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When returns are low, reaching for more is usually unwise: James Saft
September 8, 2017 / 8:01 PM / 3 months ago

When returns are low, reaching for more is usually unwise: James Saft

(Reuters) - If an investment strategy is good enough for one of the top minds in finance, it is probably good enough for you, right?

Wrong.

It is very likely too good for the likes of you, or me, for that matter.

The current environment of extremely richly priced financial markets, increased risk taking and the poor average returns these imply is sending investors scrambling. Some are considering reducing risk while others go further afield in an attempt to find the few remaining undervalued assets or overlooked special situations.

Having explained in great detail why we should not have great expectations from today’s and tomorrow’s markets, legendary investor Howard Marks of Oaktree Capital Management detailed his strategy for investing in a low-return world.

“I would mostly do the things I always have done and accept that returns will be lower than they traditionally have been,” Marks wrote Thursday in a note to investors.

“While doing the usual, I would increase the caution with which I do it, even at the cost of a reduction in expected return. And I would emphasize 'alpha markets' where hard work and skill might add to returns, since there are no 'beta markets' that offer generous returns today.” (here)

While I think there is a reasonable expectation that someone with the skill of Howard Marks can make that work, the rest of us face some pretty formidable execution risks, especially when it comes to the parts about exercising caution and searching out higher returning markets and managers.

That first point, to follow the principles you’ve always used in investing but to make preparations for getting a lower return than the historical norm, is by far the best strategy for the average saver, or I would argue, for the average professional money manager.

Current valuations give meaningful information about future returns, with the higher the prices paid for assets now, the lower the returns it is reasonable to expect. The 10-year trailing price/earnings multiple of the S&P 500 just went above 30, territory we’ve only previously seen just before the 1929 and 2000 meltdowns. Large swaths of the government and private debt markets are similarly priced for perfection, with the main difference being that the zero lower bound for interest rates theoretically makes the risks asymmetrically distributed against investors.

DESTINATION UNKNOWN

Still, valuation is not destiny, and while it is right to assume that returns will be poor, or at best sub-par, exactly how this happens and when is a hard, and potentially very expensive thing to do. Marks rules out moving to cash as a means to reduce risk, but the actual mechanics of increasing caution to reduce risk are fraught, to say the least.

The traditional means of cutting risk in a portfolio would be to reduce equities and hold more liquid government debt, forgoing the circa 4 percent annualized payment of the equity risk premium. While Marks points out that this could be painful if a market reversal takes years to arrive, the other scary thing about attempting to cut risk in current markets is to know the risk of bonds. Government bond yields are so low that, though they represent a pickup of two percentage points a year or so above cash, they could potentially generate unusually deep losses if inflation picks up. And with central banks holding huge stocks of bonds which they claim to soon want to unload, that risk is harder to fathom than ever. I doubt we’ll see a Federal Reserve taper any time soon, but don’t particularly see the wisdom in betting on it as a means to cut risk.

Marks’s last strategy, what he calls “special risk and special people” is the one - and he’d very likely agree - which is least well suited to most mortal investors.

It isn’t that there aren’t skilled investors who can deliver extra return, or assets which the market has failed to price efficiently. Anyone paying attention knows markets are not perfectly efficient, but the supply of people who think they can identify these inefficiencies greatly exceeds that of the investable opportunities.

It is exactly at times like these, when normal boring investing seems fraught, that most of us should be most wary about the search for alpha, or outperformance.

Alpha is out there but people chasing it are usually buying things they don’t understand while employing the services of intermediaries whose skill they can’t measure.

Save more, expect lower returns and don’t make plans based on alpha bailing you out.

(The opinions expressed here are those of the author, a columnist for Reuters)

Editing by James Dalgleish

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