Weekly Edition #67

In this edition:


Nobody really knows where the 60/40 (60% invested in stocks and 40% invested in bonds) portfolio came from. But the reality is that it became the standard investment portfolio for institutional and retail investors alike. Some institutions have since moved on from the traditional allocation, but it still serves as a benchmark for many portfolios. Ever since the 2009 lows, a 60/40 portfolio has had spectacular risk-adjusted returns. This is because we’ve just lived through a period which was very favorable for both stocks and bonds.
Stocks tend to do best in economic regimes characterized by rising growth and falling inflation. Bonds tend to do best in periods of falling growth and falling inflation. Therefore, a 60/40 will do best when inflation is falling, which is exactly what we’ve lived through the last 10 years. Not only do stocks and bonds tend to do well in periods of falling inflation, but the correlation between both tends to be negative during periods of low inflation. This means that when inflation is low, stocks and bonds tend to move in different directions. Therefore, in periods when stocks drop, bonds tend to move in the opposite way and provide diversification. The last 10 years were the perfect environment for a 60/40. Both stocks and bonds did well, and their correlation was negative, so a 60/40 portfolio was fairly well diversified.

Ever since 2009, central banks around the world have been trying to create inflation but have been unable to do so. Today that’s a different story. After the covid stimulus measures, the supply chain disruptions, and now with the war in Ukraine, inflation has been running much hotter than before. Central banks have been slow to react but have now embarked on rate hikes which are expected to continue. So far growth is still positive but there is a risk that interest rate hikes will lead economies into recession. Therefore, the perfect environment for a 60/40 is rapidly turning into the nightmare scenario. If inflation continues and growth slows, stocks and bonds should do poorly and their correlations should increase, which reduces diversification benefits. We’ve seen this already this year, as of May 31st, the S&P 500 was down 12.79%, US Aggregate bonds were down 8.74% and a moderate allocation ETF was down 10.10%. This is exactly why we need to diversify away from only stocks and bonds and include other assets and strategies in portfolios.

Bitcoin’s story has changed several times since it was first created. It’s main story originally was that it was going to be a payments system to replace traditional fiat currencies. Now that it has gone up by thousands of times since then, the conversation has changed to more of a digital gold, inflation hedge, and store of value. The conversation has changed because of the incredible volatility bitcoin has. There’s a famous story in which in 2010 a guy paid 10,000 bitcoins for 2 Papa John’s pizzas. This amount today would be worth $300 million. If you believe that bitcoin will continue to go up, then the only logical thing to do is to hold it and not spend it. This is why the narrative has changed away from payments.
The next narrative was that it was an inflation hedge and an uncorrelated asset to traditional risk assets. However, this narrative is also falling apart. Bitcoin is down roughly 50% since it reached a high of $67k in November of last year. This year it’s down 37%, all while inflation has been running at the highest pace in several decades and stocks and bonds are all down. Therefore, the inflation hedge narrative and uncorrelated asset narrative don’t really hold up either. What will the next narrative be? A store of value? With all the volatility we doubt it. Digital gold? Maybe, but gold has a 3,000-year head start. We think bitcoin is a risk asset (at least in the Western world), that might fit in an investment portfolio, but nothing else. We don’t think it’s an efficient payments mechanism (at least in the West, people in autocratic countries will disagree), and we definitely don’t think that it will replace the dollar or any other fiat currency for that matter.

Traditional finance theory tells us that in order to earn higher expected returns investors need to take on more risk. The higher expected return is offered to compensate the higher risk. This is why typically stocks earn higher returns than bonds, which in turn earn higher returns than cash. We need to make sure to differentiate expected returns from realized returns. Expected returns is what you expect to make in an investment. Realized returns is what you actually made after the fact. Stocks offer higher expected returns than bonds, but realized returns are not always higher. For example, the period from January 2000 until December 2011, the S&P 500 returned 0% (dividends included). We often hear that stocks return between 9-10% per year, but this can have decades which stocks return 0% (like 2000-2011) or decades where stocks return 14% per year (like the last 10 years).

There’s increasing evidence that riskier investments don’t always return more than less risky investments. For example, in stocks, more volatile stocks tend to underperform less volatile stocks. Riskier bonds tend to underperform less risky bonds. Both in a total return and especially on a risk adjusted return basis. This has been shown to work across many different assets, through time, and in different markets. This is an interesting point because it goes against the most basic tenet of finance, which higher risk should be rewarded with higher expected returns. There are several explanations of why this can be but the data seems to be pretty clear. In order to earn higher expected returns you don’t necessarily need to take on more risk.

One of the main selling points of private equity is that it earns higher returns with lower volatility than public stocks. As you have probably figured out from our writings, we don’t agree with this point. We think that if you measure private equity with the right metrics (not IRR), the outperformance pretty much all goes away. And this is even before we start to think about the lack of liquidity, more leverage, and higher risks. If we start from a first principles perspective, the main difference between private and public equity is that one is traded on an exchange and the other is not. Since private equity is not traded on an exchange, there is no market price readily available. This means that, by definition, it will be less volatile than something that has market prices which change very millisecond. But if we think about it, if a private company had a market price, it should be much more volatile than a public stock. Private equity companies tend to be smaller and with more leverage than public companies. If we look at the universe of public companies and focus on the smaller subset with more leverage, they are more volatile than larger less levered stocks.

Even though the lower volatility of private equity is an optical illusion, there is real value in it. Even if an investor knows that the true volatility is much higher than what they see, it is nice to be able to ignore it and not see the portfolio getting marked down. The good news is that you can create the same effect with any investment. If you want your S&P 500 investment to be less volatile, then just don’t open your brokerage account every day. If you check it once every 3, 6 or 12 months, it will be much less volatile than if you check it every day. You don’t need to invest in private equity to reap the benefits of “lower” volatility, just forget your brokage password and you’re done!

This video is a refreshing take on ESG. Recently all the news regarding ESG has been either about how many funds are now moving to be ESG, how ESG funds should outperform, and how climate change is the biggest risk facing the world and we need to do something about it. In this video Stuart, takes the opposite view to many of these claims. He has several main claims:

  • Asset prices have continued increasing even as warnings have become ever graver. This means that either: 1. climate risk doesn’t matter, 2. it’s already priced in, or 3. all investors are wrong.

  • Due to the effect of compounding, a 5% contraction of the economy in 2100 will be negligible since the economy is going to be several multiples larger than what it is today

  • Even though climate catastrophes have increased, the damage and deaths from these catastrophes have come down because humans are great at adapting to new situations.

  • Finally, he goes into some detail into assumptions that some papers make to reach their climate change impact numbers and how they are unrealistic. Like we like to say, if you torture the data long enough it will tell you whatever you want to know.


Again, we’re not saying we agree or disagree with Stuart, but it is interesting to see someone taking the other side of the argument and arguing against ESG. The ESG conversation is stepping up, the SEC is proposing new rules to prevent greenwashing, and regulators are cracking down on greenwashing claims from ESG funds. Like we’ve been writing for a while now, we need to make sure we understand what we’re investing in to not be misled by false claims.

Thanks for reading!

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