During this week’s global stockmarket volatility, as in 2017, we were again reminded of the importance of following an investment approach based on discipline and diversification vs. prediction and timing. As we leave the new year and venture into 2018, we can look at several examples during 2017 that provide perspective on what guidance investors may want to follow, or not follow, in order to achieve the long-term return the capital markets offer.
Each January, a well-known financial publication invites a group of experienced investment professionals to New York for a lengthy roundtable discussion of the investment outlook for the year ahead. The nine panelists have spent their careers studying companies and poring over economic statistics to find the most rewarding investment opportunities around the globe.
Ahead of 2017, the authors of the publication’s report were struck by the “remarkably cohesive consensus” among the members of the group, who often find much to disagree about. Not one pro expressed strong enthusiasm for global equities in the year ahead, two expected returns to be negative for the year, and the most optimistic forecast was for a total return of 7%. They cited “gigantic geopolitical issues,” including a Chinese “debt bubble” and a “crisis” in the Italian banking system.
The above-mentioned panel was no aberration. Among 28 economists polled by Financial Times, for example, more than two-thirds anticipated parity between the euro and the US dollar in 2017. Expert or not, there is little evidence that accurate predictions about future events, as well as how the market will react to those events, can be achieved on a consistent basis.
THE MILLION DOLLAR BET
Last year saw the conclusion of a 10-year wager between Warren Buffett, chairman of Berkshire Hathaway Inc., and Ted Seides, a New York hedge fund consultant. Seides responded to a public challenge issued by Buffett in 2007 regarding the merits of hedge funds relative to low-cost passive vehicles. The two men agreed to bet $1 million on the outcome of their respective investment strategies over the 10-year period from January 1, 2008, through December 31, 2017. Buffett selected the S&P 500 Index, Seides selected five hedge funds, and the stakes were earmarked for the winner’s preferred charity. The terms were revised midway through the period by converting the sum invested in bonds to Berkshire Hathaway shares, so the final amount is reported to be in excess of $2.2 million.
The 10-year period included years of dramatic decline for the S&P 500 Index (–37.0% in 2008) as well as above-average gains (+32.4% in 2013), so there was ample opportunity for clever managers to attempt to outperform a buy-and-hold strategy through a successful timing strategy. For fans of hedge funds, however, the results were not encouraging. For the nine-year period from January 1, 2008, through December 31, 2016, the average of the five hedge funds achieved a total return of 22.0% compared to 85.5% for the S&P 500 Index. (Results for 2017 have not yet been reported.)
Having fallen far behind after nine years, Seides graciously conceded defeat in mid-2017. But he pointed out in a May 2017 Bloomberg article that in the first 14 months of the bet, the S&P 500 Index declined roughly 50% while his basket of hedge funds declined less than half as much. He suggested that many investors bailed out of their S&P 500‑type strategies in 2008 and never participated in the recovery. Hedge fund participants, he argued, “stood a much better chance of staying the course.”
Seides makes a valid point — long run returns don’t matter if the strategy is abandoned along the way. And there is ample evidence that private investors sold in late 2008 and missed out on substantial subsequent gains. But do hedge funds offer the best solution to this problem? We think educating investors about the unpredictability of capital market returns and the importance of appropriate asset allocation will likely prove more fruitful than paying fees to guess where markets are headed next. A hypothetical global diversified allocation of 60% equities and 40% fixed income still outperformed the hedge fund basket over the same nine years (41.8% vs 22.0% in total returns).
Over any time period some managers will outperform index-type strategies, although most research studies find that the number is no greater than we would expect by chance. Advocates of active management often claim that this evidence does not concern them, since superior managers can be identified in advance by conducting a thorough assessment of manager skills. But this 10‑year challenge offers additional evidence that investors will most likely find such efforts fail to improve their investment experience.
EXPECT THE UNEXPECTED
Financial markets surprised many investors in 2017, but then again they have a long history of surprising investors. For example, from 1926–2017, the annualised return for the S&P 500 Index was 10.2%. But returns in any single year were seldom close to this figure. They fell in a range between 8% and 12% only six times in the last 92 years but experienced gains or losses greater than 20% 40 times (34 gains, six losses). Investors should appreciate that many times realised returns may be far different from expected returns.
For a number of investors, 2017 was a paradox. The harder they tried to enhance their results by paying close attention to current events, the more likely they failed to capture the rate of return the capital markets offered.
New Year’s resolution: Keep informed on current events as a responsible citizen. Let the capital markets decide where returns will be generated.