Is the money game destined to become even tougher? If you look at historical trends and a growing body of research, the answer is yes. While economic growth slows, the correlations between asset classes are rising. Trying to get better returns without risk will be no picnic.
Yet the landscape implies investors will indeed be under greater pressure to embrace higher risk, because the status quo may mean lower returns.
Forecasts are always suspect, of course, but this is more than rank speculation from the usual suspects. Historical data suggests the pace of economic growth in U.S. GDP over recent decades is in fact slowing. And the greater correlation among major asset classes suggests diversification will make it harder for investors to keep a lid on risks. They face an awkward choice: suffer a lesser rate of return or add more parlous assets.
Historical Implications
Leading the dismal charge in growth forecasts is Robert Gordon, an economics professor at Northwestern University and a member of the Business Cycle Dating Committee at the National Bureau of Research. In a recently penned set of papers, he laid out what some say is a compelling, as well as disturbing, case for decelerating growth. In “The Demise of U.S. Economic Growth: Restatement, Rebuttal, and Reflections,” he points at four key problems.
1. There will be fewer hours worked per capita because of demographic changes.
2. There will be stagnation in education “as the U.S. sinks lower in the world league tables of high school and college completion rates.”
3. There will be rising economic inequality.
4. And there will be a long-term increase in the ratio of debt to GDP, which will trigger higher taxes and slower growth in government spending on social programs, such as Social Security and Medicare.
His forecast may be controversial, but he isn’t alone in projecting slower growth due to structural factors, including the expected widening gap between the rich and not-so-rich. A study published in August by Standard & Poor’s also warns that increasing income inequality threatens to squeeze U.S. growth. “At extreme levels, income inequality can harm sustained economic growth over long periods,” S&P said. “The U.S. is approaching that threshold.”
Some economists argue that the sluggish recovery after the last recession shows the hobbled potential for expansion. “The U.S. recovery has been slow because its long-term capacity for growth has slowed,” declared economist Andrew Smithers in a recent essay in the Financial Times.
New technologies have traditionally been a key source of growth in the past. The rise of the railroads in the 19th century and the digital economy in recent decades are examples. Technological advances will surely continue, but their contribution to growth will decrease on the margins from here on out, say some economists.
It’s less about the loss of ideas than the limits of growth after a lengthy run of success. “The American economy has enjoyed lots of low-hanging fruit since at least the 17th century, whether it be free land, lots of immigrant labor or powerful new technologies,” writes Tyler Cowen of George Mason University in his 2011 book The Great Stagnation. “Yet during the last 40 years, that low-hanging fruit started disappearing, and we started pretending it was still there. We have failed to recognize that we are at a technological plateau and the trees are more bare than we would like to think.”
Lots of people disagree, of course, and for good reason. Predictions that technological innovation has run its course have been proved wrong in the past. The head of the U.S. Office of Patents said in 1899 that “everything that can be invented has been invented.”
Yet U.S. GDP growth has undeniably been inching down in the post-World War II era since 1948 (Figure 1).
There are several ways to measure growth, of course, and you can spin the data to prove whatever you want. Some analysts emphasize that U.S. real per capita GDP has a long history of rising at 1.8% a year—since the late 1700s! The pace has recently ticked lower, but that’s not unprecedented. Nor is it when growth accelerates after a fallow period.
“I think we’ve had slow growth for long enough that a breakout to the upside is more likely than continued slow growth,” says Laurence Siegel, the director of research at the CFA Institute Research Foundation and the former director of research at the Ford Foundation.
But the notion of another snapback isn’t universally accepted, at least not one that comes anytime soon. The Organisation for Economic Co-operation and Development warned in a recent study that the risk of slower global growth is a key challenge in the decades ahead. “Global growth prospects seem mediocre compared with the past,” according to the group’s recent paper, “Policy Challenges for the Next 50 Years.” Emerging markets are still expected to rise faster than developed nations, but the edge is projected to fade because of “a gradual exhaustion of the catch-up process and less favorable demographics in almost all countries.”
If growth is slowing for an extended period, what does that imply for returns on risky assets—stocks in particular? The answer varies depending on your time frame and economic assumptions. But this much is clear: There’s a generally close relationship between changes in the economy (GDP) and equity returns across the decades, as Figure 2 shows.
Equity returns may wander off on their own in the short run. But expecting stock performance to disconnect from the real economy for any length of time is expecting too much (Figure 3). If economic growth is slow, it will eventually catch up with investors.
All Together Now
Bill Bernstein, a widely read financial planner and the author of several best-selling investment books, isn’t particularly worried about slower economic growth. He’s more worried that correlations among investments will increase.
He thinks diversification through conventional asset allocation strategies will be under pressure in the years ahead. “As markets become ever more connected, ‘short-term’ correlations are rising,” he said in an interview with Financial Advisor.
He outlined the case for this future in his 2012 booklet Skating Where the Puck Was: The Correlation Game in a Flat World. The payoff for diversifying into so-called alternative asset classes will likely fade in the years ahead, he writes. As markets become ever more globalized, and the financial industry persists in securitizing assets that were once obscure, investors will get less bang for their buck by adding formerly exotic assets such as commodities, foreign securities and real estate investment trusts. It won’t juice performance or curtail risk as well.
The problem is that good news travels fast. As the crowd loads up on “new” asset classes and chases a finite supply of them, the features that made them so attractive in the first place—low correlations with stocks and bonds and relatively high expected returns—tend to fade.
“Elders of the investment tribe long enough in tooth will recall the refrain of a popular song from the distant 1970s,” Bernstein writes. “‘Call someplace paradise, kiss it goodbye.’ Well, the same is generally true of diversifying asset classes: As soon as a new one gets discovered, it’s already gone.”
Clever investors are continually seeking out so-called anomalies and inefficiencies to boost opportunities, and for a brief time the edge is available to the early adopters. But the secret leaks out eventually and the outsized returns retreat. History is rife with examples.
Consider hedge funds, which thrive by exploiting unnoticed opportunities. Nice work if you can get it, but the relentless competition has dulled their edge. Some of those competitors are ETFs and mutual funds attempting to replicate hedge strategies for the masses—at a fraction of the cost.
“Many hedge funds simply repackage or lever cheap benchmark indices and sell it as expensive outperformance,” said Howard Wang in a conversation with Bloomberg. Wang is a former analyst at legendary hedge fund shop Bridgewater Associates and has started his own firm, Convoy Investments. “While true uncorrelated active management is more valuable than ever, investors need to make sure they are getting what they pay for,” Wang said.
Good advice, but easier said than done when you consider that the average hedge fund has dramatically underperformed broad U.S. equity indexes. The HFRI Fund Weighted Composite Index is ahead by an annualized 5.8% for the five years through this past July, according to HFR Inc. A modest return, far below the 16.8% annualized total return for the S&P 500 over that span.
Inexpensive ETFs have promised investors diversification far and wide. As they have drawn more assets, the results have been predictable: higher correlations. Consider how four formerly exotic markets compare in terms of rolling three-year correlations with the U.S. stock market (Figure 4).
A decade or two ago, it was relatively rare for investors to go into foreign stocks in developed and emerging markets or to own commodities and REITs. But now it’s become ordinary, thanks to the rise of publicly traded funds offering access to these markets at index product prices. The result is that there’s a lot less disparity between the returns of these investments and those of U.S. stocks. The diversification benefits are less.
Strategy For A New Market Order
If returns are headed lower and correlations higher, what does that imply for portfolio design and management? Business as usual could mean fewer gains with more risk (since assets likely to move together are also likely to suffer in unison).
What to do? You may decide to simply grin and bear it. But planners seem to recognize that a different, or at least evolving, approach to portfolio management is necessary. A recent study by Natixis Global Asset Management (The 2013 Global Survey of Financial Advisors) found that 59% of advisors around the world “agreed there is a need to replace traditional diversification techniques with new approaches to achieve results.”
There are sound reasons to do it, but it’s not obvious that the majority of recent converts to tactical asset allocation, say, or the like will triumph.
Brent Schutte, a CFP licensee who’s also the senior investment strategist at BMO Global Asset Management in Chicago, says his long-standing preference for tactical asset allocation was the exception a decade ago but has since become widespread. Either the crowd has become enlightened or, as Schutte asserts, it’s still Wall Street’s penchant to chase fads.
“I agree that risk is going to be higher and correlations will be closer to one than they have been,” notes Kevin Karrh at Karrh & Pierce Wealth Management Group in Plano, Texas. What’s driving the change? “A lot more money in the system chasing returns,” says this self-described veteran of the “trend following” approach to portfolio management.
More advisors may be using some form of dynamic asset allocation, such as trend following, arguably because it’s the only way to remain competitive. But that doesn’t mean success is ensured. By some accounts, it will be that much tougher to reach financial objectives as these strategies draw more players. A higher share of assets linked to trend-following signals exaggerates market volatility.
In turn, there will be greater risk in market-timing techniques, which are the foundation of many (if not most) dynamic portfolio strategies at the asset allocation level.
“The industry has jumped the shark regarding tactical asset allocation by confusing absolute and relative return strategies and redefining risk as peak-to-trough returns,” says Ken Solow, a partner at Pinnacle Advisory Group and author of Buy and Hold Is Dead (Again): The Case for Active Portfolio Management in Dangerous Markets. “The result is that short-term market-timing strategies that are almost 100% technically based and drawn from a rules-based, back-tested performance history are now considered OK.”
Solow isn’t against quant strategies, per se. The problem, he explains, is a growing tendency to adopt these strategies in the extreme—at the expense of long-term market-risk exposure. “A strategy that shouldn’t go down in a bear market isn’t suitable as a core holding,” he emphasizes. “There’s a risk that investors don’t get back in and don’t participate in the future.”
Finding an intelligent balance between core and satellite holdings is essential, he adds, although Solow has his doubts that most advisors rushing into tactical strategies will find this equilibrium. “This isn’t going to end well.”