Another turning point, a fork stuck in the road

Time grabs you by the wrist, directs you where to go

So make the best of this test and don’t ask why

It’s not a question, but a lesson learned in time

It’s something unpredictable, but in the end is right

I hope you had the time of your life — Green Day

I suspect that most people who allocate a portion of their

portfolios

to lower

volatility

assets have little appreciation for what they are giving up in exchange for this benefit, or more specifically for the magnitude of this sacrifice.

In the

bear market

which followed the bursting of the late nineties tech bubble, hedge funds far outperformed their traditional, long-only peers. Predictably, investors subsequently piled into

hedge funds

, causing assets to grow in the U.S. from several hundred billion dollars in 2000 to more than US$2 trillion by 2007 and to over US$4 trillion today.

Just as Adam Smith’s theory of supply and demand would have predicted, hedge fund returns have been sorely lacking. Over the past 10 years, the HFRX Global Hedge Fund index has delivered an annualized return of 1.87 per cent, as compared with 9.8 per cent for the MSCI All Country World Equity index. Using these figures, a $10 million investment in the HFRX index ten years ago would currently have a value of $12,035,470, while the same amount invested in global stocks would be worth $25,469,675.

Given this stark difference, investors should ask themselves whether their aversion to volatility is mostly financial or mostly emotional. For those with long-term horizons, the emotionally driven component of volatility aversion has proven, and likely will prove to be costly indeed!

Over the past decade or so, private assets have become increasingly viewed as being able to deliver strong returns while simultaneously shielding investors from high volatility and severe losses in challenging environments. These perceived attributes have enabled assets under management to increase from roughly $600 billion in 2000 to $7.6 trillion as of the end of 2022.

While most funds may provide accurate values for their holdings, this may not always be the case. Although 2022 was a horrific year for both stocks and bonds, many private equity, private debt, and private real estate funds reported negligible losses. Relatedly, A Financial Times article, titled

The volatility laundering, return manipulation and ‘phoney happiness

’ of private equity, suggests that “return manipulation” is prevalent among private asset managers.

Private holdings also expose investors to the risk of not having liquidity when they are most likely to want or need it. Moreover, I would be surprised if the same Adam Smith dynamic that has been a headwind for hedge funds does not “infect” private asset managers in a similar fashion, causing future returns to be far more muted.

If a manager delivers twice the return of their peers but also exhibits twice the volatility, they have simply produced twice as much of the “good thing” (return) in exchange for exposing their clients to twice as much of the “bad thing” (volatility). Similarly, for a manager who has half the volatility of their peers with half their returns, the same “robbing Peter to pay Paul” dynamic applies: zero value added.

The Merriam-Webster dictionary defines the term lopsided as “lacking in balance, symmetry, or proportion.” On its face, this description is far from flattering (I certainly wouldn’t take kindly to being referred to as lopsided). However, when it comes to investing, lopsidedness can be good or bad.

As attributed to Nobel Prize winning physicist Niels Bohr, “Prediction is very difficult, especially if it’s about the future.” It is futile for investors to bang their heads against a wall trying to predict the future. However, it is a worthwhile endeavour to construct portfolios that can deliver more gains in good times than losses in bad times.

The accompanying chart looks at how different money managers react to market advances and declines, and how that works out for the investor.

  • Both managers A and B do no harm but do no good to investors.
    – Manager A captures 100 per cent of the upside in rising markets but also experiences the same proportion of the downside in declining markets.
    – In a similar vein, manager B captures 70 per cent of the market’s upside in the good times but only experiences the same proportion of the market’s losses when things go awry.
  • Managers C and D are undesirable.
    – Manager C reaps 120 per cent of the market’s gains in favourable times but suffers 150 per cent of the market’s losses in challenging environments.
    – Manager D suffers from a similar problem of “bad” lopsidedness, participating in only 60 per cent of market gains while experiencing 80 per cent of market losses.
  • Lastly, managers E and F are superior managers.
    – Manager E participates in 110 per cent of rising markets while suffering 100 per cent of market declines.
    – Manager F is also beneficially lopsided, reaping 100 per cent of market gains while suffering 90 per cent of its downside.
  • Even long-term investors who are focused exclusively on higher long-term returns and are unconcerned with shorter-term volatility are still better off using leverage to invest in managers E or F rather than allocating to the badly lopsided manager C with the highest returns. In doing so, they could achieve higher returns than manager C with either the same or lower volatility (depending on how much excess returns are desired).
  • Similarly, even investors who are highly focused on shorter-term volatility are better off investing a lesser amount in managers E or F than they would in badly lopsided manager D with the lowest volatility. In doing so, they would achieve lower volatility than manager D with either the same or higher returns (depending on how great their desire for volatility mitigation).
  • Noah Solomon: You can’t always get what you want — the tariff rendition
  • Solomon: Investors can do this the easy way or the hard way

The bottom line is that, regardless of where you lie with respect to your risk/return preferences, you are always better off with positively lopsided managers who are more efficient deployers of capital.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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