Students of behavioral economics are of course familiar with the adage about making hay while the sun shines, an insightful observation on how as humans we may need a nudge to acknowledge that good times may not always last. Investors, when acting rationally, do understand that if the market as a whole is up or one particular strategy is succeeding particularly well, that’s no guarantee anything will continue to perform favorably. At Aperio Group, we’re big fans of investors looking at their strategies with eyes constantly kept wide open to the potential pitfalls and dangers.
How do investors and money managers generally respond when a particular strategy has been succeeding? As is well researched, we believe that investors often get seduced by a herding instinct to follow the recent success of others and try to cash in on a good thing, such as tulips in 1637 or any company with .com in its name in 1999. Money managers, who of course always put their clients’ interests ahead of their own revenue inflows, face a similar behavioral tendency to try to steer assets toward recently successful strategies. Their own financial incentives are maximized by gathering as many assets as possible. Thus both investors and their money managers often seek to make hay while the sun is shining.
How do you know when a good thing—say, a particular factor tilt—has gone on for too long? Lots of research has demonstrated that it’s just as hard, if not impossible, to know exactly when to exit a recently successful strategy as it is to know when to get into it in the first place. Factor timing has been shown to be as elusive as overall market timing itself. Let’s turn now to such an example. Like all good investment researchers selling a particular strategy, we’ll pick two of Aperio’s most recently successful strategies, quality and minimum volatility with a value tilt. Both of these approaches entail taking lower risk than the market (as measured by standard deviation), which for portfolio theory purists would imply that over time they should earn a lower return than the market.
Chart I below shows the historical return since inception of Aperio’s Global Quality Strategy along with its risk and return numbers. As can be seen in those numbers, this strategy happened to have performed quite well over the period December 31, 2010, through March 31, 2017. Does that historical performance necessarily make it a good investment today, looking forward?
Along the same lines, Chart II shows the historical return since inception of Aperio’s Global Minimum Volatility (Value Tilted) Strategy from December 31, 2012, through March 31, 2017.
Chart II 2
Both charts show extraordinarily good historical performance beyond what should have been expected on a forward-looking basis, given the difference in calculated market risk versus the benchmark inherent in these strategies. Because of their relative low risk, modern portfolio theory would suggest these strategies should have earned returns below their respective market benchmarks, but in hindsight, each actually earned risk-adjusted returns above the market.
Normally, money managers, seeking to make hay while the sun shines, flog their most recently successful strategies and emphasize the superior performance, with perhaps a passing compliance-driven reference to past performance not guaranteeing future performance. The US Securities and Exchange Commission mandates just such disclosure for a very good reason.
At Aperio, however, we urge potential investors in either of these strategies to show a lot of caution and to examine their motivations. What are good reasons for entering into either of these strategies? For those who seek to maintain their allocations to equities and yet simultaneously reduce market risk, we believe that a low-risk strategy can be a valid and effective approach. Alternatively, those who have followed practitioner or academic research around lower-volatility strategies may believe that in the long run such approaches earn a higher return for the risk borne, although of course you can never be sure over what periods that superior risk-adjusted performance may prevail.
What’s an unhealthy reason for entering either of these strategies? Performance chasing. Investors potentially seduced by the recent historical performance who don’t really care that much why or understand the strategies are the most likely to experience real disappointment whenever such strategies do eventually perform worse than the market on a risk-adjusted basis. While as investors or investment professionals we may assure ourselves that we’re too sophisticated to be swayed by the allure of just past performance, in fact our brains are wired to be susceptible to just that. Remember from Greek mythology that Odysseus, knowing that the Sirens would lure him to crash his ship on their rocks, was smart enough to have himself bound to the mast so he couldn’t do himself harm, a wise lesson for modern investors who want to avoid the seduction of high returns.
Why would Aperio issue caution concerning the interpretation of the historical returns of these two particular strategies? Is it because we know something about what’s coming or that volatility and other factors may have become overpriced? Anyone who has worked closely with our firm knows that we claim no insight into when factors may turn from market leading to market trailing. We issue a warning based not on close market assessment but rather on close behavioral and psychological assessment driven by what clients request. We’ve seen assets grow in those strategies, which we still consider as solid choices for those seeking lower risk. At the same time, however, we understand that all of us can be lulled and seduced by good performance and thereby forget that any factor will almost certainly face bad performance at some point in time.
While we know nothing special about the timing of factor shifts, we do believe that all of us, even the most rational, are still human beings and thus potentially vulnerable to unrealistically rosy expectations. When lower-volatility strategies finally do turn negative compared to the market, there will be a great brouhaha and search for explanation (or to put it more cynically, a search for scapegoats to blame). Unfortunately, the explanation that "gee, that factor finally turned negative" may be highly accurate but still psychologically unsatisfying to those watching a strategy that’s had such a great run finally lose some of its luster. Should we be asked at that time if we think it’s wise to withdraw after it’s turned, our answer will be the same as it is now, before things have gotten bad, namely, "If you’re in this strategy for the risk reduction and there’s no evidence the anomaly has disappeared, then stick with it." For those who no longer seek lower-risk strategies, that might be an appropriate time to exit the strategy.
Of course new and valid academic research could come to light that pokes holes in the anomaly or somehow undercuts confidence in these low-risk strategies. Reacting to new research can be quite wise, but it’s also quite likely that simply performance alone will suddenly prompt investors to abandon particular factor strategies. In such a situation, maybe Odysseus had it right by tying himself to the mast so he wouldn’t do himself any harm.
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