Reducing the Risk of Black Swans Read online

  Praise for Reducing the Risk of Black Swans

  The search for the holy grail of investing has intensified since 2014 with development of new investor alternatives facilitating more efficient strategies for investors. Swedroe and Grogan clearly present and illustrate this path to improved investment performance to the benefit of us all.

  —John A. Haslem, Professor Emeritus of Finance, Robert H. Smith School of Business, University of Maryland

  New to this edition is a practical guide to finding alternative investments to black-swan proof your portfolio. Swedroe’s books on investment mistakes, factor investing and now this one form the backbone of my investment strategies course. My students love the way his books help them think clearly, write crisply, and guide them to new discoveries.

  —Ed Tower, Professor of Economics, Duke University

  Reducing the Risk of Black Swans does an excellent job describing a set of unique alternative investments, which can be used to build portfolios with less downside risk without sacrificing expected returns. Investment pros should read this book.

  —Wesley R. Gray, Ph.D., CEO of Alpha Architect and Co-Author of Quantitative Momentum

  Jumping out of airplane offers a much more thrilling experience than riding a bicycle down the street. But what if skydiving were as safe as riding that bike? Swedroe and Grogan pose the financial equivalent to that question in their updated book, Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility. This new edition introduces some newly available products. By coupling such products with Nobel Prize winning theory, Swedroe and Grogan explain how investors can earn higher rewards, while taking lower levels of risk.

  —Andrew Hallam, Author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School and Millionaire Expat: How To Build Wealth Living Overseas

  If the holy grail of investing is many dependable but uncorrelated sources of return, then Swedroe and Grogan have charted a valuable course for investors. This book covers a variety of traditional and alternative risk premia and anomalies, supported by a tsunami of evidence, and rounded out with fund and ETF recommendations. Market conditions may offer auspicious timing for this book, but the takeaways are timeless. Get it and read it for better investment outcomes.

  —Adam Butler, Chief Investment Officer, ReSolve Asset Management

  Copyright

  Copyright © 2018 by Larry Swedroe & Kevin Grogan

  ISBN: 978-0-692-06074-2 (paperback)

  ISBN: 978-0-692-06075-9 (ebook)

  All rights reserved. No part of this publication may be reproduced, distributed, or transmitted in any form or by any means, including photocopying, recording, or other electronic or mechanical methods, without the prior written permission of the publisher, except in the case of brief quotations embodied in critical reviews and certain other noncommercial uses permitted by copyright law. For permission requests, write to the publisher, addressed “Attention: Permissions Coordinator,” at the address below.

  BAM ALLIANCE Press

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  Design by Alan Dubinsky

  Layout by Alan Dubinsky & Dave Vander Maas

  Contents

  Acknowledgements

  Preface

  Foreword

  Introduction

  Part I: Using the Science of Investing to Build More Efficient Portfolios

  Chapter 1: How to Think About Expected Stock Returns

  Chapter 2: A Brief History of Modern Financial Theory

  Chapter 3: Building a More Efficient Portfolio

  Chapter 4: Is the “Larry Portfolio” Well Diversified?

  Part II: Alternative Investments

  Chapter 5: Alternative Lending

  Chapter 6: Reinsurance

  Chapter 7: The Variance Risk Premium

  Chapter 8: AQR Style Premia Alternative Fund

  Chapter 9: Time-Series Momentum

  Chapter 10: How Much to Allocate to Alternatives?

  Conclusion

  Appendix A: Monte Carlo Simulations

  Appendix B: Other Known Sources of Return

  Appendix C: The Role of REITs in a Diversified Portfolio

  Appendix D: How to Evaluate Index and Passive Funds

  Appendix E: Enough

  Appendix F: Implementation (Mutual Funds and ETFs)

  Sources of Data

  Acknowledgements

  For all their support and encouragement, we thank our colleagues at Buckingham Strategic Wealth and The BAM ALLIANCE, with special thanks to Dan Campbell for his help with the data. In addition, we would like to thank the research staffs at AQR Capital Management (specifically Anti Ilmanen, Ronen Israel and Toby Moskowitz, as well as Mark McClennan), Bridgeway Capital Management (especially Andrew Berkin), and Dimensional Fund Advisors (especially Jim Davis, Marlena Lee and Weston Wellington, as well as Bo Cornell).

  We would also like to acknowledge the contributions of Adam Butler, Wes Gray, John Haslem and Ed Tower, each of whom reviewed the book and offered valuable suggestions.

  Larry thanks his wife, Mona, the love of his life, for her tremendous encouragement and understanding during the lost weekends and many nights he sat at the computer well into the early morning hours. She has always provided whatever support was needed—and then some. Walking through life with her has truly been a gracious experience.

  Kevin thanks his wife, Julie, who makes every day a joy, for her love and patience. He also thanks his parents, brother and sister-in-law, who have always supported him and had his best interests in mind.

  Finally, we express our great appreciation to Ross Stevens of Stone Ridge for providing the foreword.

  The usual caveat applies that any remaining mistakes are ours.

  Preface

  The first edition of this book was published in 2014. In that version, we showed how investors could create more efficient portfolios using what we refer to as the science of investing. Such portfolios, built on evidence from peer-reviewed academic journals, not only have delivered higher risk-adjusted returns, but also have significantly reduced the negative impact of rare, downside events, known as “black swans.”

  Since 2014, favorable developments have led us to conclude that the time to update the book had arrived. The most important development has been the “retailization” of investment strategies once solely the domain of hedge funds and institutional investors. The good news is that mutual fund sponsors have been bringing these strategies to the public in the form of vehicles regulated under the Investment Act of 1940, with expense ratios well below those of the traditional 2 percent of assets and 20 percent of profits, or “2/20,” fee structure of hedge funds.

  Because many hedge fund strategies involve investing in illiquid investments (allowing investors to access the illiquidity premium), fund sponsors had to develop an alternative to the open-end mutual fund structure that provides daily liquidity. An example of a strategy that requires an alternative structure is investing in longer-term consumer loans, such as a student loan. You cannot make a three-, five- or seven-year loan if the capital you need to originate it can be withdrawn on a daily basis. Another example is investing in reinsurance contracts, which typically are for one year. The interval fund structure was developed to address this issue.

  An interval fund is a closed-end investment company that periodically (typically quarterly) offers to buy back a stated portion of its shares from shareholders. However, while interval funds are valued daily, their shares typically do not trade on the secondary market like other clos
ed-end funds.

  Another important development has been the “fintech revolution.” Firms such as Lending Club, Square and SoFi have been utilizing technology to disintermediate traditional lenders, such as banks, in the consumer, small business and student loan lending markets. Their lower costs have enabled them to offer more attractive rates than traditional banks. These firms need committed sources of longer-term capital to make term loans and provide immediate funding to borrowers. Interval funds partner with such lenders, providing investors access to these markets.

  These developments have enabled retail investors to access new and unique sources of risk and returns. Each of the alternative investments we will discuss have equity-like forward-looking return expectations that show low to no correlation to the returns of the traditional stocks and bonds dominant in portfolios. The combination of equity-like returns and low correlation allows investors to build more efficient portfolios than when the first edition of this book was published.

  It is important to understand that none of the five alternatives we will discuss are new investments. As previously mentioned, in many cases they have resided for decades on the balance sheets of hedge funds and endowments. Now that they are available to financial advisors and investors without the higher fees typically associated with hedge funds, we are including them in our client portfolios.

  Part I of this book updates the data from the original work. Part II offers our insights on five alternative investments that can add greater efficiency to your portfolio and further reduce the negative impact of the dreaded black swan.

  Foreword

  Most individual investors’ portfolios are dominated by two asset classes: public domestic equities and bonds, the “risky” and “safe” asset classes, respectively. This traditional portfolio (colloquially referred to as “60/40,” reflecting an allocation of 60 percent equities and 40 percent bonds) has performed extremely well over the last 30 years and enabled millions of investors to meet their objectives of purchasing a home, paying for college, and ultimately funding a more secure retirement. However, this performance has been driven by a number of favorable tailwinds—a secular decline in interest rates, favorable demographics, globalization, financial deregulation and the “democratization of investing”—many of which are unlikely to have the same impact going forward. This creates an acute challenge for today’s investors who may have the same goals as the prior generation, but will be unable to rely on the traditional portfolio to deliver the required returns.

  A primary culprit is interest rates. Short-term interest rates across the developed world now hover around zero, with longer-dated bond yields at or near all-time lows. The days of putting money in a bank account and getting 5 percent or getting 8 percent in longer-duration bonds are gone, and unlikely to return any time soon. This is a critical issue because all asset classes price relative to cash. For example, if bank accounts yield 5 percent then equities might be priced to earn a return of 9 percent to induce investors to take equity risk; but if bank accounts yield 0 percent, investors are willing to hold equities even if they expect to earn far less, say 4 percent, because it still beats getting zero. In other words, low rates mean that all assets are now priced to earn lower returns.

  While low interest rates themselves represent a drag on portfolio returns, they also create an asymmetric risk. There is likely limited room for rates to go much lower to boost returns, but a whole lot of room for them to go up, weighing returns down. The last time the United States experienced a long-term rise in interest rates from such lows began about 50 years ago, and it was a time period investors would soon rather forget. From 1964 through 1981, as rates were generally rising, the annualized excess returns (i.e., the returns an investor could get above what he could get by putting his money in a bank account) of the 60/40 portfolio were -1.4 percent before taking out taxes and fees.

  And it’s not just that anemic yields today are suppressing future expected returns. Low rates are also increasing the risk in fixed income allocations. With rates coming down so much, the duration1 of bonds has increased (e.g., the duration of the Barclays Capital U.S. Aggregate Bond Index has gone from a low of 3.7 years at the beginning of 2009 to 6.0 years in January 2018—health warning: This is exactly like levering your fixed income portfolio 62 percent during this time period; did you mean to do that?), which means that forthcoming increases in rates will have an even more pronounced impact on returns. It’s a double whammy.

  If we narrow the lens to a more recent time period, post the 2008-2009 financial crisis, it’s likely that not all investors appreciate the historical uniqueness of the last eight years. Fueled by the combined sugar high of unprecedented central bank asset purchases, and the irresistible siren song of recency bias, the pain and memory of the financial crisis has been comfortably, if only temporarily and quite dangerously, numbed. Consider the following:

  Since March 2009, the 60/40 portfolio has delivered annualized excess returns of 12.7 percent, annualized volatility of 6.9 percent, and a Sharpe ratio of 1.8. The 90-year average for the 60/40 portfolio is 5.0 percent annualized excess returns, with 12.0 percent annualized volatility, and a Sharpe ratio of 0.4. So compared to the long-term average, post-crisis the 60/40 portfolio has enjoyed 2.5 times the annualized excess return, about 40 percent less volatility, and more than 4.5 times the Sharpe ratio.

  If we limit the analysis to stocks, as we begin 2018, we just experienced the only calendar year in which the S&P 500 Index had positive returns every month, with the streak now growing to 15 months. In addition, the S&P 500 Index has been profitable in 22 out of the last 23 months, which has never happened. And during this stretch, the Sharpe ratio of the S&P 500 has been 3.3, 10 times its historical average. Is there a more crowded trade in capital markets today? Is there an asset class with a stronger sense of entitlement to positive, long-term returns among its owners? Let’s remember first principles: A stock entitles its holder to the last claim on the cash flow of a company, after the firm pays rent, insurance, interest, compensation, cost of goods sold, etc. If, and only if, there’s anything left over, the equity owner gets it. Instead, lately stocks have been acting like they are the first claim on the cash flows of a company. It’s not supposed to be this easy to make so much money, especially with such remarkable consistency.

  Going back to the 60/40 portfolio, try the following thought experiment: Holding volatility constant at the long-term average, what would annualized excess returns have to be over the next 10 and 20 years, for the post-crisis 60/40 portfolio Sharpe ratio to be equal to the long-term average?

  The answer: Negative 2.6 percent annualized return for the next 10 years, and positive 1.2 percent annualized return for the next 20 years. Imagine making essentially no money on your investments for the next 10 or 20 years. No, really, stop and think about it for a moment. What would that mean for you?

  Thankfully, enter Larry and Kevin!

  As the dynamic duo explain in this extremely insightful and extraordinarily practical new book, one way to escape this dilemma is conceptually simple and entirely consistent with the tenets of modern portfolio theory: Add new return streams that can both a) provide returns consistent with what investors need going forward to grow their wealth, and b) provide sufficient diversification so that investors can protect their wealth.

  Larry and Kevin show that instead of “turning the dial” away from bonds toward more of the same risky assets that are already in the portfolio (e.g., equities, high-yield credit, etc.), investors can now turn it toward investments that can maintain, or even enhance, the future return profile of their portfolios, but in a way that does not increase risk, and, in fact, almost surely decreases it.

  What other types of investments offer potential returns consistent with those of riskier assets like equities, and can provide diversification properties that will allow investors to reduce risk? And if the solution is so obvious, why haven’t investors embraced these new types of investments before?

/>   There are two explanations which, taken together, are why this book makes such a significant contribution. First, many of these return streams haven’t historically been accessible as investments. Second, investors suffer from an acute form of regret syndrome, i.e., don’t do anything too different out of fear you might underperform relative to doing nothing at all. The first of these is changing fast; and with it, investors must change their mindset from one driven by fear of the unfamiliar. A major contribution of this book is reframing the “unfamiliar” as, in fact, quite familiar. The sources of some of the risk premiums Larry and Kevin discuss—particularly (re)insurance, lending and the VRP—have been around longer than stocks.

  The reality is that we are standing at the front end of a long-term shift in how risk is held, but most investors don’t know it yet. Quiet as this shift in risk-holding has been, though, it really is a revolution, not a fad. Here’s how you can tell: When one party finds a way to make money by taking advantage of another, that’s a fad—at some point, the disadvantaged party will learn to avoid the trap. When innovation creates a situation where everybody can be better off than they were, that’s a revolution.

  The first wave of revolutionary financial innovation “democratized investments” by making it possible for large numbers of investors to access the equity and bond markets via lower-cost mutual funds and ETFs. The second wave, now just underway, involves “democratizing balance sheets,” uncovering a much broader array of risks arising from financial intermediation—by banks, (re)insurance companies and market-makers—and making them available in cost-efficient structures.

  In this second wave, together we shift risk-holding from a tiny number of gigantic balance sheets to a gigantic number of tiny balance sheets. Together, we unlock profitable business lines historically buried within financial institutions. Together, we de-risk the financial system. And, together, we empower access to valuable P&L streams that can diversify the 60/40 portfolio.