Running With The Bulls Can Get You Trampled

By Venk Reddy
Originally published in Q4 2017 letter
 

With another new year upon us, we humbly reflect on the opportunity we have had over the last 8½ years to develop a dialogue with our readers.¹ On and off these pages, we have shared our views on fixed income markets, portfolio risk allocation, due diligence and a variety of other topics. We have described our own approach to the portfolios we manage at Zeo, directly and indirectly, with our well-worn emphasis on caution and vigilance, market-independent risk profiles and longer-term investment horizons. We have had welcome feedback from these observations– a handful of you even agreed with what we had to say or found our thoughts helpful!

And yet, as we end another year of very low volatility in the markets, the conversations we are hearing in the marketplace tell us we and those who agree with us are still in the minority among the broader investment community. But therein lies the opportunity. We realize we won’t change everyone’s mind, but we’re not trying to. We work for those investors who share our view of fixed income; who value our emphasis on strong risk-reward metrics and low volatility; and who don’t mind joining us in the minority who prefer portfolios which can help them achieve their goals independent of market direction and volatility. And there’s no place we’d rather be.

John Maynard Keynes said in his masterful The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Or, to put it in less elegant terms, lemmings as a class may be derided but never does an individual lemming get criticized.)

Warren Buffett²

To be fair, running with bears can also get you trampled. But the observation is the same: It has been our experience that long-term wealth is neither created nor preserved by following the conventional wisdoms of the majority. With so many investors lining up to board the “index fund” train, can there be any doubt that these investors are all on the same side of the market, advancing when the indices go up and declining when the indices go down?

As important, who do they expect will lessen the pain of the decline when it does happen? It is unlikely to be another index investor, as they will be rushing for the exits alongside one another. Rather, they are likely counting on the investor who, to paraphrase another of Mr. Buffett’s maxims on investing, was fearful when they were greedy and will now be greedy when they are fearful. Whether this comes in the form of long-term value investors like Berkshire Hathaway or tactical traders who actively trade index funds to express their short-term views on market direction, these are the pipers being paid by the subscribers to conventional wisdoms.

While this argument is often given as a defense of active managers who invest in equities, these issues are magnified when considered in a fixed income context. After all, while equity is a game of yards, fixed income is a game of inches. While an equity has the potential to gain as significantly as it can lose, bonds are asymmetric to the downside – large potential price declines with gains coming mostly from a relatively modest coupon and limited potential price appreciation. If an investor finds himself on the wrong side of a fixed income market decline, as may happen if interest rates spike in the coming years, it will be quite some time before the interest he is earning would recover the loss he experiences at the outset. In this sense, the argument we present against the conventional wisdoms that have driven investors into index funds is arguably even more valid for bonds.

But for fixed income portfolios, the risks aren’t limited to the majority of investors who invest in indices. First, the markets are awash with capital. If a majority of those investors seeking to mitigate the risks we describe above pursue the same opportunity to do so, they too expose themselves to a herd mentality. Since they are all generally aiming to mitigate the same risks, this is highly likely to happen when paired with our second observation.

Fixed income asset classes, because of the broad expectation that they are safer than equities, have managed to evolve in a way that obscures risks in order to appear in accordance with the conventional wisdoms investors hold dear. This is not always intentional and is as often the result of an over-application of long-held but well-intentioned assumptions as it is the result of intentional malpractice. But, regardless of the cause, what has resulted is a plethora of alternative strategies designed to satisfy the risk mitigating appetite of a subset of fixed income investors, which in turn, exposes them not only to the same groupthink as index investors but also to additional unintended risks created by an adherence to old-fashioned assumptions.

Especially in the context of discussing our capital preservation approach to fixed income, we hear a lot of conventional wisdoms. Most often, we hear bank loan funds cited as a safe haven against rising rates. Just as often, we hear a preference for high income short term investment-grade bond funds. In both cases, investors are swayed by commonly held assumptions whose validity is limited in scope, exposing them to unintended risks and creating opportunities for those who wade into the less correlated world of exceptions to the conventional wisdom rules.

Why not explore less-trafficked opportunities? Why not look for other metrics like meaningful absolute returns coupled with low volatility? Why not better understand the risks being taken in a straight-forward way? Why not find managers who prioritize depth of analysis, appropriate investor fit and long-term consistency? In our view, the conventional wisdoms we hear often fall short by one or more of these measures – they may be majority opinions, but they are misguided at best and potentially dangerous if misused.