Great. Thanks for all of your answers. The next question comes from the live room as well, and this person asks, “Why even buy treasuries in the current inflationary environment if the ‘alternative investment risk to reward profile’ is so good?”
And then also, maybe I don’t know if these would necessarily go together, but we also had a question submitted in advance about “What do you think about tips?” So, I don’t know if that would be separate or if there’s some overlap between answers to those, but whoever would like to go first, please do.
Want me to take the alternatives, Adam?
Yeah. So, here’s a way to think about portfolio construction that I think will be helpful for everybody on the call. It informs all of our thinking, and hopefully I’ll be able to explain in a way that you will find helpful. So, our first principle (like everything we do at Buckingham) is based upon the academic research and peer-reviewed papers that shows that while markets aren’t perfectly efficient, there are some inefficiencies, or even some groups of stocks that are called lottery stocks. I’ll let you know about them in a moment that have God-awful returns on average. They go through some periods, usually in manias like the dotcom boom and the recent period where stocks that have high investment/low profitability, and are kind of social media stocks, if you will, whatever is the hype of that era.
These small companies with high investment and low profitability have earned worse returns than treasury bills in the long term. But in the late 1990s, they did great. In the 2018, 2019, and 2020 period, they did great. And then of course, they got crushed. Most of the NASDAQ stocks, for example, are down 60% to 70% already from their peaks just two years ago, similar to what happened in the dot-com era. So, all the funds we own actually exclude all of those stocks while index funds would own them if they’re in an index. So, there are some small pockets. Altogether they’re just a few percent of the market. So, we think most of the market is highly efficient. And that leads you to conclude that you don’t want to be trying to either pick individual stocks or try to time the market. With that said, as one of the questioners mentioned, I wrote a book called Your Complete Guide to Factor-Based Investing.
Factors are nothing more than traits or characteristics of stocks, and there are certain traits or characteristics that have generated higher than market returns in the long term. Shouldn’t be a surprise to most people on this call. They’re exactly the kind of stocks that Warren Buffett has been telling people to buy for 70 years or so (maybe 60 years). And finally, it took the academics decades to catch up with Warren Buffett. I even wrote a book about that called Think, Act, and Invest like Warren Buffett. But those stocks are the ones that have outperformed are smaller companies that are more profitable and are cheaper, meaning they have low price to earnings, price to book value, etc., and they also tend to have positive or at least not negative momentum as well. So those are the stocks that we buy…all have those characteristics, no matter which fund family we are using. We incorporate.
So, there’s no individual stock selection. We buy all the stocks that meet the criteria. Say for a small value fund, I’ll just make this up, but Bridgeway might have a maximum size of market cap of $2 billion, a maximum price earnings ratio of 12 at this point in time—things like that. So, no stock selection, market timing, sector analysis—none of that goes on because the evidence says that doesn’t add value likely.
So, our first principle is to assume markets work. They’re highly efficient. If you believe markets are highly efficient, then logically it absolutely must follow—there’s no other logical conclusion you could draw—other than to say that all risky assets have to have similar risk-adjusted returns when we account for all types of risk. So, it doesn’t mean just volatility. Many of you on the call may be familiar with something called the Sharpe ratio, which looks at return for each unit of volatility.
So, something with higher volatility better provide you with a higher return to compensate you for that risk. Well, the Sharpe ratio is just one measure of risk. There are other things, for example, illiquidity is a risk, and you should be compensated for that. Stocks or securities that have fatter left tails—where there’s more downside risk—they’re riskier because we worry much more about the downside than the upside. So, they should carry risk premiums. That’s called skewness and kurtosis in technical terms. So, we want to consider those things. But here’s what I mean by what I said, if security A or asset class A (let’s call it reinsurance for arguments sake) had higher risk-adjusted returns than say middle market lending, then money would flow out of middle-market lending, lowering those valuations, and raising the yield. Money would flow into reinsurance, driving down its expected return until we got this equilibrium, and they both had the same or very similar risk-adjusted returns.
We think that’s the way the world works. And if you believe that’s the way the world works, then you should invest of course, as many unique sources of risk as you can possibly identify, because they all have the same risk adjusted returns. Why do you want to concentrate your assets in a single factor or trait like stocks and global stocks as you saw just in the last six weeks or 12 days or so are all subject to the same geopolitical risks. And the typical 60/40 portfolio that the average investment advisor builds for their clients has about 85% of their risk in that equity risk. Even with a 60/40 portfolio, most people don’t understand that they don’t have 60% of their risk there. That’s 60% of their assets. Let me explain what I mean by that.
Let’s say you come to Adam with a typical safe or traditional portfolio that has 60% equities. Those 60% equities have a volatility, if it’s a broadly diversified portfolio saying owning Vanguard’s equities—both U.S. and international—is going to have historical volatility of about 20. For use that as the measure of the risk, remember again, I said, it’s not the only one, but it’s a good one, 60% times 20, that gives you 1,200 risk points. Now we take the 40%. Let’s say it’s in five-year CDs or five-year municipal bonds. That’s going to have volatility of about four. So, four times 40 is 160. 160 and 1,200 is 1,360, about 90% of your risk there in that example is in equities. But if all risk assets have similar risk-adjusted returns, why would I rationally put 90% there? Why not own other things like reinsurance, like private line, like these other factors and broaden and get a much more diversified portfolio?
So, that’s how we think about things. So very specifically these alternatives are: 1) a lot less known by people, which means they don’t have a popularity premium. It’s sort of the opposite. There’s not a lot of capital allocated to them. And 2) highly ill-liquid in some cases. That demands a big premium. Let me just give you an example. If a bank makes a credit card loan, let’s just say it’s got a 14% yield on that credit card and it securitizes it and sells it to the public, the yield will all of a sudden be (if it’s in that pool of a million loans that look like that), be 12% not 14% because someone’s willing to pay or give up that extra 2% because now I can trade it every day. Banks do that, and they get rid of that asset. They collect that premium, and they get to redeploy the capital.
So, if I can hold an ill-liquid asset, like Cliffwater’s fund that’s yielding 7%, why would I want to own the same credit risk if I don’t need the liquidity in Vanguard’s fund, which is yielding 3.8%? If I can bear illiquidity, which I’m willing to bet everyone on this call can do so for at least 5% or 10% or 20% of their portfolio, I should gravitate to that if I understand the nature of the risks involved. So, there are logical, as I explained to Jim, both credit risk premiums, which today are very wide, historically so, and you have massive illiquidity premiums there as well. So that’s the logic here. We’re looking at different risks and also illiquidity premiums. And in many cases, they’re just not a lot of capital deployed yet in that space. And that can change over time. You want to take advantage of it. Obviously, the biggest profits go to the early adapters.
I’ll give you one other example of something that we are looking at as an investment. I’ve actually made one investment personally as well. And it’s actually going to be included as a sleeve if you will, in a new Cliffwater fund, which was just approved. So, everyone on this call may be familiar with something called the viatical or a life settlement. So, somebody has a life insurance policy they have been paying into for decades. Maybe unfortunately they find out they’ve got to go to a nursing home for the next several years, and they don’t have the money to fund that, so they’re can’t keep paying their premium on their life insurance policy. So, they abandon their policy. Well, that doesn’t make much sense because today because there’s now a highly regulated broker market in structured settlements.
And I think it’s 47 or 48 states, the insurance companies who want you to abandon that plan because now you’re closer to death, they’re happy if you quit. They actually are required to inform you that instead of abandoning a plan, you have the right to sell it. So, there’s a market now. When that market first developed about 20 years ago, because nobody knew much about it, it was highly illiquid. Some hedge funds went in, and they were buying these policies up at massive discounts, giving them returns of high teens even after the big fees to the hedge funds of say 2% in 2020. Then a lot of money came flying in chasing this return on this great asset that’s totally uncorrelated, of course, with the stock market and maybe even returns go up if you get a pandemic because people die early, right?
And the yields dropped to the higher single digits and it’s because cash flow became popular. Then the 2008 crisis hit, and liquidity became a big issue. And today, those yields are back up into the low double digits. And there’s a lot more regulation. It’s not a wild west rodeo any longer. Top firms like Blackstone, a name many of you may know, Private Equity and Citadel play in this space. And there are firms that are beginning to create looking at funds. I’ve actually pushed the fund to create an interval fund that could access this. So, we’re looking at that. But that’s an example where clearly there’s a risk premium there because we don’t know when people are going to die and so you get a premium for taking that side of the bet. So that’s just an example. You should ask before you invest, what’s the logical reason why I should expect a risk premium. Otherwise, don’t invest if your advisor can’t explain that. That’s why we write 10- or 15-page whitepapers walking through all of the risks, why there’s a premium, what the issues are, and illiquidity. So, hopefully that answers the question.
I think it does, but I’ll tell you what I was thinking about when you were talking about risks and two specifically: 1) you should get a premium if you are willing to give up liquidity and 2) you should get a premium if you could handle volatility.
Well, gee, I’m willing to give up liquidity for my Roth IRA because it might have, as you said, maybe a 30- or 40-year investment period. I’m also willing to give up liquidity and volatility because it’s just not relevant. So now I’m going to get a higher return in something that really isn’t costing me anything because I don’t need the liquidity.
For you it’s a free.
I don’t mind the volatility.
Yeah, Jim, the way I think about it, it may not be a free lunch because there are some risks there, but for you, it’s a free stop at the dessert tray anyway.
And even in taxable accounts, most people know that they don’t need to access all of their assets. This is one way the Harvard’s and Yale’s of the world have been generating higher returns for decades is by investing in these less liquid assets. And fortunately, the SEC approval of these interval funds about four or five years ago has brought them availability to the public markets, and people like Cliffwater have been driving prices down so they’re not cheap anymore still, but they’re a lot cheaper than two in 2020. Cliffwater’s fund is about one and a half percent, which I don’t think is that bad for someone who’s in effect, running a bank for you. That’s really what they’re doing.
Larry, I actually think I read somewhere that Harvard’s endowment grew by $11 billion in 2020 alone. Something like that—like a 27% growth rate. So, when you mention that, it just brought that to mind right away.
Well, the endowments have the advantage. They know they’re set, they are in perpetuity, and they intend to spend, let’s say 5% a year. So, they know at least for one year, 95% is available and even out to five years, 75%, So, they invest in things, I’ll just make this up, like a rubber plantation in Indonesia, which might take 10 years for the plants to grow. Someone who is 85 years old is not going to do that. And so, there’s a more limited market and they get a big illiquidity premium for that type because most investors won’t go into that space. So, wherever there are liquid assets, yields are lower. The more liquid the asset, the lower the trading costs, and people are willing to rightly pay more for that. The less liquid the asset, the higher the trading costs, and then people are going to assign lower price. That’s one reason why small companies historically have had higher returns because their trading costs are higher because they’re just more illiquid. And in bear markets, God help you if you try to sell into a market that’s crashing with these illiquid microcap stocks, you’ll see much higher trading costs there.