CBIS’ Market Insight – “The Return Factory”

There is a lot of talk about risk these days, as pension funds, foundations and large endowments face the challenge of meeting income needs in an environment of zero or negative rates. Just as the characters young and old, rich and poor, rushed to the candy stores in search of the Golden Ticket in Willy Wonka, investors worldwide are looking for the Golden Investment, with access to the Return Factory and the Magical 8% Return.

Make no mistake, the current investment climate is challenging. Short-term, high quality investments such as Treasury bills, commercial paper, etc. have yields close to zero. That’s right, invest money for 6-12 months, and at the end you get your money back, or less if you are in Europe or Japan. Given this alternative, stuffing the mattress looks like a pretty good idea! As one moves out the risk spectrum, as investors are now doing in with the hopes of manufacturing a higher return, the prospects don’t appear any more appealing. The S&P 500 Index generated a 15.1% annualized return for the last three years ended 12/31/15. The calendar year 2015 was a less than fulfilling 1.3%. And, it will be awhile before anyone forgets the -37% return witnessed in 2008. When looking at the output from the “Return Factory,” the time period does matter.

I am concerned the investors lined up at the Return Factory have forgotten the benefits of being a long term investor. They are trying to manufacture a specific return year in and year out. The long term investor has become the short term speculator. Hedge funds, promising positive absolute returns in all market environments, continued to gain in popularity but now face the music as returns have suffered the past few years. Faced with the prospect of low market returns in the short term, investors were lured by the promise of “alpha.” Successful investors had been shown, through solid analytical analysis and hard work, to outperform the broad markets by 1-2% per year over long time periods, yet investors were still looking for more. One CIO for a large sovereign wealth fund was overheard stating his alpha return objective for his hedge fund portfolio was 9%! If you are making assumptions, why stop at 9%, why not assume your managers will outperform by 10%? It reminds me of sitting at my child’s parent/teacher conference and hearing how everyone’s child was “above average.” Think about it, how can everyone be above average? The Return Factory is promising everyone to be above average!

John Wooden, the Men’s Basketball coach at UCLA, whose teams won the NCAA Championship 10 times from 1964 to 1975, including winning 7 years in a row, can provide some pointers on how to successfully invest for the long term. John Wooden and his teams were fastidious in terms of preparation, with complete focus on the things under their control. Wooden and his coaching staff did not spend hours analyzing game tapes of their opponents. Time was spent in preparation and focusing on the things under their control, including little things. Wooden taught his players how to put on their socks so there were no creases to cause blisters, and kept their hair short to minimize perspiration getting on their hands or impacting their vision. Trivial? Maybe, but it is hard to argue with his success.

Two of Wooden’s maxims continue to stay with me: 1) “Big things are accomplished only through the perfection of minor details,” and 2) “The more concerned we become over the things we can’t control, the less we will do with the things we can control.” In the game of investing, what are the things that are beyond our control, and what are the things that are within our control? Investors can control the types of risks they are exposed to in the pursuit of investment returns. Bear in mind, investment returns are achieved only through the exposure to different types of risks. Investments that on the surface appear to be risk free may not be. As an example, consider an investment in a 3-month certificate of deposit issued by a bank with FDIC insurance. This investment appears to be safe; principal will be returned in three months and you know in advance the interest you will receive at maturity. But what if your investment horizon is longer than three months? What if it is five years, and you are pursuing an investment strategy of reinvesting in 3-month CDs? If this is the case, you do not know what the future interest rates will be; your rate of return over your investment horizon is unknown. You have taken on reinvestment risk, in what you thought was a risk-free investment.

Investors can control how they diversify across different investment risks, commonly called asset allocation. Investors can also control and manage these risks as realized returns vary overtime through a rebalancing strategy. Recognizing the benefits of possessing a longer term investment horizon, CBIS follows a rigorous rebalancing strategy and does not deviate from the asset allocation policies determined for participants’ funds. When one follows this strategy, and markets are volatile, a benefit accrues to the portfolio: buy low and sell high. Assets that have outperformed are sold to purchase assets that have underperformed. Recognizing that trees can’t grow to the sky, the gain from the outperforming asset is harvested and reseeded.
The allure of the Return Factory is tempting. Resist the temptation and focus on the things under your control!

A recent article in the Wall Street Journal also discussed how investors are increasing risk in order to hopefully meet return targets. Once again, the moral of the story is it is hard to manufacture returns.

For more information on CBIS, please reach out to your Portfolio Specialist or contact 800.592.8890.