As excerpted from the latest Weekend Notes by One River CIO Eric Peters
Today’s greatest challenge in asset management is that the biggest pension funds need to generate 7.5% returns in perpetuity or face insolvency. An annual loss would be debilitating, a multi-year loss devastating.
For a couple decades, the solution has been a portfolio of risk assets paired with a hedge (gov’t bonds). They’ve leveraged the bonds so that volatility of both are equal. The great attraction of this portfolio is that the hedge has paid interest and rolled down the yield curve. Both have generated extraordinary returns. It’s been magnificent.
If there are two rules in investing they are that magnificent portfolios attract inflows, and inflows ultimately destroy magnificent portfolios. As this magnificent portfolio came to dominate all others, the price of risk assets and bonds rose, inexorably, reflexively.
Everything is now expensive, so that today’s ratio of private sector wealth to GDP is 5.0x, an unprecedented high (this ratio is naturally mean-reverting and its long-term average is roughly 3.8x. It hit 4.4x at the 2000 peak then fell to 3.8x. It hit 4.7x in 2007 then 3.8x in 2009).
So now that risk assets and hedges are both so expensive the magnificent portfolio is incapable of delivering the extraordinary returns its holders have come to depend on. And they’re looking for the next magnificent portfolio. But no such construction exists for an investor who is not allowed to go short risk assets. And yet they still need to earn 7.5%. So they must take more risk, then pair it with a new hedge.
One way to take more risk is to sell volatility. So they do, in a myriad of implicit and explicit ways. While searching for a hedge.
Hedges almost always cost money. So investors avoid them, even when their cost declines, which it has, and now approaches 60yr lows. Systematic trend strategies (CTAs) generate returns over the long-term, and usually profit in big bear markets. So they look like hedges that don’t cost money. They’re not exactly equivalent to owning bonds, but when bonds are this expensive, and the Fed is raising interest rates, they’re an attractive alternative. Which is why you see trend strategies popping up in lots of the world’s biggest pension portfolios.
Trend strategies differ in material ways (I believe our approach is superior), but they all tend do well in slowly unfolding bear markets, like 2008. They also tend to do poorly in fast market reversals like 1987. But one strategy that does well when markets decline like in 2008, and does extraordinarily well when they decline fast like 1987 is long volatility. Which is why, when volatility is low, pairing our trend and long volatility strategies with a portfolio of risk assets is as close as you can get to replicating that magnificent portfolio that no longer exists.