How to Build a Portfolio That Outperforms for a Century
(Bloomberg) -- There’s a scene in 2011’s “Moneyball” — the Hollywood take on Michael Lewis’s 2003 book — where economics grad Peter Brand describes a new approach to building a baseball team by finding value in players “that no one else can see.”
Baseball had traditionally relied on a network of scouts who would roam the country looking for new talent, often zooming in on the flashiest up-and-comers who reminded them of the great stars of the past. But by using rational statistical analysis, Brand argued, managers could identify and snap up “misfit” players that could then be used to create a cohesive team able to outperform over a season. The whole could be stronger than its individual (misjudged) components.
For Chris Cole, the founder of Artemis Capital Management, there’s a parallel between “Moneyball” and investing for the long-term. For years, he says, traditional fund managers have been trying to identify assets with the most potential to outperform on a risk-adjusted basis, relying on a narrow slice of history to back up their expectations. Managers are chasing the same kind of talent that worked before.
Cole’s solution is to build a portfolio able to survive big regime changes in markets and outperform over 100 years. The simple premise here is that focusing on each component’s individual performance can make a portfolio less resilient to big swings in markets — for instance moving from a deflationary regime where bonds outperform to an inflationary one where commodities surge. Or as he put it in a recent episode of Odd Lots:
“The problem with many of these institutions is they bought into the Sharpe Ratio myth. They look at these investments, be it private equity or these other investments. And they say, ‘Okay, what's the Sharpe Ratio? We want to put together all of these investments that have high Sharpe Ratios.’ Well, the Sharpe Ratio, if you go back and you read the original paper that William Sharpe wrote, you know, capital asset prices -- that was the paper that he wrote when he was 30 years old in 1964 -- it's clear that a Sharpe Ratio is not intended for components of the portfolio. The Sharpe Ratio should only be used for the aggregated portfolio.
“Sports management has gotten really smart about selecting players and advanced statistics that measure how a player helps the team win. These are things like wins over replacement value and plus/minus ratios. But we have no metric for that in the investment industry. So what ends up happening is that these institutions buy into this myth of Sharpe Ratios and they keep layering on investments that have high Sharpe Ratios. But what ends up happening is that -- you can put together a bunch of investments that have high Sharpe Ratios but your portfolio will have lower risk-adjusted returns and higher drawdowns. It's really amazing. And the reason is that the Sharpe Ratio doesn't take into account the skew or the extreme right or left tails of the investment. It doesn't take into account the correlations of that investment versus the rest of your portfolio.”
In Cole’s portfolio, there’s space for things like long-volatility, commodities and momentum-strategies to work together with more traditional financial assets like stocks and bonds. That, he says, helps create a more robust portfolio where at least two of the five components (or “players”) are always outperforming no matter what market regime they’re in — be it inflation, deflation, stagflation, or whatever. Here’s Cole again:
“Investments like long volatility, which don't look that good on paper, you know, they don't have great Sharpe Ratios -- but when you add them to your portfolio they push your portfolio out on the efficient frontier and result in a better risk-adjusted return for your portfolio. Assets like gold, Commodity Trading Advisors and long-volatility in defensive hedging, even though they don't look that great on a Sharpe Ratio basis, you put them into the portfolio and they help your portfolio win. That's what you really care about.
“That’s what the average U.S. pension institution and the average retail investor fails, I think, to fully comprehend. And this is so important because this Sharpe Ratio problem is a social problem. Because if we don't fix this, we are all going to end up paying for it. So I really am passionate about this. I really believe this. I think the math proves this out. The history proves this out. And I think these are some of the most undervalued assets that one could put in the portfolio. Even though they may not look that good on paper, we need to stop evaluating the player and we need to start evaluating the team. That’s the secret to building better portfolios.”
If you go back to the “Moneyball” analogy, the Oakland As did well using statistical analysis that has since become the norm in sports, but they famously failed to win the playoffs. Why? Statistical models require volume, and the playoffs were just three games as opposed to the 162 games of a regular season. The team didn’t have enough competitions to revert to the mean.
What worked for the season didn’t necessarily work for a handful of games. In a similar way, Cole argues, investment strategies that outperformed recently might not be able to pull off the same thing over a hundred years. Or as he put it:
“What's really interesting about, in particular, the last 40 years is that there's a tremendous recency bias that market participants have. The last 40 years are incredibly comparative to overall history. And I believe as I'd make the case in the paper that recency bias is now a systemic risk. 91% of the price appreciation for a classic 60/40 portfolio over the last 93 years has come from just the 22 years between 1984 to 2007.”
The full transcript of the interview with Chris Cole will be available soon on Odd Lots.
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