In 2019, the bull market thinking of fixed income investors argued for a more disciplined approach to risk and return. The markets today are facing very different circumstances, but are suffering from the same lack of risk management. This is in part due to a broad-based misinterpretation that the Federal Reserve will bail out corporate credit1, and in part due to the explosion of day trading by risk-seeking individuals with nothing better to do in quarantine.2 Furthermore, we still have a global pandemic on our hands, with a virus that appears difficult to understand and that no one seems to be able to agree how to address. And much has been made of the science therein and what we do and don’t know about COVID-19. But with this uncertain backdrop, two things are clear to us: If you listen to the science, you wouldn’t buy the market now...and you wouldn’t sell it either.
Our point here is not to litigate the correctness of one set of policies or another. The reality is that reasonable people can disagree, and contradictory conclusions can often be drawn from the same set of facts. In the financial markets, we can see that the one underlying theme here is a decided lack of risk management experience. After all, if an investor ever set out to avoid all risks, she could never expect to generate anything more than a risk-free rate of return except for by good or bad luck as a result of failing to identify a hidden risk in her portfolio. Meanwhile, if that same investor chose to take a risk because it could not be proven that it would definitely turn out badly, then every risk would seem worth taking. As we have said many times before, just because a risk doesn’t manifest itself doesn’t mean it doesn’t exist. Neither of these approaches would result in a reasonable balance of risk and reward in an investment portfolio.
The hard truth is that investing is inherently uncertain, and the most successful investors over the long-term are those who take calculated risks. In an era where portfolios are evaluated based on short-term performance, identifying such investors becomes a more difficult task than it should be. But, just as with good public policy, a good investment strategy is one that weighs many oft- contradictory factors and aims not to minimize risk or maximize return but to optimize risk/reward. This is not a portfolio that should be expected to always “outperform” broad-market benchmarks, nor is it a portfolio that should be expected to avoid having any risk manifest itself. But by aiming to take those risks that may come with asymmetrically positive returns and to avoid returns that may come with asymmetrically negative risks, one may be able to construct a portfolio that is better positioned to capitalize on uncertainty.
What does this all mean right now? We have long held the view that the biggest asymmetries in the markets, whether up or down, come not from absolute outcomes (e.g. whether a company’s earnings are good or bad) but from outcomes relative to expectations (e.g. whether a company’s earnings met or missed consensus expectations). Good outcomes are less impactful if expectations are high; bad outcomes are less impactful if expectations are low. But good outcomes with low expectations and bad outcomes with high expectations often result in the most dramatic market movements. This observation, in and of itself, will likely not be revelatory to our readers. But we do think it is instructive when we apply this mindset to the current set of potential outcomes that investors are being forced to evaluate.
When thinking through the various outcomes that might significantly deviate from market expectations, we find them to be highly contradictory. On the one hand, we believe it would be a negative jolt to the markets if global efforts failed to identify a vaccine that is successful against COVID-19 and lasts for some reasonable period of time. After all, it seems that there is a general expectation (or maybe, it’s hope?) that an effective vaccine will be found. On the other hand, we believe there is a consensus in the institutional markets that there will be a long-tail recession as a result of the economic devastation wrought by the pandemic. To us, there is asymmetry in the risk that this is not the case. We can enumerate other similar consensus expectations in the current environment which, if proven wrong, might result in large market moves, but the main point here is that, for the first time in a while, it feels to us as if the asymmetries don’t all point in one direction.
As a result, for prudent investors, it doesn’t seem appropriate to avoid risk entirely even as caution is warranted. Taking calculated risk in strategies which are designed to identify attractive risk/reward opportunities allows the investor to strike a balance in a potentially more resilient portfolio. It is important to note that risk is never gone even if it hasn’t happened yet. We believe the scenario least considered in today’s market actions is also the one in which the risk is never gone: that the world ends up living with the risk of COVID-19 and future viruses with similar characteristics for multiple years if not permanently. We aren’t saying this will definitely happen, but we believe it’s the outcome most easily dismissed because it’s the hardest one to manage. To consider such a scenario requires an approach in which risk is neither indiscriminately taken nor entirely avoided but is always present and, to the best of one’s ability, managed. In our opinion, this is true whether one is constructing public policy or investment portfolios.
Making this task even more difficult is that security prices have never felt more divorced from the reality of the world we live in or the markets in which we invest. Every day, we watch markets go up and down in reaction to one headline or another, but conviction in a market direction is understandably elusive despite what the recent run up may have led some to believe. When there is so much uncertainty, we at Zeo take refuge in the relative confidence that comes with being value investors focused on underlying company fundamentals. While an issuer’s business may be impacted by the crisis at hand, that impact can be more reasonably evaluated and quantified than a shift in the psychology of the market. Such a distinction, in our view, is the difference between investing and betting.
By focusing on investing, we can view the current markets through a lens of opportunity. After all, it is our strategy to seek out securities whose prices are divorced from reality. In times like these, we believe the mandate of every investor is to buy what is undervalued rather than to buy everything in an asset class. This moment calls for a prudent evaluation of risk and reward. Security selection, not broad market indexing, speaks to this demand for investment strategies that aim to manage risks rather than avoid them entirely or take them indiscriminately.
To this point, we believe investors have simply not been focused on individual securities. Both on the way down, with indiscriminate selling regardless of duration or credit quality, and in the recent recovery, investor sentiment seems to be focused on trying to avoid or capture market momentum. This behavior is not grounded in the underlying fundamentals of bond issuers but rather implicitly assumes the fundamentals will not be relevant to the performance of those bonds in the short term.
This indeed may be the case, but the trick for any investor is defining what “short term” means, because in our experience, fundamentals will matter at some point. We think the economic impact of COVID-19 will be too hard to ignore. We think the impact of a looming long-tail recession on company earnings will be too hard to ignore. We think impending credit downgrades, bankruptcies and restructurings will be too hard to ignore. At that point, which may be soon and sudden, we expect price movements based on momentum to reverse while price movements based on fundamentals take hold. In the meantime, we don’t dismiss the risk that the markets remain strong due to some expectations (including some which we have mentioned here) that point downwards and may yet be proven wrong. For those fundamentally strong bonds which have rallied recently, this would all be good news as their risk of declines should be lower; for those fundamentally strong bonds which have not rallied recently, this should be better news as they may have more upside as well; and for those fundamentally weak bonds which participated in the recent market gains, this is likely not a positive outlook.
To be invested in indices or managers with high-beta and tactical strategies3 is to make a proactive decision that buying a broad slice of the overall market is a good idea. Right now, this means buying both fundamentally strong and weak issuers by design. In our opinion, and in our portfolios, we believe it is more prudent to target “cheap” bonds, not all bonds. This approach may not always be the fastest way to get a return on one’s money, but we feel more confident in assessing an issuer’s fundamentals than the market’s psychology.
By Venk Reddy
1 We have repeatedly disagreed with this conclusion. The Federal Reserve’s primary objective in their bond and ETF buying programs was to put in place a backstop, and in turn a deterrent, to avoid a disorderly panic similar to the one we experienced in March. That said, with the exception of high yield ETFs (whose inclusion we think was not at all responsible), the purchases are limited to current investment grade credits and those that were recently downgraded. In our view, that focus is likely further limited to those credits at risk of a downgrade which could spark indiscriminate selling and incite another market panic. It is reasonable for one to disagree with the policy as too expansive, but the market doesn’t seem to be doing that. The misrepresentation that the policy is so expansive as to cover all corporate debt, and the subsequent market actions due to this misrepresentation (intentional or not, by investors or the media) are why we find ourselves in this peculiar situation to begin with, with prices and fundamentals moving in seemingly opposite directions, with only uncertainty and volatility catalysts nestled in between.
2 It’s too easy to dismiss this subset of market participants as foolish, and it is unwise to do so. In the wise words of Annie Duke, professional poker player and author of Thinking In Bets: Making Smarter Decisions When You Don’t Have All the Facts, “Life is poker, not chess.” And in many ways, so are the financial markets. It’s all too comfortable to dismiss day traders, especially younger ones that just discovered the markets through a free share of stock from the trading app Robinhood, as inexperienced and irresponsible. But, in many ways, they are just gambling, and many are doing so deliberately. To them, trading the markets isn’t necessarily a way of life or a way to grow a nest egg. Rather, for some new investors, it is entertainment, with the side benefit that they may create some amount of additional wealth if they get lucky. The rest of us, sitting at that same table, trying to count the cards and do the odds in our heads to give us a statistical advantage, must recognize that the most dangerous players in the game are the ones that are unpredictable and don’t “play by the rules.” In that way, we are playing poker, not chess. Playing the game our way won’t tilt the probabilities in our favor by itself. With so much uncertainty being introduced due to this new type of unpredictable gambler, in our view, the smarter play isn’t to try to predict what he will do (i.e. to aim to bet on the right asset classes at the right time) but rather to take a more defensive approach and try to protect the portfolio from him (i.e. to aim to manage risk by focusing on fundamentals and security selection). Reasonable people may disagree, but it remains our view that, given the unpredictable nature of today’s markets, prudence calls for being selective and aiming to position for resilience regardless of what happens.
3 It has traditionally been hard to recognize these managers, but the recent run up of the markets due to the Federal Reserve bond and ETF purchasing programs has revealed a lot. The sensitivity of managers to the broad market ETFs of their respective asset classes since the end of March has been a telling sign of whose recovery has been fundamentally-driven and whose recovery has been beta-assisted. Meanwhile, the tactical manager’s agility is dependent on a view that betting on entire asset classes through ETFs is sufficient. While this may be true in some markets, we don’t believe this is one of them.
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
For more information contact Zeo directly at 415-875-5604 or visit www.zeo.com.
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