Swedroe: Lessons From 2016, Part Three

So far this week, we have covered six important lessons that the markets taught investors in 2016 about prudent investment strategy.

These lessons, some of which repeat year after year, have taken on active management as a loser’s game, the fact that so much of returns tend to come in very short and unpredictable bursts, the propensity for events to occur that no one ever predicted, the value of forecasts, the difficulty of predicting the direction of stock prices and the dangers of chasing performance. Today we’ll conclude our series with three additional lessons, giving us a final total of nine.

Lesson 7: “Sell in May and Go Away” Is the Financial Equivalent of Astrology

One of the more persistent investment myths is that the winning strategy is to sell stocks in May and wait to buy back into the market until November.

While it’s true that stocks have provided greater returns from November through April than they have from May through October, since 1926, an equity risk premium has still existed in those May-through-October months. From 1927 through 2015, the “Sell in May” strategy returned 8.3% per year, underperforming the S&P 500 by 1.7 percentage points per year. And that’s even before considering any transaction costs, let alone the impact of taxes (with the “Sell in May” strategy, you’d be converting what would otherwise be long-term capital gains into short-term capital gains, which are taxed at the same rate as ordinary income).

How did the “Sell in May and Go Away” strategy work in 2016? The S&P 500 Index’s total return for the period from May through October was 4.1%. Alternatively, during this same period safe, liquid investments would have produced virtually no return. In case you’re wondering, 2011 was the only year in the last eight when the “Sell in May” strategy would have worked.

A basic tenet of finance is that there’s a positive relationship between risk and expected return. To believe that stocks should produce lower returns than Treasury bills from May through October, you have to believe stocks are less risky during those months—a nonsensical argument. Unfortunately, as with many myths, this one seems hard to kill off. And you can bet that, next May, the financial media will be resurrecting it once again.

Lesson 8: Hedge Funds Are Not Investment Vehicles, They Are Compensation Schemes

This lesson has appeared about as regularly as our first lesson, which is that active management is a loser’s game. Hedge funds entered 2016 coming off their seventh-straight year of trailing U.S. stocks (as measured by the S&P 500 Index) by significant margins.

Unfortunately, the streak has continued into an eighth year, as the HFRX Global Hedge Fund Index returned just 2.5% in 2016, and underperformed the S&P 500 Index by 9.5 percentage points. The table below shows the returns for various equity and fixed income indexes.

As you can see, the hedge fund index underperformed the S&P 500 and eight of the 10 major equity asset classes, but managed to outperform all three of the bond indexes. An all-equity portfolio allocated 50% internationally and 50% domestically, and equally weighted in the asset classes within those broad categories, would have returned 11.0%, outperforming the HFRX index by 8.5 percentage points. A 60% equity and 40% bond portfolio with the same weights for the equity allocation would have returned 6.9% using one-year Treasurys, 7.6% using five-year Treasurys and 7.1% using long-term Treasurys.

Thus, each of these three portfolios would have outperformed the hedge fund index. Given that hedge funds tout their freedom to move across asset classes as their big advantage, one would think that it would have shown up. The problem is that the efficiency of the market, as well as the costs of the effort, turns that supposed advantage into a handicap.

The evidence is even worse over the long term. For the 10-year period from 2007 through 2016, the HFRX Global Hedge Fund Index lost 0.6% per year, underperforming every single equity and bond asset class. As you can see in the following table, hedge fund underperformance ranged from 0.4 percentage points when compared to the MSCI EAFE Value Index, to as much as 8.8 ercentage points when compared to U.S small-cap stocks.

Perhaps even more shocking is that, over this period, the only year the hedge fund index outperformed the S&P 500 was in 2008. Even worse, when compared to a balanced portfolio allocated 60% to the S&P 500 Index and 40% to the Barclays Government/Credit Bond Index, it underperformed every single year.

For the 10-year period, an all-equity portfolio allocated 50% internationally and 50% domestically, again equally weighted in the asset classes within those broad categories, would have returned 4.1% per year. A 60% equity and 40% bond portfolio with the same weights for the equity allocation would have returned 3.0% per year using one-year Treasurys, 4.1% per year using five-year Treasurys and 5.1% per year using long-term Treasurys. All three dramatically outperformed the hedge fund index.

The bottom line is that the evidence suggests investors are best served by thinking of hedge funds as compensation schemes, not investment vehicles

Lesson 9: Don’t Let Your Political Views Influence Your Investment Decisions

One of my more important roles as director of research for The BAM Alliance is preventing investors from committing what I refer to as “portfolio suicide”—panicked selling that arises from fear, whatever the source of that fear may be. After the election of President Donald Trump, it seemed like the vast majority of times I was called in to help investors stay disciplined and adhere to their financial plans involved anxiety generated by politics.

We often make investment mistakes because we are unaware that our decisions are being influenced by our beliefs and biases. The first step to eliminating, or at least minimizing, errors is to become aware of how our choices are impacted by our views, and how those views can influence outcomes.

The 2012 study “Political Climate, Optimism, and Investment Decisions” showed that people’s optimism toward both the financial markets and the economy is dynamically influenced by their political affiliation and the existing political climate. Among the authors’ findings were:

• Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power. This leads them to take on more risk, and they overweight riskier stocks. They also trade less frequently. That’s a good thing, because the evidence demonstrates that the more individuals trade, the worse that they tend to do.
• When the opposite party is in power, individuals’ perceived uncertainty levels increase and investors exhibit stronger behavioral biases, leading to poor investment decisions.

Now, imagine the nervous investor who sold equities based on his views about, or expectations for, a Trump presidency. While those who stayed disciplined have benefited from the rally following the election, investors who panicked and sold not only missed the bull market, but now face the incredibly difficult task of figuring out when it will be once again safe to invest.

I know of many investors with Republican/conservative leanings who were underinvested after President Obama was elected. And now it’s investors with Democratic/liberal leanings who have to face their fears. The December Spectrem Affluent Investor and Millionaire Confidence Index surveys provide evidence of how political biases can impact investment decisions.

Prior to the election, respondents who identified as Democrats showed higher confidence levels than respondents who identified as Republicans or Independents. This completely flipped after the election. Democrat investors registered a confidence reading of -10, while Republican and Independent investors showed confidence readings of +9 and +15, respectively.

What’s important to understand is that if you lose confidence in your plan and sell, there’s never a green flag that will tell you when it’s safe to get back in. Thus, the strategy most likely to allow you to achieve your financial goals is to have a plan that anticipates there will be problems, and to not take more risk than you have the ability, willingness and need to assume. Furthermore, don’t pay attention to the news if doing so will cause your political beliefs to influence your investment decisions.

In conclusion, this year will surely provide investors with more lessons, many of which will be remedial courses. And the market will provide you with opportunities to make investment mistakes. You can avoid them by knowing your financial history and having a well-thought-out plan.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.