Building An Anti-Fragile Investment Portfolio
- 1. Building an Antifragile Investment Portfolio Greg Johnsen, CFA Eastgate Advisors, llc
- 2. Life Is Full of Randomness and Uncertainty Some examples: • Evolutionary changes in biological organisms. • Genetics. • Lottery winners. • “Expert” forecasts. • Global market returns. Can we actually benefit from uncertainty, randomness, disorder or volatility in our investing?
- 3. YES! By Building Antifragile* Investment Portfolios *Taleb, Nassim Nicholas. “Antifragile. Things That Gain From Disorder”. Random House, 2012
- 4. Fragility • Something fragile breaks when stressed or something unexpected happens. • But, something that is antifragile benefits from stress, randomness, disorder or uncertainty.
- 5. A fragile investor is one who owes $100,000 and loses a job, an antifragile investor is one who has $100,000 in savings. Fragile Versus Antifragile
- 6. Antifragility • Antifragility limits the adverse impact on us when bad things happen. • Antifragility does not mean avoiding bad things. • Antifragility allows us to survive and prosper with the uncertainty and randomness of life. • Antifragility does not require advanced degrees. • Antifragility does not require predicting the future. • Antifragility does require accepting controlled stresses. • Antifragility is not the same as certainty.
- 7. Antifragile Investing • Investors who require a return which exceeds the return of a risk free asset must assume risk (stress). • An antifragile investment portfolio benefits from volatility, randomness and uncertainty and has greater upside potential than downside risk. • Antifragile portfolios possess optionality.
- 8. What is Optionality? • Optionality allows investors to take advantage of opportunities or avoid assuming more stress than desired. • Optionality is a valuable trait of an antifragile portfolio.
- 9. Some Investing Truths • Market returns are mostly random and uncertain. • Investors do not have control over global markets. • Skilled, active managers exist but fewer of them exist than the investment industry would have us believe exist. • Even skilled active managers have cyclical periods of underperformance. • Most active manager excess returns are statistically random outcomes: It takes from 11 to 44 years of return history to determine, with 95% certainty, whether an active manager has skill or is just lucky. • Investors do not have control over active manager returns.
- 10. % of Active US Equity Managers Outperforming Style Benchmarks Source: Morningstar Direct. © 2014 Morningstar. All Rights Reserved.
- 11. More Truths…. • Investment fees and expenses are one of the things an investor can control. • Investment fees and expenses matter. • Investors tend to feel losses more acutely than gains, so managing down-side risk is important. • Investors also control the risks they choose to assume.
- 12. Conclusions • Investors should focus on controlling what they can actually control. • Investors should build antifragile investment portfolios that benefit from randomness and uncertainty. • Investors should measure success over years and not quarter-by-quarter.
- 13. Some Basic Theory William Sharpe’s market portfolio concept (1964) • Best expected return for the market risk assumed. • He called this the “efficient” market portfolio. Eugene Fama’s Efficient Market Theory (1970) • Market prices reflect all known information relating to the price of an asset. • Only new information has an impact on prices. • Each asset should have the same price in all global markets if markets are efficient. • Implies that active management should not add value.
- 14. Sharpe’s Global Market Portfolio - Market Risk + --ExpectedReturn++ Global Market Portfolio of all investible risk assets Levered GMP: GMP + borrowing De-levered GMP: GMP + Risk Free Asset Risk Free Asset
- 15. What Does The Actual Global Market Portfolio Look Like? – $150 trillion in global markets* • 67% was debt/bonds ($100 trillion) – US bond market was about 24% of total global debt • 33% was equities ($50 trillion) – US stock market is about 50% of total global equities – 67%/33% allocation implies an expected return of about 4% annually to the global markets portfolio. *2012 Bank for International Settlements (BIS) quarterly global review of bank holdings report.
- 16. Investment Risk Considerations • Some investment risk has expected returns. • Some risks have no expected returns. • Investors need to understand their risk tolerances. • Investors should avoid uncompensated risks. • Volatility by itself is not compensable.
- 17. Examples of Compensated Risk • Market risks – Risk relative to the global market portfolio – Size (small stocks have outperformed large) – Low price-to-book stocks (unloved stocks) – Term (longer maturity bonds have outperformed) – Credit quality (lower quality has outperformed) • Leverage • Liquidity
- 18. Examples of Uncompensated Risk • Idiosyncratic risk- lack of adequate diversification. • Fees- A form of wealth transfer. Higher fees do not necessarily result in better returns, just wealthier investment managers. • Active Risk- Few active managers have demonstrated statistically significant, persistent skill. Fama’s efficient markets theory implies that positive excess returns should not exist if markets are efficient. • Principal-Agent risk- what is good for the agent is not always good for the principal (investor).
- 19. Building Antifragile Portfolios • Consider Sharpe’s global market portfolio. – Diversified across markets and asset classes. • Combine the global market portfolio with the risk free asset to de-lever the market portfolio or to manage down-side risk. • Or, lever up by borrowing or using small cap stocks, emerging markets, high yield bonds, private markets in higher % than they are found in the global market portfolio (a form of leverage).
- 20. Some Considerations • A de-levered global market portfolio has lower risk and a lower expected return than the GMP. • A levered global market portfolio has higher risk and a higher expected return than the GMP. • Investor down-side risk tolerances and return requirements are important.
- 21. Building Antifragile Portfolios • Start with a mutual fund or ETF with global, multi-asset class market exposures. • Combine it with a US treasury bill to control down-side risk or to manage liquidity. • Add specialist managers/funds to add incremental value or lever up the GMP if needed (examples include emerging markets debt, small cap stocks, commodities, REITs).
- 22. The Antifragile Portfolio • Global markets portfolio (95% ticker AOR) – Global equities (60%) • US equities (large, mid and small) • Non-US equities (large and mid) • Emerging markets equities (large and mid) – Bonds (40%) • USD denominated bonds (US and non-US issuers) • US treasuries (all maturities > 1 year) • US credits (investment grade, non-investment grade) • US Treasury Bill (5% UST) • Cost: = .24% annually (plus advisor’s fees)
- 23. Antifragile Portfolio Benefits • You have a globally diversified GMP proxy which benefits from the unpredictability and randomness of global asset returns. • You have built an investment portfolio that can experience small but not catastrophic losses. • You control the level of down-side risk you assume by combining the GMP with a risk free asset. • You can control investment expenses. • You have preserved the majority of your up-side return potential and possess optionality. • Your portfolio is theoretically supported. • You have reduced your stress and simplified your life.
- 24. Thank you for your time. Feel Free to Contact Us Greg Johnsen, CFA Eastgate Advisors, llc gjohnsen@eastgateadv.com
Editor's Notes
- #3: Do global markets have a major impact on the returns we earn in our investment portfolios?
- #8: Optionality is a valuable characteristic. It allows you to take advantage of investment opportunities or provide low cost liquidity.
- #10: T-stat of 1.65 = IR * sqrt of N. The greater the volatility of active returns, the longer it takes, with 95% certainty, to determine skill or luck.
- #12: Fees eat up a large portion of investor gross returns. Active mutual funds charge about 1% and an advisor will also charge about 1% for their services so if an investor has a 50% equity and 50% bond portfolio with an expected return of about 4%-5%, fees can eat up 40% or more of the gross return. Fees and expenses matter.
- #16: Stocks: 2% dividend + 2% inflation + 2% real EPS growth = 6% *.5 = 3% Bonds: 2% inflation +0% real yield = 2% *.4 = .08%
- #22: AOR has a 60% allocation to global equities and a 40% allocation to global bonds and is rebalanced annually.