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August 2, 2004

Strategies for an Inefficent Market

John P. Hussman, Ph.D.
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The belief that risk and expected returns go hand in hand is probably one of the most widely held misinterpretations of finance theory. What finance theory does say is that when a portfolio is efficient, the only way to increase expected return is to load additional risk. But the positive relationship between risk and expected return certainly isn't true when a portfolio is inefficient.

For example, investors dangerously misinterpret finance theory when they believe that a poorly diversified portfolio has a higher expected return because it is more risky. Sure, the greater risk means that the potential range of returns is probably wider – it's easier to double your money, and also easier to be wiped out – it doesn't follow that the average expected return is higher.

In an efficient market, two things are true. First, everybody has an incentive to hold the market (say, the S&P 500) as the ideal portfolio because no other portfolio has the same expected return at lower risk. Second, everybody has an incentive to hold the market portfolio over time because there is no information that would allow investors to outperform it over time. So market efficiency has implications both for the portfolio investors hold (buy the market) and for their investment allocation over time (hold it forever).

[Geeks note: To get an efficient market, assume that all traders are rational; the sort of statistical rationality that would lead everyone to interpret the same information the same way, assume that it's common knowledge they're rational (so you know that I know that you know that I'm rational, etc), that all investors' risk preferences are constant, and the only motive for trading is an expected profit. In that case, prices will reflect all information because any time somebody tries to buy, we can immediately infer that they have favorable information, and the quoted bids and offers will move to reflect that information, even if it's private. Oh, and nobody ever trades. Efficient market theorems always go hand in hand with no-trade theorems. Quiet little secret of finance.]

Departing from a buy-and-hold

It's probably fairly obvious that I don't accept market efficiency as truth. As a result, there are two ways in which our investment strategy departs from buying and holding the market. First, the Strategic Growth Fund generally holds a different portfolio than the S&P 500, weighting some stocks and industries higher and some lower than reflected in the index. Those over-weights and under-weights emerge because we believe that, on average, individual stock valuations and price/volume action are important determinants of the total return on stocks.

Second, our exposure to the market itself varies over time. We increase the sensitivity of the Fund to market fluctuations when market-wide valuations or market action are favorable, while we try to fully hedge against the impact of market fluctuations when both are unfavorable. That's because the average profile of return and risk has historically varied depending on those conditions. Once a given Climate is identified, we don't believe it's possible to go that one step further, and forecast whether a specific market movement over a specific time period will be positive or negative (which puts us strongly at odds with investors who believe that these movements can or should be “timed”). We also generally have no idea how long a particular Market Climate will be in effect, which further prevents us from making forecasts.

In short, there are two consequences in not accepting the efficient markets theorem. One is that we generally hold a portfolio different than the major indices such as the S&P 500. The other is that we systematically vary our exposure to broad market fluctuations over time.

Average performance is important

On a stock selection basis, favorable valuation and market action on our measures are certainly not always rewarded, but that's why we diversify across about 200 individual holdings. Even at that level of diversification, our day-to-day returns can be affected by large moves in even a single holding, but those effects go both ways, and the strong average performance of our holdings, relative to the market, has been an important contributor to the returns of the Strategic Growth Fund since inception.

On a market exposure basis, the average return/risk profile of the market varies across the Climates we identify, but it's certainly not true that the market always rises in favorable Climates and falls in unfavorable ones. Basically, a Market Climate says “when these conditions were historically true, here is the set of returns that the market had – some are positive, some are negative, but look, the average return/risk profile is different in this Climate than in the other ones.” We always align our investment position with that average return/risk profile. But we don't try to forecast the next move.

High compound returns require restrained volatility

On a stock selection basis, adding risk doesn't get you higher expected return unless the portfolio is efficient. Adding volatility is an ineffective strategy unless the portfolio cannot be improved upon through stock selection.

On a market allocation basis, the simple mathematics of compounding almost ensures that high returns and restrained volatility must go together in the long-run. To see this, consider a 3-year string of 20% annual returns. Clearly, the compound annual return is 20%. Now add a 4 th year with one 20% loss. Suddenly, the combination of time and loss reduces the overall compound annual return to just 8.43%. In some strategies, it is acceptable to take an occasional 20% loss, but in general, the greater the volatility of returns, the lower the compound annual average.

That's something that actually shows up if you look at 5-year returns on the S&P 500 too. Take a set of 5-year annual returns, and calculate the annualized standard deviation of returns (using monthly deviations and annualizing them is informative). What you'll find is that the periods of very high annualized returns tend to be the ones with the lowest volatility, while the periods of poor annualized returns tend to have the highest volatility. The estimated relationship between return and risk, if you run a statistical regression, will be negative.

Consider Warren Buffett. Though he has substantially outperformed the S&P 500 over 39 years, his annual standard deviation has been 14.5% while that of the S&P 500 has been 17.4%. That's not to say that Buffett hasn't had some disappointing stretches too. Over the past 5 years, as the market has been strenuously overvalued, the compound annual gain in Berkshire Hathaway's book value has been just 5.97%. Value investing is an outstanding theme, but one that's difficult to exploit when values are rare.

It's worth looking at Buffett's volatility more carefully. Over the past 39 years, Berkshire's book value versus the S&P 500 has only had a beta of 0.48 (so that a 10% move in the S&P 500 has only induced about a 4.8% move in Berkshire's value). In addition to what would be expected from a risk-free investment, Buffett produced an average 13.8% “alpha” annually, independent of market fluctuations. Again, that's an average. In some years, Buffett's returns would fall substantially below what would have been predicted from his typical performance pattern (13.8% + risk free rate + .48 S&P return over and above risk free rate), including significant shortfalls in 1975, 1980 and 1999.

Importantly, Buffett has neither outperformed the S&P 500 on a consistent year-by-year basis, nor matched his “standard” return profile on a consistent year-by-year basis. Instead, the measures of his success have been limited volatility, the avoidance of deep drawdowns, restrained beta, and high alpha. For investors interested in absolute returns, those are the elements to consider.

Evidently, if you don't quite accept the view that the market is efficient (and Buffett doesn't either), a few strategies come in handy. First, you allow yourself to hold a portfolio that's different the market, primarily characterized by value. Second, you vary your exposure to market risk based on conditions. Refuse to load up on market risk when market risk isn't worth taking, and invest aggressively when conditions are favorable and values are abundant. That's not always easy, and not always rewarding. You don't always track the market, and you occasionally find yourself being a wallflower at the investment party. But I don't know a better way to invest.

Market Climate

Turning to present conditions, as of last week the Market Climate for stocks remained characterized by unusually unfavorable valuations but favorable market action. The entire value of the Strategic Growth Fund remains hedged with put options having strike prices roughly 2% below current market levels. But with implied volatility particularly low, we have bought in a good portion of the corresponding short-call positions we were using as a hedge. In practice, that means that the Fund would quickly and almost invariably lose at least 1-2% in the event of a substantial market decline, at which point I would expect the put options beneath the portfolio to reduce the impact of market fluctuations on the portfolio. On the other hand, I would expect the Fund to participate in market advances, with about 50% exposure to local market movements, and as much as 80% exposure to an extended advance, if one was to emerge.

That said, the Fund does hold a portfolio different from the major market indices, so the actual performance of the Fund is always affected by those specific holdings. While the relatively strong performance of our stock selection approach has been an important factor in the Fund's returns since inception, even a single holding in a portfolio of over 200 can exert an effect on a day-to-day basis. A disappointment in UTStarcom (UTSI) last week slightly muted our performance last week, despite our more constructive investment exposure.

Given the recent shift to a more favorable Climate, there is at least some hope for a pickup in trading volume. The extended sideways action of the market on low volume has made it very difficult to gain traction from any specific theme, much less from general areas of favorable valuation or market action. I've noted before that day-to-day returns can't be controlled, so a “good day” for me is one where I take actions that I believe will produce good results over time (such as buying high ranked candidates on short-term weakness, selling lower ranked holding on short-term strength, and aligning our exposure to market fluctuations with the prevailing Market Climate). I don't try to add temporary excitement to a dull market by deviating from our investment approach. The Fund continues to take good opportunities to systematically improve the valuation and market action within the portfolio.

Still, marginally outpacing marginal market gains year-to-date isn't very satisfying, and doesn't have the appeal of larger, instant rewards. My hope is that stronger trading volume might bring some new themes to life, or at least reward perennial ones like favorable value.

In bonds, the Market Climate remains characterized by neutral valuations and modestly unfavorable market action. The Strategic Total Return Fund continues to carry a 3.25 year duration, mostly in TIPS, a roughly 14% exposure to precious metals shares, as well as modest additional positions in select utilities, foreign government notes, and U.S. agency securities.

New from Bill Hester: Parting Ways - Leading Indicators and the Fed Funds Target


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