The first half of the year has proven to be extremely difficult for most asset classes and for most traditional portfolios. 10-year US Treasuries (USTs) are down roughly 9% for the year. According to Deutsche Bank, returns haven’t been this bad since 1787, when George Washington was president. The yield on 10-year USTs has doubled from 1.51% to 3.14%. The persistently high inflation reports have been a large driver of why USTs have been selling off. 20+ year Treasuries have fallen roughly 19%, in line with the S&P 500.
The silver lining in an all this is that expected returns for bonds are much higher now. At the beginning of the year, we would expect 10-year USTs to deliver roughly 1.5% per year for the next 10 years. Now we expect them to return roughly 3% per year for the next ten years. Living through these drawdowns is tough, no doubt. But if we have cash somewhere, now is a great time to put it to work. Drops in asset prices means expected returns are going up. So, the pain that we’ve lived through will translate into higher returns going forward.
The key theme in 2022 has been inflation. We’ve written several times that inflation is the kryptonite of most asset classes. During the inflationary periods of the 1970s both stocks and bonds fared poorly. This year has been the same story. Like we wrote above, stocks and bonds have both fallen this year. We’ve been writing for some time now that if inflation proved to not be transitory, traditional portfolios would suffer. We said the solution was to include inflation hedging assets such as commodities, gold and TIPS.
How have they performed this year?
Another day, another crypto hacking or scam story. Crypto enthusiasts always point towards the fact that blockchains and smart contracts only run according to their code, and that there is no centralized party that can control what happens. This is all good if the code is flawless and the developer has thought of every single edge case possible. However, this almost is never true. Software is buggy, and there are errors in code all the time. Especially in complex code like what is used in some crypto projects and some smart contracts.
Software bugs appear all the time. And some bugs are even exploited by hackers to steal information from user’s computers or company databases and such. However, the big difference is that in the traditional world, we have legal recourse. For example, if somebody hacks our computer and steals credit card information and spends a bunch of money. We can tell the bank that our credit card had been stolen and have many of those purchases reversed. If somebody steals a private key to a crypto wallet and steals funds, there is no way to get them back. Even if you lose your private key there is no way to get your funds back. Imagine if you lost or forgot your bank password and your life’s savings were gone forever, seems like a dumb system, no?
A common theme in our Weekly Recaps has been that expected returns are low. In fact, we’ve written about it so much that we decided to launch a fund that aims to tackle this problem. The low expected return problem we face today is in part because of the spectacular returns we’ve experienced over the past decade. The average annual Sharpe Ratio (return divided by risk) of a 60/40 (stock/bond) portfolio was 3 times higher over the last 10 years than it was from 1900 – 2011. In fact, only 4% of periods over the past 122 years have seen a higher Sharpe ratio for a 60/40.
According to AQR, the way to alleviate the pain of low expected returns, investors can do the following:
– Identify the best active managers
– Add private assets
– Diversify existing portfolios
Beating markets is hard to do and identifying who will beat markets before they do it is even harder. Adding private assets is not a panacea. In large part private equity has looked good (even though we think the performance is wildly overstated), because they were able to buy cheap assets and lever them up. Valuations today are much higher, therefore expected returns for private assets are also much lower. We agree with AQR that the most viable option is to diversify portfolios. Invest in uncorrelated strategies that can increase expected returns while managing risk. We would also add lower fees and taxes, and increase savings to the list.
Timing the market is hard, especially if we do it on a one-off basis and not in a systematic way. Bonds have had a terrible first half of the year. However, selling out of them now is probably a bad idea. The best idea would have been to sell out of them at the end of last year, obviously hindsight is 20/20. Moving portfolios to what has worked recently is not a great idea. Rarely do moves like this work. Investors tend to performance chase and invest in what has been doing well recently only to see mean reversion kick in and see trends reverse. We recently reviewed a portfolio that was very heavy in tech because that was what had worked recently, only to see it get crushed this year.
Nobody knows what will happen, best course of action is to diversify and have a systematic plan on how to invest. Don’t let your emotions get in the way. Create a set of rules that make sense, and stick with them for the long term. And make sure these rules make sense to you, if they don’t then you won’t be able to follow them in the long run.