Glide Path

In economics as in real life, nothing comes without cost. The U.S. monetary stimulus program resulted in $4.5 trillion in Treasury debt. As the debt level is drawn down, a return to more normal long-term rates and a slowdown in economic growth is likely to result. The U.S. is far from alone. Debt levels in the eurozone as well as China and Japan will continue to challenge the skills of macroeconomists and economic strategists. There are many risks beyond economic factors that could derail the process. Immigration, terrorism, instability in the Middle East, demographics, social and cultural rigidity, and political ineptitude can stop the hard won progress that has been achieved. It is unfortunate that so few politicians understand or are able to articulate economic imperatives so important to economic and social welfare.

However, not all is what it seems. While domestic market indices have continued to reach nominal market highs, a global perspective is valuable. In a recent article published in ETF.com, titled “When Market Highs Are About Perception,” Robert Michaud noted that domestic equity indices, on a currency or purchasing power adjusted basis, have continued to decline since the highs reached in March 2017.[1] This perspective suggests coincidence with domestic uncertainty three months into the current political climate resulting from the health insurance debate, presidential tweets, and the Russia investigation. In particular, the evolving Russia investigations now include not only influence in the 2016 presidential election but continuing efforts to promote social divisiveness along cultural wedge issues such as racism and populism. An undercurrent of anxiety sponsored by hidden foreign agents may be having an effect on America’s social and economic health. While the dollar rose this September, it remains down for the quarter and more than 7% for the year.

The quarter was also afflicted by the very real potential of nuclear armed conflict. While too awful to contemplate, because it seems beyond rational possibility, nevertheless there is a continuing danger of miscalculation and the impact of random events. The financial impact has been visible in the volatility of gold and other haven assets. Note, however, that in spite of large geopolitical risks, the average daily volatility of the S&P 500 index was 0.3%, the lowest since 1968.

There is no room for complacency with respect to the current success of macroeconomic monetary policy. The enigma of persistently low inflation and pernicious employment patterns are serious concerns. Standard rationales include technological innovation, automation, low education levels, lack of skills, and cultural rigidities. Educational background and financial status can be serious impediments in the continuation of a globally competitive economy. While economic forces can’t be legislated away without dire consequences, the transitional pain suffered by many left behind can lead to political upheavals in the social contract that threaten progress in economic growth.

Look Ahead

The mid-September Federal Open Market Commentary (FOMC) raised the expectation of one more short-term interest rate hike, probably in December, and three hikes in 2018. In addition, the Fed has begun retiring the $4.5T debt that it accumulated during quantitative easing (QE). Bond sales will include not only treasuries but mortgage securities as well. The Fed’s policies for rescuing the domestic and global economy had never been implemented in practice. It will be of great interest to observe how the Fed manages the sale of mortgage securities, which are priced domestically, as opposed to treasuries that are often priced globally.

The monitoring of European Central Bank (ECB) QE bond buying policies are also of great interest. There are no eurozone-wide treasury-like securities for the ECB to implement QE policies. Consequently, the ECB not only buys eurozone government securities but also non-eurozone corporate bonds. Such policies are well beyond standard macroeconomic monetary theory. Consider the problem of managing not only euro but non-euro denominated securities. Though very limited in scope, such policies are necessarily fraught with unknown monetary risk.

The Republican Party will need to manage the political fault lines that emerged with the effort to repeal the Affordable Care Act (ACA) for its next important legislative initiative- tax reform. Tea Party, establishment, and populist or Trumpian Republicans often find little policy agreement. The President’s support for a significant revision in taxes has boosted equity prospects and may have much bipartisan support, but investors are skeptical of anything substantive before the end of the year.

The global economy remains in a relatively stable and positive state. Most notably the U.S., but also other global economies, are on a glide path to more normal functioning capital markets. Multiple domestic hurricanes have resulted in devastating social and economic losses during the quarter. The economy is likely to experience a temporary slowdown in economic growth. Economic recovery and reconstruction will likely take months. The eurozone has begun to consider the end of QE stimulus and rising short-term rates. The Chinese economy has continued to manage a corruption campaign and capital controls, via currency management, that has allowed the economy to continue to grow. Japan is in the midst of an election that may fundamentally change its pacifist constitution and its ability to ramp up economic activity.

Geopolitical fears have not abated and have taken some ominous turns. However, as of this writing, U.S. and North Korea brinkmanship posturing has abated somewhat. The U.N. has voted for more sanctions, with Russia’s and China’s concurrence. The proposed Trump trade war with China has taken a back seat to the importance of their help with North Korea. Unfortunately, horrific terrorism incidents continue in Europe. Revelations of Russian misinformation campaigns on cultural wedge issues are still emerging.

Intelligent Strategic Investing

For the last twenty-five years, the strategic investing mantra has been that long-term asset allocation risk policy is the single most important investment decision. Risk policy is usually defined as the stock/bond ratio of the asset allocation.[2] Many large financial intermediaries as well as financial advisors consider asset allocation risk policy as dominant in long-term portfolio investing.

The research associated with strategic investing policy is based on Brinson, Hood, Beebower (1986).[3] They were the first to examine the long-term performance of institutionally managed pension plan portfolios. They reported that 94% of the variance of institutionally managed portfolios was associated with the stock/bond ratio of the portfolio. They also found that the two other components of performance, fund selection/management and market outlook, were negatively related to long-term return.

The Brinson et al studies were a shock to institutional investment community. Their results were totally at odds with what institutional asset managers had believed. Policy, not active management, was the only important factor in managing long-term portfolio return. The results were viewed as confirmation of the academic notion of the Efficient Market Hypothesis (EMH).

In an often neglected study, Hensel, Ezra, Ilkiw (1991), using a separate though similar database, also examined the long-term performance of institutionally managed portfolios. They noted that the Brinson et al studies were interpretable as the importance of asset allocation risk policy relative to riskless rate investing. In their study they decomposed the components of long-term asset allocation portfolio performance focusing on the stock/bond ratio decision, fund management, and market outlook. In contrast to Brinson et al, they find that the stock/bond decision and fund management were equal in importance, each representing roughly 40% of portfolio variance. Market outlook was attributable to most of the remaining 20% of portfolio variance.[4] They also noted, as in Brinson et al, that fund management and market outlook were negatively related to long-term return.

In hindsight, the nearly universal acceptance of the Brinson et al results may seem surprising. Why would anyone dismiss portfolio management or market outlook as insignificant in long-term asset allocation performance? One reason may have to do with effective marketing campaigns by consultants of policy based strategies. Another has to do with the iconic academic authority of the EMH. However, even accepting Hensel et al as the superior study, no component of performance other than the stock/bond ratio decision affected return in a positive way.

An alternative to the EMH consistent with similar evidence seems important for the investing community to consider. Perhaps the market is not informationally efficient but that asset management is deficient. For example, Michaud (1989) noted that traditional portfolio optimization is ineffectual because it does not consider the statistical uncertainty of risk-return estimates in investment information. Consequently, even in the presence of valid investment information, the limitations of traditional portfolio optimization would likely limit any benefit.

Asset management technology needs to show evidence of additive investment value. New Frontier multi-asset core ETF strategies benefit from significant 21st century technological advantages. Simulation tests show that the Michaud optimizer is superior out-of-sample compared to traditional portfolio optimizations.[5] In addition, the Michaud-Esch resampled portfolio rebalancing technology is the first of its kind to use portfolio similarity methods to decide when rebalancing may be advisable on a statistical basis.[6] It is worth noting that our ETF strategies are often above standard benchmarks and highly ranked relative to competing alternatives over extended time periods.[7]

References

Brinson, G., L. Hood, G. Beebower. 1986. “Determinants of Portfolio Performance.” Financial Analysts Journal, 42(4):39–48.

Brinson, G., B. Singer, G. Beebower. 1991. “Determinants of Portfolio Performance II: An Update.” Financial Analysts Journal, 47(3):40–48.

Hensel, C., D. Ezra, John Ilkiw. 1991. “The Importance of the Asset Allocation Decision.” Financial Analysts Journal, 47(4):65–72

Ibbotson, R. and P. Kaplan, 2000. Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? Financial Analysts Journal, 56(1):26-30.

Michaud, R. 1998. Efficient Asset Management. New York, Oxford University Press.

Michaud, R., D. Esch, R. Michaud, 2012. “Portfolio Monitoring and Rebalancing,” Journal of Portfolio Management, 10(4): 5–18.

Michaud, Robert. “When Market Highs Are About Perception.” ETF.com. September 21, 2017.

Richard Michaud

October 3, 2017

DISCLOSURES: Past performance does not guarantee future results. As market conditions fluctuate, the investment return and principal value of any investment will change. Diversification may not protect against market risk. There are risks involved with investing, including possible loss of principal.

© New Frontier Advisors

Read more commentaries by New Frontier Advisors