In 2010 I was the primary relationship manager for a client of my former firm. This client happened to be a large financial services membership organization with a healthy balance sheet, including a large long-term endowment that we were hired to help manage. I worked directly with the finance committee members to develop investment policy, make allocation recommendations and make specific recommendations for portfolio managers to fill those allocations.
This was sort of like being a doctor and having a group of other doctors as your patients. Not necessarily the easiest professional relationship. Members of the finance committee represented some of the largest RIA and wirehouse wealth management firms in the country. These folks were heavy hitters with 20+ years of experience in the business. Most served primarily family offices and endowments and had relationship minimums over $10 Million. I’m sure that to them I was a peon – a salaried CFP advisor at a mid-sized local wealth management firm.
We had all of the typical committee conversations you would expect to have. How do we develop an IPS? Strategic or tactical allocation? What about alternatives? Active or passive? The gamut. But my favorite memory (if you can call it that) is when we talked about how to implement a fixed income strategy.
You see, five years ago we were having the same conversation about bonds that we’re having today. Interest rates just have to go up. And the holders of intermediate term and long term bonds are going to take it on the chin. The committee was determined to be proactive to “get ahead” of rising rates. They debated (I mostly sat back and listened) short term bonds vs. floating rate debt vs. go-anywhere “unconstrained” bond managers. The simplest way to reduce interest rate risk, of course, is to buy shorter term bonds.
From what I recall, the endowment portfolio ended up owning a mix of floating rate, short term and unconstrained managers, with a sleeve of “core” bonds in something like PIMCO Total Return or Vanguard Total Bond.
And with all of the brainpower at the table, with the cumulative decades of investment experience and expertise, how did this decision work out? Let’s look at an overly-simplified example. If the committee had simply chosen to hedge interest rate exposure by buying all short-term bonds in a cheap index fund rather than buying the broad bond market index, was that a good decision?
Since 12/31/2010 the Vanguard Short-Term Bond Index Fund (Admiral, VBIRX) has returned 1.78% per year through 3/31/15, for a cumulative return of 7.77%. In comparison, the Vanguard Total Bond Market Index Fund (Admiral, VBTLX) has annualized returns of 4.00%, for a cumulative return of 18.14%. On the endowment’s $2 million allocation to fixed income, that gap would have cost just over $200,000 in the last four years and change.
That’s a pretty expensive mistake for something that nearly everyone at the table agreed was a wise investment decision. Here’s the thing: they didn’t know what was coming next. And this really isn’t about the insight (or lack thereof) of a particular group of financial professionals. It’s about you and me too. Because we don’t know. Will rates go up? Probably, eventually. Will you be able to predict the timing and magnitude of such a move? No. What’s more, this isn’t just about rates. All the things that you and I and every other investor seem to think are so obvious rarely pan out that way. A few years ago it was obvious that oil would be back over $100/bbl and stay there. Now some people think it’s “obvious” that oil will go to $20/bbl and others think it’s “obvious” that it’ll be back over $60/bbl by year-end. But they don’t know! Maybe you think it’s “obvious” that US stocks are expensive and will underperform international stocks over the next year (be honest – did you also think that was obvious going into 2014?).
The markets are generally driven by two things. 1) Stuff that happens in the world. 2) How people will react to that stuff. Even if you (hilariously) think you can predict #1 (please see Morgan Housel on that topic), you have no chance of predicting #2. You only have to look at the market’s reaction to the latest Fed minutes release or employment data or earnings reports to know that even if you had the information in advance you aren’t going to get the reaction right consistently.
So just admit what you can’t know and move on. You’ll be a much better investor when you recognize your limitations.
Bason Asset Management 