Separate facts from assumptions
There are many misconceptions in the investment world. Some are expressed overtly by market commentators, while others are reinforced more implicitly, having been deeply ingrained in economic- and marketing-thinking for many years. Some follow logical reasoning, while others rest on more dubious assumptions.
Recognizing these misconceptions can prove useful by helping you tune out noisy headlines and engage in better discussions with your investment advisors.
Here are five examples of such myths and supporting research that debunks them:
Investors spend a lot of time analyzing the next policy move of the U.S. Federal Reserve (the Fed). They reasonably assume that these moves affect market interest rates, which in turn affect bond returns. But are these relationships true?
A closer look at historical data suggests otherwise. More specifically, it demonstrates a few main points. First, Fed policy is not the main driver of market interest rates. Second, the relationship between Fed policy actions and bond market returns is weak. Third, the reason these relationships don’t hold is that the bond market does a good job of anticipating and pricing for future interest rates.
The bond market is highly competitive and efficient. Most investors should stay the course with strategic bond allocations aligned with their long-term goals, regardless of cyclical changes in Fed policy and market interest rates.
The Enigma of Fed Policy and Bond Market Returns
Investors also spend an enormous amount of time forecasting gross domestic product (GDP) growth – many with the premise that it drives stock market returns. They logically reason that higher GDP growth should translate to higher company earnings, which should result in higher equity returns.
In reality, this relationship has not panned out. In fact, statistical analysis of historical data demonstrates no meaningful relationship between equity returns and long-term or concurrent GDP growth. Alternatively, it shows that stock market prices already contain information about future GDP growth and price accordingly.
So what does drive stock market returns? Research suggests a few main market risk factors explain the majority of equity returns and that the remainder is driven by idiosyncratic risk (e.g. company, country or industry-specific risk). It also shows that while returns compensate investors for market risk factors, they do not compensate for idiosyncratic risk. The good news, however, is that investors can reduce idiosyncratic risk by diversifying.
Stock markets are forward-looking and already compensate investors for expected future growth. Returns, instead, are driven by market risk factors and idiosyncratic risk, and a diversified global portfolio is usually the best way to position for these risks.
The Enigma of Economic Growth and Stock Market Returns
Traditional performance evaluation typically compares an investment’s return to that of a benchmark or peer group. This is useful information, because it measures the success (or failure) of an investment manager to deliver performance above and beyond what is broadly offered by the market or by other investment managers. But does it accurately measure a manager’s skill, which is ultimately what most investors think they pay for?
Not quite. Research focused on U.S. equity mutual funds shows four main risk exposures – rather than manager skill – comprise the majority of actively-managed fund returns. What’s more, manager skill, on average, has actually detracted from performance on a net-of-fee basis.
Traditional performance measures do not tell the entire story. Deeper analysis by experts with the right tools to separate manager skill from other variables is needed to truly understand how the investments in your portfolio achieve returns.
Detecting True Alpha in Highly Competitive Markets
Hedge funds are often perceived by investors and represented by the media as expensive and risky. This stigma has resulted from highly publicized hedge fund closings, underperformance relative to equities in recent years and greater industry-wide fee scrutiny.
But this stigma obscures two important points about the investment category. First and foremost, hedge funds actually tend to have lower volatility than stocks. Second, not all hedge funds are created equal. While on average hedge funds might not add much value to a portfolio, the right hedge funds can materially enhance a portfolio’s risk/reward profile by contributing uncorrelated (i.e. diversifying) sources of return. The key is selectivity, as the worst hedge funds merely capture commonly available returns at a high cost.
On average, hedge funds are less volatile than stocks and can provide meaningful diversification benefits. Certain investors should consider adding them to their portfolio after seeking advice from experts with appropriate methods to identify the right ones.
Diversify with Select Hedge Fund Strategies
Investors commonly view Treasury bills as risk-free. They perceive the asset class as having no default risk and thus little-to-no volatility.
In practice, however, default is not the only risk investors need to protect against. Inflation, in particular, poses a meaningful threat to any investor who needs to preserve purchasing power to pay for multiple years of liabilities or goals.
While no investment is 100% risk-free in the real world, research shows that Treasury Inflation-Protected Securities (TIPS) may offer a good alternative for investors needing to fund multiple years of goals (e.g. lifestyle spending, discretionary purchases, charitable giving, etc.). This is even true for taxable investors concerned about after-tax returns.
While safe from default, Treasury bills expose multi-year investors to inflation risk. Investors who need to fund long-term goals should consider allocating part of their portfolio to TIPS, which may offer a better risk-free proxy.
“Risk-Free” Goal Funding