Weekly Edition #76

Editor’s Note: Judging Performance

This week we’re trying something different. No articles, rather some thoughts on a couple of events that have happened to us in the past couple of weeks. We’ve been party to a couple of events that left us thinking about portfolio performance, how we should judge it, over what time frame, benchmarking, etc. The events were:
–    Participating on the investment committee meeting (which we are members) of a non-profit foundation with a sizeable portfolio.
–    Friends have asked us about expectations for the rest of the year and how to invest.
–    This quote we read: “you’d never judge the performance of a two-year CD inside of a one-month period, but that’s the equivalent of what someone is doing when they judge stock market performance based on a one-year period.”

Let’s start with the general structure of non-profit investment committees. This non-profit has a pretty sizeable investment portfolio which is managed by a large US investment bank (doesn’t matter which one, they all do the same thing). The investment committee is composed of several independent members, some industry professionals and some not. It meets around once every quarter to discuss the current situation, portfolio performance, positioning, etc. The bank is a party to these meetings, and they usually have recommendations as to how to tilt the portfolio, new investments etc.

The portfolio currently is a 50-50 mix of stocks and bonds, they also had an alternatives bucket in the past. The bank’s mandate is to stick to this 50-50 mix, but they have discretion to over/underweight stocks and bonds by a maximum of 5%. We have access to the historical performance for the account net of fees since 2011.

The committee was recently pitched by another bank. A key section of the slide deck is the portfolio allocation. They show three hypothetical allocations (conservative, balanced, and endowment) and compare it against several market indices and ETFs. They only show hypothetical simulations and no live track record (even though the bank has been in the wealth management business for many years).

So, we got to thinking, this is a great opportunity to compare and contrast marketing documents with reality. The problem with showing these historical simulations is that they are static. By this we mean that if the portfolio is 50/50 stocks/bonds, then the simulation assumes it’s always 50/50. In reality banks will tilt portfolios up or down to try to outperform. Therefore, these simulations are not representative of what the clients will actually experience, since the bank will adjust exposures up or down based on their views. Let us make this point clearer with a table showing 10-year returns for various ETFs (sourced from the bank’s presentation):

So, we would assume that a 50/50 portfolio (the non-profit’s target) over this time period would be close to the 6.18% return for the balanced portfolio in the table above. The actual return for the non-profit over this time period was…4.4%. The portfolio significantly underperformed almost every asset class. In fact, it has even underperformed the bank’s own benchmark which has returned 5.1% over that time period. In fact, there’s a simple ETF (ticker: AOM) which invests ~60% in bonds and 40% in stocks which has returned 4.7% over the same time period. The non-profit underperformed a more bond heavy allocation during one of the best 10-year period for stocks we have ever seen.
On the second point from the original list, about friends asking us about expectations and how to invest. Knowing that tilting portfolios correctly is extremely difficult (as evidenced by the above), we tend not to do this. Instead, what we do is craft an investment portfolio that will be resilient through time and stick with it through thick and thin. If we make changes, it’s because of a change to the strategic asset allocation for the long-term. Not based on reactions to short term movements.
The final point is that if we’re investing for the long-term (like we should), then short term gyrations should be irrelevant. If we invest in a strategy that we think can outperform over the long-term then it doesn’t make sense to look at the performance month to month vs. an arbitrary benchmark. In reality the benchmark we should all have is whether we are able to stick with our investments over the long-term. In our view each investor’s monthly benchmark should be whether they were able to stay invested and didn’t make changes to their portfolios based on short-term movements. If you’re able to do this, and assuming you have a sensible asset allocation, then you will do better than the vast majority of investors over the long term. This reminds us of a chart we saw recently by JP Morgan Asset Management.

The chart shows that the “average investor” underperformed literally almost any asset class over the last 20 years. This is because of trying to time markets and destroying value. Like we said, to do better than the vast majority of investors pick an allocation that makes sense to you and hold on through thick and thin. Stop trying to time markets since you probably can’t (not only you, pretty much nobody can, us included).
This has gotten a bit longer than we expected but we just want to highlight a couple of conclusions from this exercise:
-The “value-add” from tilting portfolios between assets adds no value, in fact it tends to detract value. The non-profit would have been better just sticking with the benchmark 50/50 portfolio or buying a simple balanced ETF. In this case the bank’s active management actually cost the non-profit money.
-Simulations only make sense if the future portfolio will actually look like what is being simulated.
-Always ask for live track record (if available) and really understand if what you are buying actually looks like what is being presented. Simulations are fine as long as it is simulating what you’re actually buying.
-Doing nothing is hard, most people want their managers to adjust the portfolio based on market conditions with the hopes of outperforming. The truth is that very few people can do this, and the ones that can probably don’t work at a large investment bank in private wealth management.
-If you have a sensible asset allocation and are able to stick with it through time you will beat pretty much almost every other average investor out there.
We want to close with something we were told by a prominent economist over lunch a couple of months ago. This really speaks to the most important point we’re trying to get across. He was being asked by the bank’s clients what they should buy or sell, what was the impact of the war on Ukraine going to be on the price of oil, gold, etc. He simply said, “if I knew all that I would not be sitting here with you, I’d be retired on my own private island”.