Weekly Edition #60
In this edition:
Capital efficiency is a fancy sounding term. The whole idea of capital efficiency is being efficient with the use of cash in a portfolio. For example, you can buy bonds several different ways. Two of those ways are buying the bond directly of buying it through futures. The exposure is essentially the same and returns should be close to identical. The difference is that a futures contract is a levered instrument. Therefore, to buy $100 worth of treasury futures, you would only need to have a fraction of that money in cash to hold as collateral. You could then use this cash to invest in other instruments. If you think capital efficiency is just a fancy term for taking on leverage, then you’re right, it is.
Leverage has a negative connotation. There have been many funds that have blown up because of taking on excessive amounts of leverage. Examples include Long Term Capital Management, Amaranth Advisors, Malachite Capital Management, among many others. However, what these funds have in common is that they applied large amounts of leverage either in illiquid securities (like LTCM), or in concentrated positions (like Amaranth and Malachite). Combining leverage with concentration and/or illiquidity is a recipe for disaster. However, leverage which is smartly applied could potentially reduce risk in a portfolio while increasing expected returns. The whole Twitter thread is based on a paper that Corey wrote about how to use leverage to diversify a portfolio. The basic idea is using the leverage embedded in certain funds or securities to invest in diversifying strategies and assets. Therefore, keeping expected returns high while introducing diversifying exposures.
Even before Russia invaded Ukraine, financial markets were dropping. During January and February inflationary pressures continued which made bond yields rise which caused stocks to fall. A 60/40 portfolio had no diversification since both asset classes were showing losses. The war in Ukraine has exacerbated these inflationary pressures and has caused bonds to keep on falling. The Bloomberg US Aggregate Index returned -6% for the quarter. This has been the worst quarter since July – Sept. 1980 in which the index was down -6.56%.
Does this mean that bonds play no role in a portfolio? No of course not, bonds are an important ballast in portfolios. Predicting returns with bonds is fairly straightforward. The starting yield is essentially the return you will earn until the bond matures. For constant duration bond funds, the formula is that the current yield to worst is the return you will earn over roughly 2 times the duration of the fund (technically it’s 2 times duration minus 1). This is independent if rates rise or fall or stay the same. If rates rise, the bond fund will suffer a capital loss but as time goes on the higher coupons will make up for the capital loss and bring total returns back towards the initial prediction. Yes, bonds have lower expected returns, but this just means that everything else has lower expected returns as well. We don’t believe that stocks are priced to offer 10% returns as they have done historically. So we would keep our same allocations but prepare for lower expected returns.
Everybody wants to earn high returns, but nobody wants to deal with the volatility that comes with them. These two are intricately linked. There are a few star fund managers that can deliver outsized performance with limited volatility, but they are few and far between, and neither you or us have access to them (thinking of Renaissance’s Medallion Fund). In the hedge fund world, volatility is something we can adjust and manage. For example, you could have a fund that delivers the same strategies at two different volatility levels just by changing the exposure each strategy has. If you want to deliver 2X the volatility, then you just need to take the original portfolio and double the exposure (possibly using leverage).
The most important thing in investing we think is actually investing in something that is aligned with your risk tolerance. Invest in something too risky and you will sell out when the portfolio is down. Invest in something too safe and you will sell out when it is underperforming a riskier investment. Knowing how much to risk is not an easy subject. There are many questionnaires that will try and measure risk tolerance, but the answers are very subjective and are heavily influenced by your mood, how your day is going, etc. The best way to truly know your risk tolerance is to invest and live through different situations. This runs the risk of losing money if you invest in very risky stuff. Therefore, we always tend to err on the side of caution when talking about risk tolerance. We prefer to slightly underperform on the upside than to lose to much money on the downside.
These annual reviews of different markets are always interesting. A couple of points we thought we should highlight:
Private markets fundraising reached a new high at $1.18 trillion.
Investors keep on focusing on IRR even though it’s a flawed metric. McKinsey (which published this report) wrote about the perils of using IRRback in 2004 and still keep on using it!
Buyout multiples have been increasing steadily since 2009 – 2013 but have leveled off recently.
Leverage has increased from 4.8X in 2008 to 6.9X in 2021 (measured as debt / EBITDA)
Nearly 90% of private debt deals are now done by nonbank lenders, which are unregulated (ex. Private Debt funds)
As we’ve written many times before. Investors are flocking towards private equity and private debt as if it’s a magic asset class that can generate outsized returns when everything else is priced to deliver mediocre performance. We think this is clearly a case of performance chasing (which in itself is misguided since if you measure performance the correct way it isn’t even that good!). Eventually when the cycle turns these funds will take on losses, and the lack of liquidity will probably hurt many investors. We prefer to invest in a barbell fashion. Very early-stage venture capital / angel investing on one end and then the majority of the portfolio in liquid public markets and some hedge funds that invest in public markets as well. This has the benefits of maintaining a fairly liquid portfolio but having the potential of outsized returns from the VC/angel bucket.
There is a book called Triumph of the Optimists which has data for roughly 100 years of returns for stocks, bonds, and bills for many countries around the world. Credit Suisse publishes an update every year. Looking at long-term return data is very interesting because what we all suffer from recency bias. This is that we expect that which has happened recently to continue to happen. In investing most things are mean-reverting, therefore what happened in the last couple of years is not a great predictor of what will happen going forward. A couple of interesting points from this update:
The US stock market is the largest in the world and represents 59.9% of global market capitalization. In 1899 it was only 15%.
In 1899 the UK had the largest stock market at 24%, now it’s 3.9%.
Bonds and stocks perform much better in low inflation regimes than high inflation. In the top 5% lowest inflation years, stocks returned 12.9% and bonds 19.2% on average. In the 5% highest inflation regimes stocks dropped 10% and bonds dropped 24.7% on average.
Stocks and bonds perform better after interest rate cuts than after interest rate hikes. However, inflation tends to increase after rate hikes and fall after rate cuts, which goes against popular narrative that rate cuts spur inflation and hikes dampen it.
Investors from most countries would benefit by diversifying globally.
Developed markets tend to move more in line with each other than emerging markets.
The negative stock – bond correlation is a recent phenomenon and from 1900 – 2000 it was mostly positive.
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