Yusko: Timing Factors Can Work

Morgan Creek’s Mark Yusko thinks, contrary to popular belief, market timing isn’t necessarily a bad thing.

Mark Yusko is CEO and CIO of Morgan Creek Capital Management. He has a background in the endowment space and is considered an expert in alternative investments. Yusko will be part of a two-sided debate at the Inside Smart Beta conference taking place in New York City, June 6-7. He recently gave ETF.com a preview of his side of the timing-factors discussion and shared his expectations for hedge funds.

ETF.com: Your panel with John Davi of Astoria Portfolio Advisors at Inside Smart Beta poses the question of whether you can time factors. Which side of that argument are you taking, and why?

Yusko: I'm definitely on the that-you-can-time side. Really, it has to do with time horizons. I think both of us would agree that, over longer periods of time, there's a cyclicality to factors, and that you should think about timing. There's probably a little bit of difference of opinion on the short-term opportunities.

My view is that the momentum factor is really just human reaction to securities' prices, and that therefore humans tend to react with certain patterns, and you can time those things.

That said, I believe that if you think about the old strategic investment policy and having targets and ranges, rebalancing toward a target is just that—rebalancing. Moving away from a target is market timing. And everyone has this negative connotation about market timing; I actually don't.

There's nothing wrong with saying, “We think the value factor is undervalued; or, we think the momentum factor is overextended. Therefore, if our long-term target for a factor or a segment or an asset class or a region or a geography is X, we can temporarily take a view that we're going to be overweight or underweight that, and have that be accretive to the portfolio, as opposed to market timing always being a negative.”

ETF.com: How do you approach investing?

Yusko: We start from a fundamental approach. We look at the world and say, fundamentally, where are we? Where are we in the economic cycle? Where are we in the profit cycle? Where are we in the leverage cycle? Based on those fundamentals, we have a perspective on what factors should be in favor.

If the economy is rapidly expanding and profits are good, then certainly growth and momentum should outperform. If we're getting to late stages of the cycle and profit is starting to roll over, you should probably start migrating towards things that are cheaper, and value factors.

We also look at the technical factors. Soros said people think contrarian investing means you're always going against the trend. That's not true; he said the trend is your friend until it changes. And that's the only time being a contrarian makes sense. You have to be able to identify these trend changes.

One of the nice things about, really anything—whether it be a factor or geography, a sector, an asset class—is, during the primary trend, the volatility tends to be very low; the directionality seems to be very stable. And then suddenly you get a heightening of volatility. And that heightening of volatility gives you a signal that the trend is about to change.

It's that increased vibration in variability that gives you a sense that you're about to have a phase shift. It’s similar to when you go from water to ice, or water to steam, just like you go from value to growth, or growth to value, or U.S. to emerging markets, or emerging markets to U.S., etc.

ETF.com: What factors are you looking at now?

Yusko: We’re clearly in the camp that we are late cycle, economically, and therefore it's time to be shifting from the momentum factors to more value-oriented factors. Our first angle of attack is to start making that shift.

Rather than rebalancing back to target, we think it's probably a time that you want to blow through the targets and go to an overweight position in the value-oriented factors or the defensive factors because they're so far out of favor. Nobody wants to own things that are defensive. Nobody wants to own things that are lower volatility or low beta. Everybody's looking at high beta, high volatility, growth and momentum. And we think that game is in its final innings.

ETF.com: You accepted Buffett's challenge regarding hedge fund performance over the next 10 years. He won the last bet. What do you think will be different this time around?

Yusko: I think there are a bunch of things. What people forget about the first bet is that hedge funds were in the lead for 5 ½ of the10 years. 

Then QE started and we had a period that, even through 2016 into the first part of 2017, it wasn't clear Buffett was going to win the bet; hedge funds were doing all right. But 2017 was something that I don't think is ever going to be repeated: 2017 was the lowest-volatility year in the S&P 500, ever. It had the lowest standard deviation in history. It had the highest Sharpe ratio in history. The average Sharpe ratio over the last 150 years is 0.52. The Sharpe ratio last year was 4.39. The previous high in 100-plus years was 2.6.

Why won't that happen again? Because I think the starting valuation for the S&P is telling us that the likelihood of high returns in the S&P from here on is pretty low. Hedge funds are a T-bills-plus return. We went through a period of time from 2009 to 2018 where interest rates were basically held at zero artificially. I just don't think that's ever going to happen again.

If you think about the components of return for stocks, there are only four. There's dividend yield; there's inflation; there's real earnings growth, which is always 1% less than GDP growth because it costs money to make money; and then there's multiples expansion or contraction. We know that inflation today is around 2%. Over the next decade, let’s say it will be 2-3%. We know that dividends today are a little bit less than 2%, but let's round it up to 2%. That's 4%.

We're going to get 1% from real GDP growth. So your upside is 5%. I think multiples will contract back to their long-term average. So you're going to end up with sub-5% returns. If interest rates give us a 3-4% return, and we get the alpha from hedge funds, I think it's a pretty easy bet.

Warren's saying he doesn’t want to take the bet because of his age. But I think it's disingenuous to say, “I'm not going to take the bet, but I'm 100% convinced I'm right, and that the S&P is going to beat hedge funds.” If you're not willing to take the bet, then you can't make that statement.

For me, it has nothing to do with the bet actually; it has everything to do with raising awareness, particularly for the average baby boomer investor. They don’t have time to lose half their money, because they don't have enough time to make it back.

Whether we’re going to lose half our money for sure, I don't know. But I do know that in 2000, when valuations got to crazy levels, we lost half our level. In 2007, we got to crazy valuations, and we lost half our money. And here we are, with similar valuations.