Editor’s Letter

Having recently completed some work on the world’s leading special forces gave me an idea for this letter: Two of the most important qualities required of members of the special forces are total proficiency in their craft and the mental ability to keep questioning themselves. It occurred to me that investors ought to possess these skills, too.

Though we have already discussed some aspect of the issue I am raising, I am somewhat stunned by the dichotomy I am still seeing between economic forecasts and public and private capital market realities. Now, at a superficial level, this should not be a major surprise; the central banks of the developed world have been creating excess liquidity at an unprecedented pace, all the while several governments have purely and simply abandoned any form of fiscal discipline, a few using so-called “modern monetary theory” as a fig leaf. This excess liquidity has helped maintain interest rates lower than they should be, and thus probably did help somewhat. Yet, it has also led to misallocation of capital across entire economies; in particular, it has been sloshing around quite a number of capital market sectors, creating what we usually call “bubbles.” With the apparent determination of monetary authorities to stay the course, a few of these bubbles appear to have been inflating way beyond the point at which they would have been expected to burst.

As the saying goes, “those who ignore history are doomed to repeat it.” It is thus well worthwhile to observe that this is not the first time that we have seen this dichotomy. Hong Kong in 1982, Tokyo in 1988–89, New York in 2000 and in 2008 are but four examples of situations where fundamentals were pointing in one direction while markets were seeing something else. More importantly, in all four instances, market insiders insisted up until the inexorable last minute that all was well; dissenters were frequently laughed at. Each of these instances ended in tears. Japan persisted for several decades while the other three were followed by equally powerful recoveries. This should serve as a solid reminder of the need to keep one’s eyes on the long term and of the dangers associated with market timing. This is particularly true when one thinks of taxable investors; it is not cheap to realize a gain that one does not have to realize.

Yet, deep down, to this observer at least, the issue is not related to the question of whether capital markets are or are not overvalued and about to crater at this point. Indeed, even though a few economic forecasters have been right on and been warning of dangers ahead, the question remains—will markets discount the coming surprise, if they are right, through some major shake-up, or will markets simply underperform their long-term trends for a while, until valuations catch up with reality. The current euphemism to describe the latter scenario is, “companies will grow into the current valuations.”

To this observer, the real issue is broader. An over- or undervaluation phenomenon, as just discussed, may or may not have implications on long-term returns, particularly after tax. The real challenge involves the observation that a couple of new tendencies seem to be prevailing. The first relates to disaffection vis-à-vis facts and analytically reached conclusions and a trend toward narratives. Admittedly, such a distortion may be due to the sheer volume of facts available. However, whether these facts are plentiful or scarce, one should not allow oneself to ignore them. Yet, many of the current narratives are not necessarily based on facts, but more often on impressions, and real cynics might even add on wishful thinking (justifying rather than predicting). “Inflation will be transitory.” Why and why not? “China will have to become the world’s largest economy because it has the most inhabitants?” Is its size a new development and, if not, why is it not yet the largest economy? One could go on listing these gratuitous rationales, but the point is hopefully made. The second has to do with the fact that a whole new class of “investors” seems to view investing principally but not solely in equities as a game. “Meme” stock investing is a dangerous trend. Clearly, musical chair games can continue for a while, but they always have a loser.

Back to our special forces analogy, one could argue that many “investors” lack the proficiency in their area(s) of endeavor. Excess liquidity makes everything look simple, but it never suffices. I recently heard of an illiquid company that saw its value go up from a few million to more than a billion in just over one year. Crucially, there was no specific fundamental development. Rather, there were four distinct private equity rounds, each of which posted a major increase in the value of the company. Back to my musical chairs anyone?

Professional proficiency would allow investors to look at facts and data; to organize them, thus creating information; and to process that information to generate insights. Once that step is completed, it becomes possible to compare and contrast those insights to what market participants as a group seem to be believing. Differences between the two provide investment avenues susceptible to produce value added. Unfortunately, if few, or any, people bother with the generation of solid fundamental insights, as one could argue is the case at present, then differences between fundamental insights and market realities do not offer the potential for value added markets to continue to follow their own dynamics until an incontrovertible development causes a major break. While a source of opportunity, such developments are usually unpredictable (who would have guessed that Prime Minister Thatcher would announce in September 1982 that the UK would return Hong Kong to China in 1997?).

Thus, these opportunities generate massive increases in volatility and cannot totally be relied upon by investors, particularly when they must pay taxes to realign their portfolios. Ostensibly, excess liquidity does allow the tide to raise all boats. This may explain why many of the best stock pickers in the world have disappointed those who entrusted some of their assets to them. At the same time, how many investors or clients of investment managers would allow their portfolios to underperform for an extended period of time before they lost confidence?

This plays directly into our second special forces attribute: a willingness to question one’s views. It is very important to be able to question one’s perceived skills. How does this play in the current environment? We have just observed that it is predictable that investors who relied on traditional investment methods and tools might have underperformed. There are two possible approaches to such a bout of underperformance: One may change horses and adopt new approaches, or one may decide that the environment has changed, and not for the better, and neutralize bets until stability is found anew.

Shifting stance can, in some ways, be viewed as a form of “momentum investing philosophy” whose underlying principle is summarized in the belief that “whatever has been happening will continue to happen.” Many investors have successfully adopted that approach. Those who have the ability to question themselves will however monitor deviations from whatever “norm” appears reasonable. The combination of proficiency and self-questioning will have led them to the appreciation that something is amiss. At that point, knowing full well that they will inevitably miss the turn, identifying it after it has happened, a few will begin to shift in the direction of neutralizing bets.

Others will never even accept getting “into the game.” Their convictions will be strong that whatever development they identify is bound in the end to lead to tears. Unfortunately, they will often find themselves losing assets, if not in absolute at least in relative terms, as their underperformance will be all the more dramatic the longer the “abnormal event” lasts. A cynic might argue that the unwillingness to appreciate that decision making in the investment world is characterized by average success factors that only weather forecasters and baseball players can envy. A well-developed ability to question oneself would allow the investor not to fall into the mental rigidity of the investor who does not adapt.

In short, a solid professional proficiency and the ability to question oneself are two of the skills that should allow investors to adapt to circumstances, all the while retaining the capability to identify true excesses. This has allowed solid investors to adapt to the excess liquidity environment that has been prevailing for a while. Yet, they have been able to do it without abandoning the key anchor points, without which they are like fishing bobbers on the surface of the water.

In the end, I personally believe that investors must remain humble and avoid any form of cockiness. I also believe that they must endorse some philosophy that describes what moves security prices and how such moves can be captured. It is worrisome that many investors today seem to behave more like traders who ride waves up or down, but, in the end, do not seem to be in control.

Jean L. P. Brunel

Co-Editor

The Winter 2021 issue of The Journal of Wealth Management, as usual, covers a wide range of topics, reflecting our commitment to offer our readers a variety of insights across as much of the wealth management spectrum as possible.

The first two articles deal with asset allocation decisions. The first, by Jordan Moore, which deals with the implications of prospect theory, concludes that investment managers who structure contributions and fees to target investors with prospect theory preferences and the anchoring effect can increase individual investor savings and institutional management fees. The second, by Bryan Foltice and Steven Dolvin, examines the effectiveness of using a simple technical analysis indicator to determine overall portfolio risk level and finds that the technical strategies generally post an increase in Sharpe ratio when compared to their baseline “buy-and-hold” portfolios.

Our next two articles constitute somewhat of a discussion between two sets of authors, as they both contemplate the role of fixed income in a balanced portfolio. In the first, Aron Gottesman and Matthew Morey find that, in order to maximize the well-known Sharpe ratio, most investors over the period 1995–2019 would have been better off holding a majority of their assets in bond indices rather than stock indices. In the second, David Blanchett, finds that, focusing on “behavioral” investors, such as retirees (who typically have a strong preference for income), optimal equity allocations increase considerably when dividend yields equal or exceed bond yields, especially when considering taxes, even if equity price returns are reduced significantly.

Our next pair of articles is dedicated to tax issues in relation to investment management. The first, by Nathan Sosner and Roxana Steblea-Lora, explains how hedge fund investors might be affected by a limitation on excess business losses codified in a new IRC Section 461(l), introduced as a part of the TCJA of 2017 and later amended by the CARES Act of 2020, concluding that, on balance, Section 461(l) remains punitive, uneconomic, and unnecessary. The second, by Stephen Kuselias, Stephen Perreault, and Michael Shafer, compares the present value of social security benefits when taken early and the present value of benefits taken at the full or maximum retirement ages, concluding that taking social security early may be advantageous for many individuals.

Our last four articles offer somewhat of a heterogeneous group. The first, by Srinivas Nippani, Augustine Arize, and D. K. Malhotra, observes that the spread between the US T-bill rate and the London interbank offer rate (LIBOR), a proxy for perceived counterparty credit risk called the “TED spread,” increased, and they examine the impact of credit risk, as represented by the TED spread, on the daily returns of the ABAQ index, which represents community banks, and the KBW index, which represents the money center and other major banks. The second, by Joshua Mallett and Craig McCann, expands on their earlier article, looking at the additional non-traded REITs launched since May 1, 2015, as well as for the non-traded REITs in existence on May 1, 2015, concluding that the non-traded REITs’ underperformance is not driven by a short period of extremely poor performance but is instead common across time. The third, by Jean Brunel, follows on current literature with an important modification—the use of rolling betas relative to a qualitatively identified public market proxy, with results that may well be more representative of reality. Last, but not least, Adam Grealish and Petter Kolm look at robo-advisors and discuss the implementation of goal-based investing, socially responsible (ESG) investing, and smart beta strategies on robo-advisory platforms. They conclude that during the March 2020 downturn, portfolio performance was in agreement with broadly diversified stock and bond holdings.

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