An Evolutionary Tale
The Future is Now
Last month I published A Tale of Rules. This tale takes us on the journey that lets us understand how society transformed it’s thinking from a period where nobody invested based on rules to the present, where almost all investing is rules based. How did we get from there to here?
In the beginning there were no rules and people either invested or speculated. They made decisions based on tips, hunches, intuition, insider information or some crude method of technical analysis. Then there was an aha moment. Some smart guys, Dow and Jones, came up with a rule on how to track the US stock market and this became the first widespread index or rule. The Dow Jones Industrial Average, sprung to life. As we all know, when it comes to Wall Street, anything that’s worth doing is worth overdoing, so soon after the Dow Jones Transportation Index came into existence. Soon thereafter, you had your first technical analysis trading theory called The Dow Theory. With this theory, you could compare one index to another index or one rule to another rule and forecast what might happen based on how these indices or rules related to each other.
The Dow Theory persists to this day and as the ultimate tribute to the attraction of rules, rules and indices have grown to such an extent that we currently have more rules and indices than the components that make up the indices which is why rules rule.
What happened after the first rules or indices were created? We stumbled along for quite some time, the growth of rules was moderate and our technical analysis became a bit more refined while fundamental analysis flourished. Our ability to understand and accurately interpret a company’s financial strength grew strong and thus the argument that fundamental analysis was more important than technical analysis took hold. Fundamental analysis ruled for decades since everyone agreed that technical analysis was backward looking while fundamental analysis would take past results and at least allow you to attempt to possibly perhaps peer into the future, see around corners or capture a value invisible to the mere mortal. Please note my disdain of fundamental analysis as a stand-alone methodology.
Let’s fast forward to the early 1970’s. At that time, individual investors inhabit a place where there are very few rules-based investors, technical analysis is considered a backwater and anyone that’s any good at investing studies a company’s financials, gazes out into the abyss and invests based on their discretion. In the meantime, the typical investor can only invest in stocks, bonds or mutual funds through their stockbroker and mutual fund choices are limited to actively managed funds by, once again, those that gaze into the future or discover hidden value. The performance and reputation of these funds is based on the acumen of the mutual fund manager and money flows to those that have the best past performance. Yes folks, money flowed to top past performance even back then.
In the meantime, in tiny little parts of the world, three things were taking root.
- Jack Bogle is starting to build the first company, Vanguard, dedicated to low cost, rule-based, passive investing. The rules are easy to understand, transparent and consistently applied. It’s the beginning of the do-it-yourself approach to managing money. For those that do not know, Mr. Bogle passed away recently and I agree wholeheartedly with the tribute that says, “Nobody has done more for the individual investor than Jack Bogle.”
- The cult of academia is espousing a novel theory that tells us that those smart, fundamentally driven mutual fund managers that base their decisions on discretion can’t actually outperform an index or set of rules. Academics call these legacy mutual fund managers active investors and try to convince the world that passive investing is better. Furthermore, they tell us that if smart, full-time, experienced and active managers can’t beat the market, how can the average investor at home possibly do it? It’s a compelling case because the evidence does not lie.
- Pension Plan consultants are espousing another novel theory called Modern Portfolio Theory and the Capital Asset Pricing Model which basically says, that you should own a bunch of stuff in the right proportions, and that they, the consultants, can tell you what proportions to own and then help you select specialists at managing each of the components within the elixir.
Little did we know in the early 1970’s just how powerful this trilogy would become. It dominates our world today. Passive investing or rules-based investing has defeated active investing. Very few people think they can outperform the stock market and everyone seems to own a bunch of stuff in their portfolios based on their “objectives.”
What else brought us to the point where rules rule? The first and foremost driver was the personal computer. We were able to test theories and crunch massive amounts of data that once were impossible to analyze. This resurrected technical analysis and brought us quantitative methods to analyze markets and interactions that before were impossible to decipher. Furthermore, our government passed laws that put the management of our retirement accounts in our own hands instead of the hands of professionals. We were given the opportunity to create our own destiny/destruction in the form of IRA’s, 401k’s and 403b’s. Naturally, somebody had to serve this growing population of people that had no idea how to manage money and up sprung the “financial planner/investment consultant/wealth manager/VP of something” industry. We came a long way in a very short time.
For our younger readers, as hard as it is to believe, there was a time in this country, where if you worked for a large company or organization, they would manage your retirement money for your benefit. At that time, our lawmakers had this insane notion that professionals along with fiduciaries could do a better job managing money for you than you could for yourself. People would actually retire with something called a Pension, and they would receive a monthly paycheck when they were older in addition to Social Security. It was a crazy time where people had a safety blanket and they were still allowed to save even more and invest it to grow even richer. But those days have passed. We are now empowered to manage money for ourselves and so we must. You must now hire your own professionals and fiduciaries or do it ourselves.
What’s the last piece of the equation that has made us a rules-based society? If you answered the almost relentless 10-year bull market in the US stock market, you would be correct. An examination of the rate of return of SPY shows us that at least for the last 10 years or so it has been a great investment with almost all movement in one direction and that direction is up. This 10-year bull market has permeated into our societal thinking and we’ve seen the rise of the ETF taking over the mutual fund. No one seems to own individual stocks any longer and it’s rare that someone owns an actively managed equity fund any longer. The older established legacy mutual funds have managed to retain assets under management, but actively managed vehicles with smart people at the helm making decisions as to what to buy or sell based on their wisdom is over. People don’t want it anymore and don’t believe it. After all, why should anyone invest with a human when they can buy an algorithm is the thinking.
What’s the next evolutionary step in your portfolio? It’s anyone’s guess but what’s clear to me is the growth of more rules-based investing. However, this growth is going to come from the creation of more sophisticated rules than the simple rules we see with something like the S&P 500. You will no longer have smart folks making decisions about your portfolio, but you will have smart folks designing rules that are engineered to produce outcomes that upon inspection appear more attractive than the rules that govern SPY for example.
What else can we expect? We can expect the financial planning industry will evolve with the times as well. Why? Because the typical financial plan currently revolves around selecting the right asset allocation that provides the most likely way to solve the client objective. When asset allocation matters less and less, they will have to change their way of thinking. Expect your portfolios to look quite different in the future.
So, rules rule, there are an infinite variety of rules to consider and they are evolving rapidly and for the better. In addition to the ones that exist today, I expect to see many more rules that when analyzed can provide equal or higher rates of return than the S&P 500 with less risk as measured by maximum drawdown. I expect these rules to become the new building blocks of portfolios and gone will be the traditional financial planning allocations to “a little bit of this and a little bit of that because after all nobody can predict the future.” To be specific, if your portfolio is let’s say a 60-40 portfolio and the equity portion is diversified by equity asset classes such as small cap value, large cap growth, mid cap blend, emerging market, international and real estate which stems from antiquated beliefs as promoted by adherents to Callan Charts, you are well behind the times. You can do better. You can find rules-based strategies that disproportionately appear near the top performers on Callan Charts.
To summarize our future. There is a successful hedge fund that runs multiple rules-based systems within in. The theory is that if you can put together enough systems under one portfolio that produce positive outcomes and they aren’t correlated to each other, then over time you are creating a money machine. This fund has been and will more than likely be one of the most consistent performers available to institutional investors because the hypothesis within it is so compelling. While the typical investor can’t expect to attain this level of rules-based diversification within their portfolio, they can get pretty darn close. The future of portfolios will no longer be diversification of highly correlated asset classes but diversification of non-correlated rules. You heard it here first.
But there is a change upon us again and let me be a bit controversial because it speaks to the term asset allocation. Asset allocation has been the go-to phrase used by advisors for over two decades. They claim it is the single most important thing that matters in your portfolio. I have always found this comical because it is self-evident—of course it’s the most important thing because everyone has an asset allocation. What they really mean is, “the asset allocation we recommend for you is approximately the right one for you based on our experience, which is based on the past performance or rules of the particular set of assets we populate your portfolio with.” This means that as rules get better asset allocation will get better. The rules, they are a changing.
That said, I believe my rules are better than your rules. Your rules say that you should own a diversified portfolio of stuff based on your “objective/risk tolerance/planning horizon/” and that you should leave it alone and rebalance periodically. You believe this because you are still working under an old model created by advisors and the sort that says “asset classes matter and asset allocation matters.” Your antiquated belief says, here are a bunch of asset classes or rules, these asset classes behave in this manner, they relate to each other in this way and you must build a portfolio under these guidelines. That is yesterday’s approach.
Today’s approach, our approach, says you should construct a portfolio of strategies or rules that give us a better opportunity for success than those of the past. Today, we can allocate to very sophisticated strategies that until recently were available only to institutional investors and you can buy them very economically under an ETF wrapper. The innovations are fast and furious. They are making their presence felt and they are simply just rules.
The 9-year bull market has contributed greatly.