Context Matters

We are preparing a podcast episode where the three of us talk about our personal portfolios, how we invest our savings.

As you can imagine, my part is a bit complex. Especially if you consider that we target the podcast for an audience who has basic to no financial knowledge. It took me several posts to define my investing philosophy, imagine condensate them in a 10-minute walk-through. With no visual aid.

How should I explain “capital efficiency”? Alain, one of my co-hosts, would say that if I am not able to explain it to my grandma, I do not fully understand it. Challenge accepted (not that I have an alternative…). I thought the best way to see it is to first consider any investment return as “risk-free + risk premium”. To invest in XYZ, you want to get a premium, otherwise you would go for the risk-free option.

To get said return, you have to allocate capital…you have to invest. Capital Efficiency represents how effective we are in deploying our assets to achieve the desired risk and return characteristics. Taken to the extreme, if we can borrow at the risk-free rate, we can obtain the XYZ investment risk premium without allocating any capital. Max capital efficiency.

I am not sure how good of an explanation this one is but it made me think about the perceived risk-free investments. Now that rates are going down, feels like a good topic.

Take saving accounts. Take all those happy investors celebrating their 4% to 5% “risk-free investments”. Were they? Probably not that much, if you consider inflation risk; but true, in many countries (not Italy), even short-term investments beat inflation in the long run.

My thinking was more related to the joy of earning 5% without putting it into any context. Sure, 5% risk-free compared to the arithmetic average return of stocks at 7/8% feels great. But if you stop for a second, you realise that you are comparing apples and oranges. Nothing new under the sun, Italians notoriously felt rich in the 80s when they were getting 15% returns out of Govies…while inflation was running at 20%. Is there any other explanation, considering the absence of the same joy when you got 0% parking cash on a bank account and inflation was barely above 1%? Is the nominal rate so…confusing?

A risk-free investment should generate zero to negligible real returns. Yes, sometimes banks offer teaser rates to lure new customers at the door, I am thinking net of all those promos (and great for you if you have the time to move money and paperwork around to get that 1% extra return). How come the concept is so hard to grasp?

Consider how difficult is for active stock managers to beat their benchmark even by a few basis points. Why do you think there would be such great opportunities in a market, the cash deposits, that are easily available for anyone?

Fine, there might be temporary opportunities (cash returns and inflation are not 100% in sync) and retail investors are not able to benchmark their whole portfolio for a whole cycle, so these market timing actions look profitable when they are not (think about it: usually “new money” get parked in cash accounts. The same money could be invested in “depressed” bonds but hey, they just lost 20% so they are extremely risky while cash accounts are risk-free). Once the high (sigh) returns disappear from cash depos, investors would move money to bonds (?) that…well, their price had already rallied so they missed that gain but…who’s gonna check, innit?

At least the concept of the efficient frontier, or higher volatility compensated by higher returns is well accepted.

Large Equities are more volatile than Short Term Govies but they offer higher returns, the World is rational again. Oil, Gold (and maybe LT Govies) lay below that efficient frontier and should not be part of the portfolio of a rational investor. Case closed.

Is it?

I guess I found a way to write about Cliff Asness’s latest paper 🙂

The fact is, when you start to combine those bricks, you might end up with a portfolio that has better risk/return characteristics than any of the components. So much so that even seemingly ugly-by-themselves investments become useful in a portfolio context.

Just a few weeks ago, I was replying to a financial advisor who raised the point of how abysmal the performance of long-only commodity funds has been. I do not like the investment myself but I pointed to him that the judgement ultimately depends on where that brick is included: in the right portfolio, it might work. Subtle hint to single-line item issues. Despite so, he concluded with “I do not think that any investment that cannot keep up with inflation is worth its price”. Exactly the single-line item issue…

As usual, Cliff nails the point when he says that compound returns are overrated…if you look at the line-item level. And by the way, I talked about it here myself ;).

The obvious (?!?) issue is that modelling this stuff on Excel is easy because correlations stay put, doing it IRL has higher challenges. But this does not mean we should disregard the opportunity altogether. Maybe not going all-in on the fact that Investiment1 and Investment2 would have exactly a 0.2567 correlation but considering that in the past they exhibited low positive correlation and pondering that the future might resemble the past for this and that reasons.

In the example I made in my post, SPY and SVXY have a correlation of .62, quite high. But SVXY has a low but negative correlation to IEF while SPY has a low but positive one. This is why the switch from one to the other works. Plus, SVXY is uber volatile, so we do not need a lot of it to get ahead in terms of returns.

High volatility and high correlation are dangerous companions (I am looking at you, who diversified SPY with QQQ) but high volatility might be the best mate when the correlation is low (and you rebalance). High vol by itself doesn’t tell you anything. Even the expected value might be misleading.

We started with deposit accounts and we arrived at SVXY. Only to say that context matters 🙂

What I am reading now:

Follow me on Twitter @nprotasoni