified and balanced portfolio. And to be clear, leveraging a well-diversified portfolio may be, I think, another key thing to consider as a persistent edge. There are willing losers who would rather contaminate their portfolios with more equity in order to try and achieve a higher return rather than lever a diversified portfolio. I think that’s a key point to the way we think about leverage.
How Factor Overlays Can Help
Michael: Remember, if you’re really well-diversified and you’ve got assets exposed to all of these economic regimes that can manifest, you’re going to have something that’s killing it and you’re going to have something that’s killing you.
So now what you should want is a process in which you identify and back away from assets in a persistently negative trend. Not eliminate it from the portfolio, but just reduce the exposure to it over time and have a process that is not “on or off,” but more nuanced and probabilistic. Let’s say it’s a 70% chance that an asset class is going to have negative returns, you would reduce exposure to that asset class by 70%. And that’s the way we think about dynamically overlaying a process in the portfolio that improves the result.
Rodrigo: And that’s where our risk parity methodology is dynamic: it’s looking at trend. But versus other more traditional risk parity approaches, we also observe volatilities and correlations consistently and adjust the way the portfolio is allocated based on those changes, to deemphasize asset classes in a consistent negative trend. We’re just looking at the universe more often, applying the absolute momentum factor, and then maximizing diversification by optimizing for risk parity.
Why Sequence of Returns Risk Can Ruin Your Retirement Dreams
Meb: One of the things you guys talked about is sequence of returns, particularly for retirees. This is a topic that our investors are very interested in, and we haven’t talked much about. Maybe you all could touch on sequence of returns and how and why that matters.
Rodrigo: It’s interesting to think about the average risk-taking investor that has the majority of their money in equities. You know, I think they’re generally prepared to take some volatility and some underperforming years in order to achieve something close to a long-term expected return.
But the problem is that those negative years or negative periods can last a lot longer than what investors expect. And in fact, we outline a period from 1966 to 1997 where the Dow Jones annualized 8% on average. But over the first half, from 1966 to 1982 the returns were 0%, and from 1982 to 1987 returns were around 16%. In this case, the average return over the whole period doesn’t matter at all – it’s like having your head in the freezer and your feet in the fire, right?
In the book, we show a case study where a retiree who wants to have a certain fixed retirement income, no matter what. If that person retired in 1982, without even trying they would have sustained that income and would have left a huge estate. Somebody retiring in 1966 would have run out of money within 7 years.
Sequence of returns matters a lot.
To learn more about this and our other ongoing research topics, please visit our Critical Research Page.