“The biggest mistake of investors is to think that those markets that went up recently…are better markets, rather than more expensive markets.”
– Ray Dalio, Founder, Bridgewater Associates |
We have been in the “Golden Age” of Passive Investing. But nothing lasts forever.
Just like all golden ages of times past (like Hollywood, or Detroit’s auto-manufacturing dominance), passive investing will likely soon peak for the foreseeable future. And the idea of the “Age” of passive investing is appropriate because it’s only a product of the times we’re currently living in.
Let me explain.
I’m sure you’re familiar with, or at least aware of, the terms “Alpha” and “Beta” in regards to investing returns. When talking about alpha and beta, the return of an investment can be represented like this:
Investment Return = α + β
Alpha is excess return on an actively managed investment. Alpha is what all of the active managers out there are trying to achieve (at least risk-adjusted alpha) with all of their research, analysis, algorithms or shareholder activism. Whether it’s long/short equity, an activist hedge fund or a global macro investor, they all use their unique approach to generate alpha from the universe of investable assets. At least that’s the goal.
Beta is the market return. It’s essentially the return you get for assuming the risk associated with just holding a given investment. Beta is what an investor receives for passive investing or indexing. Of course, for the passive investor, their alpha is zero. So their investment return is only the beta, or the market return.
And right now, passive investing is gospel.
Passive investing, indexing, the FIRE crowd, holding ETFs, even target date funds (just two streams of beta) – they’re all en vogue now. Millions of investors are convinced that this investing thing is easy. Just buy the Vanguard S&P index and “hodl” (to borrow a the term from crypto trading)!
But everyone’s forgetting something – the 3rd part of the equation: Epsilon.
See, the full linear equation has an extra term. It actually looks like this:
Investment Return = α + β + ε
That little guy added to the end is Epsilon. It’s also known as the “error” term – it’s essentially everything else outside of the Alpha and Beta. And it’s of fundamental importance.
Paradigm – The Foundation of Passive Investing
Epsilon is the current paradigm, the environment, the zeitgeist, or what investor and writer, Ben Hunt, likes to call the “narrative”. It’s how investors, market participants, wall street and main street, government and media all see the world. It’s what “we all know that we all know” about investing, the economy and the market – at a given time.
I like to think of the current paradigm (the Epsilon) as the foundation upon which the Beta rests. So investment returns could also be represented this way:
In our new representation, we can see that Alpha returns are built on Beta. In other words, Alpha is generated by investing in, or trading of, the world of Beta-returning assets. You can only generate Alpha from the assets available to you in the Beta universe.
And the same goes for Beta and Passive Investing returns. Beta is built on, and dependent upon, the current paradigm.
A passive investment only generates consistent, high Beta when the paradigm is right for that investment.
If we take a quick look at the last 50 years, we can see how markets paradigms have changed over time:
As you can see, we’ve experienced many different paradigms that have driven financial markets. Also notice that moments of “paradigm shift” are often seismic – meaning they change the rules. Most of what we thought we knew is thrown out the window and a new set of rules (a new paradigm) begins to emerge – and it can happen suddenly.
And, of course, looking more closely, we can see that the environment for passive investing over the last decade could not have been more ideal:
On top of zero rates, multiple rounds of quantitative easing, and abnormally low volatility all adding to the “Goldilocks” environment, there were massive stock buybacks, large corporate tax cuts, a decade of falling unemployment among other factors.
In other words, the paradigm for passive investing has been close to perfect. But it won’t stay that way forever.
And while earnings and growth were already decelerating, the global hit from the Coronavirus could be the catalyst for the next Paradigm shift. Goldman Sachs is estimating zero earnings growth this year as a result of the outbreak. Apple, Microsoft and others are already lowering their guidance for the next two quarters, at least.
The bottom line is that a static passive investment approach won’t work in all environments.
The key is to have an investing approach that works across paradigms.
That means your investment approach should work in rising and falling interest rates, growth and recession, bull and bear markets. In sudden moves like pandemic scares or Brexit or the Flash Crash.
To help weather the next paradigm shift (and beyond), your investing approach should ideally have a few key characteristics:
- True diversification – globally and in many different asset classes, including equity, bonds and real assets.
- Defense – you’ve got to be able to stop the losses when a paradigm shift occurs or there are shocks in the market.
- Long/Short – you need to have a way to profit from the inevitable down times as well (imagine how this could have helped you in the last few days).
- Liquidity – you need the ability to exit a position quickly, in order to preserve capital – and have capital for the next opportunity.
- Flexibility – your approach needs to be nimble – as we’ve seen, one size doesn’t fit all. Your approach must be able to adapt over multiple paradigms.
If you only have a static, conventional portfolio, you’ve likely done well over the last decade – the paradigm has been great. But now is the time to consider an active, dynamic, uncorrelated approach – one that’s designed to help protect those gains and profit from a new paradigm.
Here’s just a recent example of how paradigm shifts can affect passive investing returns for a decade or more. From August of 2000 to December of 2010 the S&P only spent a total of 18 months above its pre-crash high. That’s only 18 months in profitable territory in over 10 years:
And from where we are now, this could easily happen again.
“Last month, our estimate of prospective 12-year total returns on a conventional investment portfolio fell below zero for the first time in history…even lower than the level reached at the market extreme of 1929….
Amidst an ‘everything bubble’ driven by yield-seeking speculation across nearly every asset class, investors should not imagine that there is some widely appropriate passive investment that promises a satisfactory return…”
– John Hussman, Hussman Funds, January 25, 2020 market commentary (emphasis mine) |
So, talk with your advisor, or take a look at your portfolio. Now is the time to consider defense. At the very least, think about getting off of any leverage and raising cash.
The next environment that’s friendly to passive investing might be a long time coming.
If you’re looking for a strategy that is designed for paradigm shifts and multiple environments, at Taylor Morgan our full, proprietary investment approach does just that:
- We assess 61 assets classes and sub-classes all over the world for the best opportunities.
- Our defensive algorithms monitor every position to protect profits and avoid losses – we are sometimes 100% in cash when conditions warrant.
- Our quantitative futures component can make money in up or down markets.
If you’re interested in the possibility of avoiding the worst of the next paradigm shift and even the possibility of profiting during challenging times, we’d love discuss our investing approach and see if it’s a fit.
Please leave a comment, question, or get in touch. We’re here to help.