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Multi-Source ESG Arguments

Monday, March 4th, 2019

This article is broad scope ESG, whether by integration with other processes or as a stand-alone process.  This article is not in my words, but is a collage of expressions by numerous important sources. Each expression has a link to the source.

This is not about narrow focus, thematic funds such as funds following religious issues, or specific social or environmental issues, for example.  It is about asset management utilizing ESG (environmental, social and governance) evaluation in the broadest sense for both inclusionary and exclusionary purposes.

Third party comments are organized under:

  • Strong Opponents
  • Professional Organizations
  • Credit Rating Agencies
  • Accounting Firms
  • Academic Research
  • Government and Agency Regulations
  • Pension Plans, Pension Associations and Publications
  • Polling Results
  • Consulting Companies
  • Popular Business Publications
  • ESG Index Providers
  • Asset Managers


Milton Friedman, 1976 Nobel Price in Economics

“[in 1970 said] there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud … What does it mean to say that the corporate executive has a ‘social responsibility’ in his capacity as businessman? If this statement is not pure rhetoric, it must mean that he is to act in some way that is not in the interest of his employers …”

Kevin OLeary (“Mr Wonderful”) is Shark Tank host, founder of O’Shares ETFs and now frequent commentator, and seemingly a Friedman disciple:

“[in 2019 said] The truth is the performance has been abysmal …I think it’s thematic, it’s a fad, it’s sitting around the fireplace singing ‘kumbaya …It makes no sense to me. If you’re an institutional investor, you have to make money for your shareholders, they can take their profits and redistribute their wealth any way they want.”


CFA Institute

May 2017, 47,208 CFA Institute surveyed 47,208 portfolio managers and research analysts members online and received 1,588 valid responses … 73% of survey respondents take ESG issues into account in their investment analysis and decisions, with governance being the most common.

Harvard Law School

… Public companies are being bombarded with messages, requests and demands around “ESG”—environmental, social and governance—matters. …



At Moody’s, we seek to incorporate social considerations, where meaningful, into our credit analysis.

S&P Global Ratings

Environmental, Social and Governance risks and opportunities have the potential to affect creditworthiness. At S&P Global ratings our analysts work to ensure that we provide essential insights into ESG factors as the relate to the financial markets … we have incorporated relevant environmental, social and governance (ESG) factors, where material in our view, into the qualitative considerations and forecasts for the entities we rate …..



Pre-Financial Risks: Environmental, social and governance (ESG) risks increasingly demand the attention of chief financial officer (CFOs). Companies that aren’t addressing these issues may be caught flat-footed as these pre-financial risk become central to business strategy. …

Ernst & Young

It is clear from the latest EY research that there is a general, global trend toward increased interest in nonfinancial information on the part of investment professionals. … “One of the key benefits provided by ESG analysis for investors is risk avoidance and measurement.”


We see ESG issues as being fundamental to a company’s long-term performance, requiring serious attention in the boardroom. How a company manages environmental and social issues—and connects these activities with strategy—are important signals to investors of how well the company is run and its long-term financial sustainability…. Given the significant opportunities and risks associated with ESG, companies that excel at identifying and incorporating these issues into their strategy enjoy a competitive advantage in the marketplace and among institutional investors. It is increasingly clear that ESG and ROI are connected…

Price Waterhouse Coopers

There’s good reason for investors to put this emphasis on ESG questions. Companies with risk management practices that take into consideration broader industry, regulatory and societal risks are more likely to drive long-term sustainable performance—and shareholder value.


Harvard Business School (ESG for stocks)

Myth Number 1: Environmental, social, and governance (ESG) programs reduce returns on capital and long-run shareholder value. Reality: Companies committed to ESG are finding competitive advantages in product, labor, and capital markets, and portfolios that have integrated “material” ESG metrics have provided average returns to their investors that are superior to those of conventional portfolios, while exhibiting lower risk. …

Myth Number 5: ESG adds value almost entirely by limiting risks. Reality: Along with lower risk and a lower cost of capital, companies with high ESG scores have also experienced increases in operating efficiency and expansions into new markets …

… Myth Number 6: Consideration of ESG factors might create a conflict with fiduciary duty for some investors. Reality: Many ESG factors have been shown to have positive correlations with corporate financial performance and value, prompting ERISA in 2015 to reverse its earlier instructions to pension funds about the legitimacy of taking account of “non-financial” considerations when investing in companies.

Wharton Business School (ESG for bonds)

Companies are increasingly scrutinized on how they manage environmental, social and governance (ESG) risks. … ESG risks do affect a company’s bottom line…

Is there an alpha? How much do [stock investors have] to give up in terms of returns or can we reduce the volatility of returns? …But if you think about who takes a long-term perspective, looking 10 to 20 years out, it’s been the creditors. There has been a surge of interest looking at bonds and loans, and trying to see if better management of environment, social and governance risk factors affects loan spreads, credit spreads, or credit default swap spreads.. … There is data that shows that credit default swap spreads, credit spreads and loan spreads actually do correlate with the ESG risks….. The amount you pay goes up if you’re not very good on ESG. Credit default swap spreads are financial derivatives whose prices are correlated with the likelihood that a bond will default


Principles for Responsible Investment

… 38 of the top 50 economies have or are developing some sort of government-led ESG disclosure guidelines for corporations ..

United States Dept. of Labor / ERISA (May 2018) – Harvard Law School summary

U.S. Department of Labor issued a bulletin on its prior interpretations related to considerations of ESG factors by ERISA plan fiduciaries. Since then there has been some speculation that perhaps the positions outlined in the Bulletin would act as a speed bump to the increasing focus by investors on ESG matters at public companies.

ERISA requires plan fiduciaries to act solely in the interest of plan participants and beneficiaries for the exclusive purpose of providing benefits to such persons and to discharge their fiduciary duties with the care, skill, prudence and diligence a prudent person would use under similar circumstances.

… Managers of mutual funds and governmental pension funds are not bound by the Bulletin as these funds are not subject to ERISA and therefore not subject to DOL oversight.

The Bulletin makes clear that plan fiduciaries in managing and investing plan assets cannot assume greater investment risks, or sacrifice investment returns, to fulfill social policy goals.

… But social policy issues, which might otherwise be considered “collateral issues,” could be treated by plan fiduciaries like any other economic consideration when those issues present material business risk or opportunities that officers and directors need to manage as part of their companies’ business plans.

… plan fiduciaries cannot focus on ESG factors solely to benefit the greater societal good, or assume that ESG factors that promote positive market trends are by their nature economically relevant. However, ESG factors or tools, metrics or analyses can be evaluated if fiduciaries believe they would impact an investment’s risk or return.

European Commission (Non-Financial Reporting Directive)

EU law requires large companies to disclose certain information on the way they operate and manage social and environmental challenges. … Companies are required to include non-financial statements in their annual reports from 2018 onwards. … This covers approximately 6,000 large companies and groups across the EU

China Securities Regulatory Commission (Harvard Law School summary)

Pension funds and investment managers in China are now encouraged by the government to look closely at ESG risks and opportunities in their investment process. … these themes are also part of the newly revised Code of Corporate Governance for Listed Companies (2018) from the China Securities Regulatory Commission (CSRC);


Japan’s $1.37 Trillion Government Pension Investment Fund CIO Hiromichi Mizuno:

“Asset managers have to adjust their conventional business model. Investors will be more focused on the long-term investment theme, as AI will take over the short-term trading…In other words, investors will shift their focus to the long-term sustainability of their portfolio, and more focus on their investment themes like ESG …”

… The world’s largest pension fund takes a strong stance. Japan’s Government Pension Investment Fund with US$1.4 tn of assets under management now requires external asset managers to incorporate ESG. GPIF’s size and focus on ESG integration is having a material impact on investor stewardship and engagement with ESG, including for passive asset managers …

Investment and Pensions Europe Magazine

Nobel prize-winning economist Milton Friedman argued that “there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud”. His views influenced generations of academics and corporate executives.

Friedman stated in his 1970 article for the New York Times: “What does it mean to say that the corporate executive has a ‘social responsibility’ in his capacity as businessman? If this statement is not pure rhetoric, it must mean that he is to act in some way that is not in the interest of his employers.”

Institute for Pension Fund Integrity

In our experience, long-term value creation is not possible for companies entangled with ESG controversies.


Harvard Institute of Politics

… survey, done by Harvard University in 2016, showed that a majority of millennials reject capitalism. According to the data, 51% of young adults aged 18 to 29 said they didn’t support capitalism …

Pensions & Investments (on Edleman survey)

(surveyed 500 CIOs and buy-side analysts managing $4.5 Trillion assets) … Most institutional investors demand public companies address environmental, social and governance issues to be regarded as trustworthy … It’s plain to see that ESG is a major criteria for investors … this is a meaningful shit within the investment community in terms of critical mass being reached …

State Street Global Advisors

According to a survey of 475 institutional investors … more than half of institutions that have adopted environmental, social and governance (ESG) investing cite a lack of clarity over ESG terminology.

Bank of America Merrill Lynch

… we analyzed (2005 to 2017), S&P 500 stocks with high Environmental scores based on the three datasets we analyzed would have outperformed their low ranked counterparts by as much as 3ppt per year. An investor who only bought stocks with above-average Thomson Reuters’ Environmental and Social scores five years ahead of a company’s bankruptcy would have avoided 90+% of the bankruptcies that occurred in the S&P 500 since 2005. And ESG is a better signal of earnings risk than any other metric we have found. ..

Morgan Stanley

June 2018 Morningstar polled 118 public and corporate pensions, endowments, foundations, sovereign wealth entities, insurance companies and other large asset owners worldwide

Compared to the investment universe as a whole, more than one quarter of the world’s professionally managed assets— roughly $22.9 trillion—now have some sort of sustainable investing mandate, with about $8.7 trillion of that in the United States, $12 trillion in Europe and the rest shared by other regions.

consumer trends point toward greater returns for sustainable companies. Nearly nine in 10 (87%) U.S. consumers say they will purchase a product because of a company’s stance on an issue they care about, and 78% say they want companies to address important social issues…. Among millennials, this is even more pronounced. Our 2017 survey of individual investors found that millennials are more than twice as likely as other generations to purchase products from companies they view as sustainable.

… fully 78% of respondents listed risk management as an important factor driving their adoption of sustainable investing.

a majority (57%) continued to believe that investing sustainably requires a financial tradeoff.8 While this perception may have grown out of early views of ESG as a negative screen that narrows the investment universe, it appears that large institutional asset owners may be replacing this view with a more sophisticated recognition that ESG factors provide unique insights into long-term risks and opportunities that might not be captured by traditional financial factors. The belief in a trade-off appears to be fading

ESG Integration ESG integration—proactively considering ESG criteria alongside financial analysis—emerged as the most common approach …More than half are required to do so by their Investment Policy Statement

Restriction Screening Restriction screening, employed by 85% of respondents, intentionally avoids investments generating revenue from objectionable activities, sectors or geographies

Thematic Investing Thematic investment strategies, used by 81% of respondents…


Callan Associates (pension consultants)

3% of US institutional investors incorporated ESG factors in 2018 vs 22% in 2013

McKinsey & Company

Strengthening risk management. Institutional investors increasingly observe that risks related to ESG issues can have a measurable effect on a company’s market value, as well as its reputation. Companies have seen their revenues and profits decline, for instance, after worker safety incidents, waste or pollution spills, weather-related supply-chain disruptions, and other ESG-related incidents have come to light. ESG issues have harmed some brands, which can account for much of a company’s market value. Investors have also raised questions about whether companies are positioned to succeed in the face of risks stemming from long-term trends such as climate change and water scarcity.

Bain & Company

… the investor community will fully integrate environmental, social and governance (ESG) considerations into its investing approach.

There is no question that sustainability is moving up on the corporate agenda. When Bain & Company surveyed 297 global companies, 81% said sustainability is more important to their business today than it was five years ago, and 85% believe that it will be even more important in five years. The evidence is everywhere. Sustainability is now incorporated into two-thirds of companies’ core missions …

Boston Consulting Group

…For decades, most companies have oriented their strategies toward maximizing total shareholder return (TSR). This focus, the thinking has been, creates high-performing companies that produce the goods and services society needs and that power economic growth around the world. According to this view, explicit efforts to address societal challenges, including those created by corporate activity, are best left to government and NGOs.

Now, however, corporate leaders are rethinking the role of business in society. Several trends are behind the shift. First, stakeholders, including employees, customers, and governments, are pressuring companies to play a more prominent role in addressing critical challenges such as economic inclusion and climate change. …


Our analysis indicates that, in general, increasing exposure to ESG rarely underperforms the market, and often outperforms the market,…

… to what extent are ESG scores different from the factors found in commercial fundamental factor risk models, such as value, size, industries and countries? … To the extent that ESG scores overlap with traditional factors, then ESG can be interpreted as beta (“smart beta” to the marketers); to the extent these scores do not overlap with traditional factors, then ESG can be interpreted as residual, idiosyncratic or company specific (“alpha” to the quants).

Addition of ESG may not always boost performance, but it also appears unlikely to be a significant drag on performance. And there have been periods of time across multiple regions in which ESG has improved performance.

Finally, we note that there is no standard, accepted methodology for combining separate E, S, and G scores into a composite ESG score. It is possible, indeed, likely, that ESG scores from different vendors will exhibit different performance characteristics.


The Economist

Two perennial questions have accompanied the deluge of money. The first is whether the approach comes with special costs: ie, is there a virtue discount? Second is the question of what should be measured. Neither is easy to answer

…One attempt to answer the first looked at the converse: were returns higher for shares that would not qualify for inclusion in these efforts: in other words, is there a vice premium? … A paper published in 2009 called “The Price of Sin”, by Harrison Hong and Marcin Kacperczyk, two academic economists, concluded that there were indeed unusual returns in firms that sold tobacco, alcohol and gambling. …

However, a second paper published this year (“Sin Stocks Revisited”, by David Blitz of Robeco Asset Management and Frank Fabozzi of EDHEC Business School) contests these results. It argues that added risk factors such as low reinvestment rates mean that there is no evidence that sin stocks provide a premium for reputation risk. Robert Whitelaw, a professor at New York University’s Stern School of Business, says that the conflicting analyses reflect the broader results of more complex efforts aimed at tracking results from (“virtuous”) companies that would qualify for these funds. Results are mixed.


…. Of the world’s largest 250 companies, 92 percent reported in some way on their social and environmental impact in 2015

Alternative Bottom Lines …Numerous terms are used for investments that consider social and environmental effects. Many are used interchangeably [but they are not the same].

  • exclusionary screening, divestment, negative screening
  • ESG (environmental, social, governance), positive screening, active ownership
  • impact investing, double-bottom line investing, thematic strategies
  • values-based investing, fait-based, responsible, ethical or mission related

…Warren Buffett has pledged to give his fortune away but has said social-impact agendas in business force executives to pursue a confusing array of goals. Free-market guru Milton Friedman decried them in a 1970 essay that’s still debated today. … Advocates of sustainable agendas dispute the premise that there must be a cost. They cite studies in which companies with such goals financially outperformed companies without them, though researchers face a challenge proving it was the strategy that created better results… In any case, better information is needed to determine how companies perform on non-financial goals.


…ESG factors cover a wide spectrum of issues that traditionally are not part of financial analysis, yet may have financial relevance. … Institutional investors were initially reluctant to embrace the concept, arguing that their fiduciary duty was limited to the maximization of shareholder values irrespective of environmental or social impacts, or broader governance issues such as corruption. … But as evidence has grown that ESG issues have financial implications, the tide has shifted. … The idea that investors who integrate corporate environmental, social and governance risks can improve returns is now rapidly spreading across capital markets on all continents. …Cynics may argue that responsible investing is just a fad. But a closer look at the forces that have driven the movement over the past 15 years suggests otherwise. … For investors, ESG data is increasingly important to identify those companies that are well positioned for the future and to avoid those which are likely to underperform or fail. …


…Today there’s a growing body of evidence showing that companies that put social responsibility first can also finish first in the market. … When companies make decisions that show respect for the environment, their communities, and their employees, there’s less likelihood that they’ll be hit with the kinds of fines, public backlash, and boardroom turmoil that can slam their share prices. … There’s also a strong correlation between ESG-minded management and longer-term strategic thinking—another factor that increasingly distinguishes top companies from laggards.


According to ESG advocates, companies that stand out in these areas will be more successful over the long haul than companies that don’t. … The knock on all social investing strategies has been that … you sacrifice some return. Morningstar analyst David Kathman says maybe not. “There is no evidence that shows ESG or socially responsible investing helps or hurts performance …Over the long term, it probably evens out.”


MSCI (largest provider of ESG data in the world)

Lower risk of severe incidents … Over the past 10 years, higher ESG-rated companies showed a lower frequency of idiosyncratic risk incidents, suggesting that high ESG-rated companies were better at mitigating serious business risks.


In 2018, most major asset managers are committed to incorporating ESG criteria and risk factors in their investment … As increasing numbers of investors seek to integrate sustainability and ESG risk factors in their investment strategies, it is becoming clear that there is a lack of clarity with regard to the various approaches adopted as well as a sense of frustration that there is no general consensus about what is financially material in this context. … Investors are generally asking, “Which factors and underlying data should we consider,what are the key sources of ESG risks and subsequent value creation for a particular industry or company, and which long-term risk patterns are likely to have a negative impact on these value drivers?” … ESG performance can be directly related to companies’ revenues and costs … allows investors to hedge potential portfolio drawdowns, i.e. a certain minimum frequency of severe risk incidents related to a particular ESG issue in a specific sector is XX % likely to have a negative impact of at least YY bps and increase beta of a stock by ZZ %.

JUST Capital Foundation

… companies who invest in their employees, treat their customers well, work to create quality products, are sustainable, care about their communities, create jobs, and have ethical benefit employees, consumers, communities, and the environment, [but do they] benefit shareholders and the companies themselves … do JUST stocks outperform over the long-term? … Since its November 30, 2016 inception through September 2018, the Index has cumulatively outperformed the Russell 1000 … [but] does the Index provide a positive alpha, or unexplained investment residual, after controlling for the five Fama-French factors? After running a regression of the daily [index] excess return over the Russell 1000 on the five Fama-French factors from December 1st, 2016 through August 31, 2018 … we’d answer yes, it does.



One of the most frequently asked questions is whether an investor can “do good and do well” when screening portfolio. … A simple yes-or-no answer is no reasonable because there are a variety of potential inclusionary and exclusionary screening preferences … There is currently no industry consensus on this answer and commonly cited meta study has shown mixed results …


ESG Investing (environmental, social, and corporate governance) used to carry the stigma that investors needed to make certain concessions in order to participate. But research shows you don’t necessarily have to sacrifice performance or price when choosing investments that make a positive impact.

Wellington Management

“Evidence shows that companies that have better ESG management tend to outperform in the long term, and they’re more resilient during times of economic downturn,” says Christina Zimmerman, manager of ESG research at Wellington Management. “We do this to get better risk-adjusted returns.”


“If you don’t take it [ESG] into account, you miss part of the puzzle when evaluating a company,”

Neuberger Berman

Neuberger Berman believes that ESG considerations are an important driver of long-term investment returns from both an opportunity and a risk mitigation perspective

Northern Trust

Is ESG such a factor?With some caveats, we feel that ESG can indeed be utilized as a factor in portfolio construction.most academic studies on the topic suggest that at worst the relationship between ESG and corporate financial performance is at least non-negative.

What makes ESG unique is the degree of disagreement regarding what should go into an ESG score and how those metrics should be weighted. Further, there are no simple ESG definitions, no book-to-price equivalent of ESG that can be applied universally. … When building a quantitative, factor-based portfolio, we feel that these ESG ratings are best used when integrated with certain other financial factors.

Specifically , we find that ESG and quality make a particularly potent factor combination as each factor captures a different dimension of sustainability — non-financial and financial. … he jury is still out on whether ESG is a compensated risk factor.


We find ESG can be implemented across most asset classes without giving up risk-adjusted returns. … ESG-friendly portfolios could underperform in ‘risk-on’ periods – but be more resilient in downturns. … Early evidence suggests that focusing on ESG may pay the greatest dividends in emerging markets (EMS).

State Street Global Advisors

… while accidents and impropriety can happen at any time, the ESG themes manifest themselves over longer time horizons as opposed to more traditional financial metrics whose consequences can impact more quickly. … ESG information tends to be the most effective at identifying poor ESG firms that are more likely to underperform as opposed to predicting future outperformers.


Since the Forum for Sustainable and Responsible Investment (US SIF) began researching SRI in 1995, the assets in these types of investments have grown from $639 billion to nearly $12 trillion. That’s an 18-fold increase and a compound annual growth rate of 13.6%.1

Additional data from Morningstar shows that, on average, SRI mutual funds have slightly outperformed their non-SRI counterparts in the short, medium and long terms …

GMO (Grantham, Mayo & Van Otterloo) – login required

EM … countries are generally both more vulnerable to ESG issues and less prepared to deal with them. … although ESG signals are worth integrating in all strategies …

performance and integration of ESG data in an investor’s EM country and stock selection processes. …

the value in integrating ESG into investment decisions as it impacts security valuations through a host of avenues such as the volatility of earnings, resilience of assets, and the cost of capital …

EM countries are more vulnerable to the ill effects of ESG issues as they have far greater exposure to extreme weather events (e.g., floods, droughts); resource scarcity (e.g., water, food); social unrest; corruption; and poor governance

AQR Capital Management (in Journal Of Investment Management)

… we show that poor ESG exposures predict increased future statistical risks. While the effect is modest in magnitude, it is consistent with ESG exposures conveying some information about risk that is not captured by traditional statistical risk models. … ESG exposure tends to predict increases in statistical risks (i.e., risks captured by traditional risk models) in the future. Controlling for current risk characteristics of a given stock, that stock’s ESG score helps forecast future statistical risks up to five years later. In other words, ESG exposures may convey information about future risks that are not captured by statistical risk models….

…the total volatility of the average stock in the first quintile (worst ESG) is 35%, versus 30% for the average stock in the fifth quintile (best ESG). …

Goldman Sachs

… a revolution rising – from a low chatter to a loud roar … ESG factor allows for greater insight into intangible factors such as culture, operational excellence and risk that can improve investment outcomes … nearly half of all S&P 500 companies addressed ESG issues in Q4 2017 conference calls … society’ rally call on ESG topics are getting louder … Twitter posts mentioning ESG topics grew 19x over the last five years …

Environmental and social shareholder proposals represented 41% of all documented shareholder proposals in 2017, up from 33% in 2016, including contributions from BlackRock, Vanguard, Fidelity, Capital Group and others …

…Social media platforms such as Facebook, Twitter and Glassdoor have handed society a powerful megaphone. The speed and scale at which news now spreads expose companies to new reputational risks and in effect holds them more accountable to internal and external ESG issues. …

… according to surveys from Deloitte and Cone Communications (part of Omnicom Group), responsible business practices have a profound effect on Millennial’s views of business and ultimately their employment decisions. …

…ESG is directly impacting credit ratings, as agencies integrate ESG factors into their risk assessment and ratings methodologies …

BlackRock CEO Larry Fink: “Environmental, social, and governance (ESG) factors relevant to a company’s business can provide essential insights into management effectiveness and thus a company’s long-term prospects”

T. Rowe Price CIO Rob Sharps: “Environmental, social and governance factors are important in any comprehensive investment research process.”

Putnam Investments CIO Aaron Cooper: “There is a growing realization in the marketplace that companies engaged in sustainability often show enhanced fundamental and financial performance”

GMO Founder and CIO Jeremy Grantham: “Interest in ESG isn’t necessarily because of the rush of blood to being good. It could be just good business. … There’s quite a lot of work that suggests that people who are early movers on good behavior are demonstrating that they are simply thinking more about the future, how it will look, how it will play out over 10 or 15 years.”

Martin Currie

Martin Currie believes ESG is especially valuable in emerging markets where corporate governance standards are often more complicated.

Putnam Investments

Deep fundamental research plus intense sustainability analysis are at the heart of our investment process.

Russell Investments

…when investors seek value these days, they often end up with securities that represent values – an alignment with increasingly popular environmental, social and governance (ESG) principles. …we identified positive ESG tilts as consistent with many fundamental investment processes.

… We had heard that ESG might be value-detracting, so we expected to see a negative tilt in active portfolios. Instead, we discovered that many active managers, who are seeking to add value over their benchmarks, actually have positive ESG tilts. In a number of regions, more active managers have positive ESG tilts than negative ESG tilts.

This finding suggests that positive ESG tilts are consistent with managers’ intent to add long-term value through security selection. While the manager may or may not be purposefully screening for ESG factors, their investment criteria are identifying securities that in fact result in significant ESG tilts. Think of this as latent ESG.

Bank of America / Merrill Lynch

…we recommend using ESG in conjunction with fundamental attributes like valuation, growth and quality. In this report, we analysed results from combining ESG with other fundamental factors, and found that adding ESG would have consistently outperformed fundamental strategies with less risk. For example, dividend investors who had added ESG to their process would have increased their average returns by ~200bps per annum….

… Is ESG just another Wall Street fad? We see sticking power…

Relative Momentum Portfolio Rotation to Minimize Bear Market Risk

Friday, August 24th, 2018
  • Relative momentum rotation between strategic assets and cash
  • Relative momentum rotation between a choice of strategic assets and cash
  • Potential problems when using relative momentum approach

One approach to a simple rules-based, mechanical system to manage opportunity and potentially minimize maximum drawdown in Bear markets is to use relative momentum between each strategic asset and a risk-free asset (T-Bills) as an alternative — all-in or all-out of each strategic asset based on its return versus the return of T-Bills.Bear market.

The shorter the evaluation period, the smaller the maximum drawdown exposure — but the greater the trade frequency which is not tax efficient in a regular taxable account, and the more frequent the whipsaw (sort of a head-fake by the market requiring reversal of the position with positive loss or opportunity cost).

The longer the evaluation period, the larger the maximum drawdown exposure — but the lower the trade frequency, which is more tax efficient in regular taxable account, and the less frequent and potentially less costly the whipsaw.

Ways to attempt the avoid the worst of each evaluation period length while attempting to capture some of the best of the each evaluation period may be to use an average of shorter and longer periods, or to step into and out of strategic positions in phases by using more than one evaluation period length.

Relative Performance Rotation With the Swensen Portfolio:

Let’s look at an example, using the Swensen Reference Portolio as a base case with 2018-08-23 data.

Swensen is the CIO of the Yale Endowment, who proposed his “Reference Portfolio” as something from which to depart for a personally suitable portfolio in his book, “Unconventional Successs: a Fundamental Approach to Personal Investment”. He did not recommend momentum rotation in that book.

The Swensen portfolio is 70% OWN, 30% LOAN and 0% RESERVE.

This table shows the Swensen portolio as the default allocation, and to the right of that are four alternative allocations based on whether the strategic risk asset has outperformed risk-free cash over a 3, 6, or 12 months rating period, or the average of those periods. Where the risk asset did not outperform, cash is held in lieu of the asset.

(click images to enlarge)

Pink shaded cells indicate that the strategic risk asset is not held and instead the money for that slot is held in Reserve in risk-free T-Bills.

The tables on the left show the total return of each asset over each evaluation period and the excess return. The excess return is the total return minus the return of the risk-free asset (T-Bills) for the same period.

For equities (OWN), the relative momentum method suggests not owning the emerging markets fund at this time, and only owning the non-US developed markets fund if using the 12-month evaluation period.  Total US stocks and US REITs have positive excess return for all periods and would be held at the full strategic allocation level.

For debt (LOAN), the relative momentum method suggests intermediate-term Treasuries should not be owned if using the 12-month evaluation period.  Short-term TIPS are OK for all the periods.

You can operate portfolios, with any chosen set of risk assets using relative momentum as illustrated here. Such portfolios can be rebalanced at intervals ranging from monthly, quarterly, semi-annually to annually.

The longer rating periods may lag too much, and the shorter periods may be prone to whipsaw losses or opportunity cost. The method is intended to capture the bulk of major up trends and to avoid the bulk of major down trends.

This is not a panacea approach, and may or may not improve returns, but probably can limit maximum drawdowns associated with Bear markets without relying on the variable quality of judgement (assuming as is typically the case that market tops are a process of rolling over; not a steep, sudden drop).

Staged In-and-Out Approach:

Let’s say, you were using a staged in-and-out approach to each strategic asset based on three steps governed by the 3-month, 6-month and 12-month relative returns.

  • VTI would be 30% (all-in)
  • VEA would be 10% (1/3 out)
  • VWO would be 0% (all-out)
  • VNQ would be 15% (all-in)
  • VGIT would be 10% (1/3 out)
  • VTIP would be 15% (all-in)
  • CASH would be 20% (residual not in strategic assets).

Critical Note:

This simple relative momentum investing does not include consideration of the fundamental condition, fundamental prospects for or valuation of the assets used and being rotated. That is a key weakness and risk factor associated with this approach unless the assets are pre-selected based on fundamentals and/or valuation.  Presumably, the strategic assets and their allocation weights would have been chosen for a good long-term fundamental, non-technical reasons.  This method is meant merely to modulate exposure to each strategic asset based on performance relative to a risk-free asset (T-Bills).

Building More Complexity:

The approach can become progressively more complex and granular. For example, a portfolio may have a tactical sleeve that involves less diversified assets, that may be higher opportunity/risk or that are expected to exhibit particularly favorable momentum over shorter periods of time.

Such a sleeve might be for the top momentum sector funds, or top country funds, or top ETFs of any type, or top momentum individual stocks, or the top security from a custom list.

In the example below, we created a tactical sleeve that would invest in the top 2 momentum sectors among the 10 Vanguard US large-cap/mid-cap sector funds, and also invest in the top momentum stock among the 5 FAANG stocks [Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NLFX), Google (GOOG)].

In addition, just to make it yet more complex, the default strategic assets are considered for substitution with a related alternative.  In this case we use these alternatives:

  • default S&P 500 (SPY), alternatives S&P 500 pure growth (RPG) and S&P 500 pure value RPV)
  • default total US stocks (VTI), alternatives S&P 100 (OEF) and Russell 2000 (IWM)
  • default total international stocks (VXUS), alternatives DM markets (VEA) and EM markets (VWO)
  • default US REITs (VNQ), alternative  international real estate (VNQI)
  • default US high dividend (VYM), alternative international high yield (VYMI)
  • default short-term Treasuries (VGSH), alternatives short-term investment-grade corporate bonds (VCSH), ultra-short-term, investment-grade, floating-rate debt (FLOT)
  • default intermediate-term Treasuries (VGIT), alternative intermediate-term corporate investment-grade corporate bonds (VCIT)
  • default long-term Treasuries (VGLT), alternative long-term investment-grade corporate bonds (VCLT)
  • default short-term TIPS (VTIP), alternative long-term TIPS (TIP).

Note: This is not a recommendation for a portfolio, merely an illustration of how complexity can be increased.

It is probably obvious that as the number of portfolio slots increases, and the number of securities considered for each slot increases, the decision process moves from one of paper and pencil to one requiring a database return download source and some coding in an Excel spreadsheet – unless you want to drive yourself a little bit crazy.


Life Stage Asset Allocation Reference Timeline

Monday, August 13th, 2018
  • Consensus Life Stage appropriate asset allocation
  • Historical Life Stage asset allocation returns
  • Forecasted Life Stage asset allocation returns

During this long Bull market, some portfolios have been more aggressive than might be expected over the long-term. Now, we are approaching or may be in the 9th inning or the 11th hour, and are exposed to some extraordinary event risks. It may be appropriate to review what the consensus Life Stage allocation is according to major money management institutions.

By Life Stage, we mean, not age, but how many years before you convert from adding assets to your portfolio to withdrawing assets – the Withdrawal Stage of Life.

While people can enter the Withdrawal Stage at any age, the standard reference model is at age 65 with an estimated 30 years to live (for the portfolio to last). Based on that assumption, institutions have designed what they believe are the most sensible and prudent allocations leading up to and following the commencement of the Withdrawal Stage.

This is the model simplified to 4 asset categories that is near the average of the recommendations of 12 leading institutions (excluding the cash level, which tends to be around 2%-4% in later stages):

You may wonder how those allocation levels have performed historically.

This table shows recommended allocations at 5-year intervals before and after entering the Withdrawal Stage, and how they performed over various cumulative periods through July 2018, and over individual calendar years through 2017, plus forecasts by Vanguard and BlackRock.

The data is for indexes, except for international Dollar hedged government bonds which is based on the Vanguard fund with that objective from 2014-2017, and the VALIC foreign government bonds fund (Dollar hedged opportunistically) from 2008-2013.


Even though the stock market may continue on longer than expected, we think those near or in the Withdrawal Stage should give careful consideration to these “rule of thumb” allocation levels; judge strategic aggressiveness relative to them; and if more aggressive, shift tactically toward them.

We’d like to be more safe than sorry over the next couple of years. As we have discussed before, we are using ultra-short-term, investment grade, floating rate US bonds in lieu of other bonds during this Fed rate hiking cycle; probably until early 2019 (maybe longer for the international bonds portion).

[directly related securities:  VTI, VXUS, BND, BNDX, FLOT, FLRN]

Compare 10-Year Projections Using Historical and Forecasted Returns

Thursday, May 17th, 2018

Institutions generally agree that total returns over the next 10 years will be lower than the long-term historical level:

  • 5.42% mean for US large-cap stocks vs 11.92% from January 1987 – April 2018
  • 3.19% mean for Aggregate US bonds vs 6.07% from January 1987 – April 2018.

Forecasted returns used here are averages of forecasts by BlackRock, State Street Global Advisors, JP Morgan, Bank of NewYork/Mellon, Callan Associates (pension consultants) and Research Affiliates.

Considering mean return history or forecasts is not adequate for setting portfolio expectations, because future results have a wide spread of possibilities around the mean due to the impact of volatility (often made worse by investors selling in panic at bottoms and re-entering late in Bulls).

This table shows simulated probabilities for a $1,000,000 bonds or stocks portfolio at the 10th, 25th, 50th, 75th and 90th percentile probabilities (covering 80% of likely outcomes, but still leaving 10% more extreme possibilities at either end of the spectrum undefined).

(click images to view full size)

This table shows four common allocations: 40/60 (conservative balance), 50/50 (allocation Vanguard uses in their target date funds for investors age 65 just beginning retirement), 60/40 (traditional balanced fund allocation) and 70/30 (aggressive balanced allocation).

If the institutions are correct in their assumptions, you should expect lower returns, and lower cumulative values for your portfolio over the next 10 years. The differences in cumulative portfolios per million Dollars of starting capital between simulations based on historical data and forecasted data are in the hundreds of thousands of Dollars.

For example, per $1,000,000 for a 50/50 portfolio allocation at the 50th percentile simulation probability, you should expect an inflation adjusted (real) portfolio value at the end of the next 10 years to be about $624,000 smaller (about 35% less) based on forecasted returns and volatility rather than based on historical returns and volatility. Maximum drawdowns are expected to be similar.

This table shows the actual total returns of US large-cap stocks, US aggregate bonds and nine allocation levels between them over a variety of periods all ending at 12/31/2017.

This table based on daily prices shows the rolling period price returns (not total returns) ending on all market days since the beginning of 1928. All the data is for actual results — no theory or hypotheticals here. There were many very good and very bad rolling period returns.

Bottom line – a simplified look at historical mean returns all ending on a recent day, and not understanding how volatility creates a wide spectrum of possible outcomes and occasional Maximum Drawdowns is not a safe way to look at what may occur in the future. Your allocation decision is critical – more critical than your choice of specific securities – in determining the likely range of return outcomes and the severity of likely Maximum Drawdowns.

Presuming you make reasonable choices of securities and have a diversified portfolio, those decisions will have far less impact on your overall outcomes than your Own / Loan / Reserve allocation decision.

And, whatever your Own / Loan / Reserve allocation decision, the predominate institutional opinion is that returns are likely to be lower over the next 10 years than the last 10, 20 or 30 years.

As you can see in the simulation tables, the lowest projected returns are also paired with the largest Maximum Drawdowns. Minimizing Maximum Drawdown exposure is almost synonymous with maximizing return. Selecting a static allocation is implicitly selecting a likely Maximum Drawdown exposure.

There are two ways to minimize Maximum Drawdowns, not involving derivative products or shorting:

  • Select a more conservative allocation
    • Requires lower overall return expectations
    • Rebalancing maintains risk level, but does not increase return
  • Shift between more aggressive and more conservative allocations as risk levels change
    • Requires a rational signal system for increasing and decreasing risk exposure
      • Trend following approaches are superior to trend prediction approaches
    • Shifting will experience false positives that drag on performance during Bulls
    • Generates tax costs in taxable accounts that reduce return benefit
    • Shifting as risk levels change can avoid the largest part of Maximum Drawdowns
    • Missing the largest part of Maximum Drawdowns can increase returns
    • Requires active oversight and time commitment.

Think about these historical and projected returns, and how you are most comfortable with managing risk levels.






Maximum Drawdown and Allocation Approaches

Sunday, May 6th, 2018
  • Simple Buy & Hold, Strategic Fixed Risk Level Allocation, Strategic Flexible Risk Level Allocation, Dynamic Tactical Risk Level Allocation.
  • 4.5 to 10.5 years time to recover to breakeven associated with 6 example Bears.
  • Our view of suitable allocation within Flexible Strategy.

There are many types of risk when investing. Here are 10 of them:

Credit risk
Interest rate risk
Inflation (real return) risk
Currency risk
Tax risk
Active management risk
Valuation and forecasting error risk
Volatility risk
Maximum drawdown risk
Portfolio longevity in retirement risk

Each of these deserves attention in portfolio construction. In this letter, we examine Maximum Drawdown Risk, which is probably the greatest risk portfolios face over the next couple of years.

Maximum Drawdowns occur infrequently but massively, and it typically takes years to breakeven with the pre-crash portfolio value. In the battle of philosophies between Buy & Hold and Tactical Trend Following, the long recovery time after a Maximum Drawdown is the trend follower’s main argument. We are in the Tactical Trend Following camp for long-term trend reversals. We prefer to take cover in falling markets, by tilting away from equities toward bonds or cash.

Since 1936, US large-cap Bear markets have taken mostly 4 to 6 years from the pre-crash peak to the bottom and back to a breakeven level. Total return recovery from the 2000 Bear took 6.15 years, and from the 2007 Bear it took 4.5 years. Of course, a portfolio diversified with debt assets, experienced a less extensive drawdown and a total return recovery over a shorter period.

This table shows how long it would take for total return breakeven after various levels of portfolio decline, assuming various post-drawdown rates of return:

(click images to enlarge)

Many of us, don’t have the luxury of waiting 4 to 6 years to breakeven with pre-crash levels, particularly if we are making regular withdrawals from our portfolios to support lifestyle.

A young person with only a small portion of future accumulations achieved, engaging in regular periodic investments, can not only ignore most Bear markets, but actually enjoy buying more shares each month at a lower price during a Bear – maybe even increasing the rate of investment during a Bear.

However, for someone, regardless of age, who has completed the process of adding new money to the portfolio, and is relying on the portfolio for sustenance, the Bear presents a threat not an opportunity. Of course, if that person has such a large asset base that withdrawals are less than the investment income (interest and dividends), for that person the Bear is more an annoyance than a threat and may present some attractive asset substitution opportunities.

But for most of you, and for me, the Bear is more of a threat than an opportunity if we lean into it and take it in the face full force.

Those are the reasons that generic advice to someone starting out is to put all assets in stocks, to maximize regular monthly savings, and damn the torpedoes in a Bear market. And, those are the reasons as we achieve more and more of our ultimate accumulation (Financial Capital), and the present value of our future earnings from work (Human Capital) declines, and the number of years we have before beginning to withdraw assets decreases (Time Horizon), that we need to diversify our risk (specifically the correlation of return of the assets we own), to mitigate the damage that a stocks Bear market can have on the ability of our portfolio to support our lifestyle now or in the future (to avoid the Risk of Ruin – outliving our assets – to protect Portfolio Longevity).

Unfortunately, diversification is a bit like insurance. It has a cost, at least it seems that way almost all the time, except in the instance that you need it. You lament the premium you pay for your auto, home or medical insurance, until you have a major claim event. Then you are so glad you had the insurance. Same thing with portfolio risk diversification (diversified asset return correlation), which is predominantly accomplished with high quality debt assets (particularly Treasuries). High quality debt assets do not generate returns over short periods as high as equities do, but they do not experience Maximum Drawdowns as severe as stocks – thus moderating overall portfolio Maximum Drawdown. This picture tells the story:

From the early 1990’s (close to 30 years) the S&P 500 generated a cumulative return over 950%, while the Aggregate Bond market generated a cumulative return of only 265% — and a balanced portfolio of 60% S&P 500 and 40% Aggregate bonds generated a cumulative total return of 630%.

Who would want 265% when they could have 950%? My grandchildren certainly should look to the 950%. But most of you can’t safely deal with Maximum Drawdowns that are likely over 30 years.

Here is how the aggregate bond index helped in the last two Bears (beginning in 2000 and 2007):

The 2000 Bear and the 2007 Bear were back-to-back in a sense, because the October 2007 pre-crash peak was only one year after the S&P 500 reached total return breakeven in October 2006 after the 2000 crash.

This chart shows how the S&P 500 (VFINX) and Intermediate-Term Treasuries (VFITX) worked together in 70/30, 50/50 and 30/70 allocations to moderate the severity of Maximum Drawdown in both Bears through their breakeven points:

Treasuries, unlike corporate bonds have zero credit risk (but like corporate bonds have interest rate risk). In times of panic, no form of debt beats a Treasury, although holding them between Bears is uninspiring. Gold may be helpful in a panic, but its performance is less certain. In times of significantly rising interest rates using ultra-short investment grade variable rate corporate debt, ultra-short Treasuries or money market funds may be best as portfolio risk moderators.

How Do Different Approaches Deal with Maximum Drawdown?

A very simplified view might be that there are 4 general approaches in portfolio risk management (excluding methods involving leverage, shorting, or hedging with futures or options) – let’s give them these names:

  • Simple Buy & Hold
  • Strategic Fixed Risk Level Allocation
  • Strategic Flexible Risk Level Allocation
  • Dynamic Tactical Risk Level Allocation.

Simple Buy & Hold means you own a fixed basket of securities, hopefully cognizant of the risk profile, with the intention of doing nothing thereafter for a long-time. You do not rebalance.

On the positive side, this minimizes taxes, transactions costs, and time commitment.

On the negative side, this basically ensures that the risk profile of the portfolio will move up and down by significant amounts over time – becoming much riskier as stocks outperform debt, and much less risky after stocks crash (and significant portfolio value has gone away).

This method is probably talked about favorably more than it is actually practiced – with many proponents during long Bull markets, but fewer who do not bail out during a crash.

For someone with many investing years ahead, with low assets relative to future additions to savings, making regular periodic investments, Buy & Hold is probably fine. However, for someone without many investing years ahead, with high assets relative to future additions to savings, and certainly those in the withdrawal stage of their investing lives; Buy & Hold of stocks is probably not a good approach, because of it’s exposure to Maximum Drawdown which could take several years to recover. For those in the withdrawal stage taking fixed amounts of money from a declining asset value accelerates the rate of asset depletion, which could be ruinous (your money dies before you do).

Strategic Fixed Risk Level Allocation means you own a selection of assets in a fixed ratio to each other (example: 50% stocks and 50% bonds) with an expected level of risk and return, with the intention to rebalance the mix from time-to-time, or when the ratio of assets held shifts materially, to restore the portfolio to the original allocation to maintain approximately constant risk and return expectations. The assets you choose have diverse return correlations (they don’t all go up or down at the same time in response to the same issues or to the same degree).

On the positive side, this keeps you in the same approximate risk/return exposure that you chose as suitable for you when the market value of your various assets fluctuates up and down. In effect, you sell high and buy low, which is a good thing, because rebalancing back to a fixed allocation level forces a trimming of outperforming assets and augmentation of underperforming assets (typically means trimming the more volatile assets and augmentation of the less volatile assets).

On the negative side, except in tax-free or tax-deferred accounts, trimming outperformers creates a tax cost. There are transaction costs to rebalancing, but those are very low these days and if the size of the taxable gain in the transaction is, let’s say, over $500, then the transaction is probably worth the transaction cost, but not necessarily the tax cost. There is a modest time commitment required to pay attention to the changes in allocation percentages. The lowest time commitment is to rebalance based on the calendar (such as quarterly or yearly). The highest time commitment is to rebalance based on allocations getting out of line with the plan, because that requires weekly or monthly monitoring. Overall, its not much of a time commitment either way, but more than Buy & Hold.

The allocation that is suitable for you changes as you approach retirement – Allocation Glidepath.

Strategic Flexible Risk Allocation, like the Fixed Risk approach to allocation, owns a selection of asset categories chosen for correlation diversification and held in a ratio to each other expected to produce the desired risk and return. And, like the Fixed Risk approach, you rebalance. However, instead of an unchanging allocation, you set Target allocation levels for each asset category, but also Minimum and Maximum allocation levels for each category, allowing you to modulate your risk and return expectations based on objective or subjective criteria as markets unfold or are expected to unfold (example: stocks Target 50%, Minimum 45%, Maximum 55%; and bonds Target 50%, Minimum 45%, Maximum 55%).

On the positive side, you are set up to use rebalancing to keep your expected risk and return at the level you determined was suitable for you, while also allowing you to modulate your allocation within pre-set limits based on changes in your expectations of return or volatility for some or all of your asset categories to maintain your risk exposure; or to modulate your risk exposure. Frankly, it satisfies the common human drive to act, while preventing misjudgment or emotional behavior from possibly creating a big portfolio performance problem.

On the negative side, it has the same negatives as the Fixed Risk approach and introduces the possibility that the reasoning behind deviation from the Targets is faulty. Use of the Minimum and Maximum allocations may produce a lower total return, or higher volatility, or larger Maximum Drawdown than the Fixed Approach. As they say, “it depends”. I find this approach is more appealing to more people than the Fixed Approach. Most people who are not Buy & Hold advocates prefer the idea of some continuing active choices about allocation.

Dynamic Tactical Risk Level Allocation is essentially the opposite of Buy & Hold. It means hold assets while they are doing well and don’t hold them when they are not doing well; and when risk assets are not doing well, hold the money that would otherwise go to them in safe liquid assets such as T-Bills, money market funds or ultra-short-term bond funds.

In practice this could be a full Long / Flat approach (example: 100% S&P 500 and 0% T-Bills, or 0% S&P 500 and 100% T-Bills). Alternatively, it could involve a stepwise movement between 100% and 0% between the asset categories.

The approach could be based on long-term trends (probably the better choice) or short-term trends (probably the less attractive choice) to day-trading (probably the worst choice, unless you are a very special person with very special skills with nerves of steel).

OPINION: If it is your intention to use a Tactical approach, it is probably best in most cases to use it only as a sleeve of your portfolio in combination with Strategic Fixed Risk Level Allocation, where the Strategic portion of your portfolio is an anchor to windward, just in case the Dynamic Tactical Allocations works out less well than planned.

I do believe the evidence shows that a Dynamic Tactical approach (probably more commonly called Trend Following) will underperform the Strategic approach during Bull markets (which could be many years), and if done well, outperform in Bear markets, and thereby outperform in the long-term.

It is not surprising that during the current Correction, we have received numerous calls about whether and when the Bull will end, and whether and how much we should be practicing intermediate-term Trend Following versus long-term Strategic Allocation.

First, if you set out with Strategic Allocation as the plan in the beginning of this Bull market, and now are prepared to cut and run, you never had a Strategic plan in the first place. What you had was a Tactical Allocation plan in hibernation.

A combination of a Strategic Flexible Allocation with a Tactical Allocation sleeve will suit more investors than not.

I believe getting out of the way of a train wreck — as long as an investor is properly prepared to get back on the rails when the wreck is cleared off the tracks. By this I do not mean day-trading or bouncing in and out of risk assets based on headlines, or forecasts, or exiting risk assets within the noise level of volatility (which means at least not within Corrections).

Going full Tactical may sound interesting now, but I doubt that most investors would have a taste for it as a continuing practice. For example, even the best long-term trend indicators generate some false positives. That means by following a tactical system, there will be times that it is wrong. You get “whipsawed”, meaning you exit, the indicator proves wrong and reverses, then you get back in. You may have capital gains taxes because of the exit, and you may get back in at a higher price than your exit. That upsets people, but that is part of tactical methods no matter how good they are.

Example Historical Drawdowns:

A tactical practitioner must accept those costs in exchange for the large payoffs that occur generally many years apart in Bears such as these:

  • Non-US Developed MSCI large-cap + mid-cap stocks
    Down 45% over 1.6 years from 3/1973 – 9/1974
    5.3 years to price breakeven in 7/1998
  • Non-US Developed MSCI large-cap + mid-cap stocks
    Down 58% over 1.3 years from 10/2007 – 2/2009
    10.5 years later (now) not yet reached price breakeven (still down 14%)
  • Emerging markets MSCI large-cap stocks
    down 58% over 3.9 years from 9/1994 – 8/1998
    10.7 years to price breakeven in 10/07
  • USA MSCI large-cap + mid-cap stocks
    Down 48% over 1.8 years from 11/1972 – 9/1974
    7.2 years to price breakeven
  • S&P 500
    down 51% over 2.5 years from 3/2000 intra-day high to 10/2002 intra-day low
    6.1 years to price breakeven in 10/2006
  • S&P 500 Down 57% over 1.4 years from 10/2007 intra-day high to 3/2009 intra-day low
    4.5 years to price breakeven in 4/2012.

I am not willing for my personal portfolio to endure Bears like that, then wait years to breakevenI do believe there is no utility (for other than the early stage investors making regular periodic investments, who may benefit by a stock market crash) to intentionally take the full force of the storm.

Stock market declines of 40% and 50% occur from time-to-time. Once a Bear has clearly arrived for a risk asset, exiting that asset after the Bear has quantitatively revealed itself, is reasonable in my opinion; then re-entering that asset is appropriate when the Bear is dead, and the Bull quantitatively reveals itself.

That is easier said than done, but it is doable to various levels of imperfection. However, an imperfect avoidance of a 50% decline, and an imperfect re-entry, can be better than the full ride down, with a 4 to 6 year or longer wait to breakeven with the pre-Bear portfolio value.

Recommendation (except for early stage investors)

Be allocated in a balanced way in a Strategic Fixed or Flexible Risk Allocation portfolio that is age, wealth and time horizon appropriate (see generic glide-path as a post-script to this letter) and have a Dynamic Tactical Risk Allocation sleeve in that portfolio – a larger sleeve if you think that way and a smaller sleeve if your appetite for a dynamic approach is more limited

Here is my thought about the Strategic Flexible Risk Allocation approach for now:

Keep in mind that major allocation shifts based on expectation of trend reversals is more likely to disappoint than major allocation shifts in response to demonstrated trend reversals.

Expected trend reversal approaches have a much lower batting average than trend reversal recognition approaches. Trends tend to persist, so following a trend whether up or down tends to work. Trend reversals become clear when they break out of the volatility noise area. Trend reversal forecasts tend to be flawed (it is much easier to predict what will happen than when it will happen). Consider fundamentals but rely on trend measurements.

The alternative to a permanent allocation between equities and debt instruments, is a flexible one that shifts toward debt when equity indexes turn down, and that shifts toward equity when equity indexes turn up.

That shifting can be quite moderate, such as moving between a 65% and 75% equity allocation around a target level of 70% in a Strategic Flexible Risk Allocation program, to a more aggressive approach such as 60% to 80% around a 70% target – and all the way to long/flat investors who go from full target equities to 100% Treasury Bills, then back again, based on equity trend conditions.

You need to look deep inside to decide where you belong in the spectrum from Buy & Hold, to Fixed to Flexible Strategic Allocation to partial to full Dynamic Tactical Trend following. For most, some combination of the approaches (effectively in sleeves of the portfolio will be most suitable).

Think about expected returns, return variability, and the likely magnitude of portfolio value change for the allocation you choose during a Correction and a Bear (Maximum Drawdown).

Current Intermediate-Term Trend View for Key Risk Assets:

This is our current intermediate-trend view of major equity indexes, using the QVM Trend Indicator.

A 19 minute video explains this indicator – its rationale, method and results in backtest to 1900.

While stocks are in Correction, the Bull trend has not reversed, but enough cautionary signs exist that a more conservative tilt within equities, or shifting of equity allocation toward the lower end of your allocation policy range may be prudent.

This is a general response to questions many are asking. Lot’s to talk about and think about. The answer to the questions depends on many individually specific facts.

If this responds to a burning question, this commentary may be a good beginning for a personalized discussion.

If you are comfortable with the way you are situated now, including the event of a Bear market sometime within the 2018 – 2020 time frame, that’s great. However, let’s go over your allocation preferences one more time just to make sure as much as we can that what you have is what you need, want and can handle both financially and psychologically when the poop hits the fan.


There are three ways to minimize maximum drawdown that we should evaluate (not involving hedging with short stocks, futures or options):

  • A higher allocation to assets that respond positively to Bears to prepare for a future Bear (Treasuries, high quality medium and short-term corporate debt, and perhaps gold — with ultra-short variable rate debt in times of rapidly rising interest rates)
  • Tactical reduction of risk assets once a Bear is revealed
  • A combination approach.

If you are going to be strategic, recheck your Target Allocations, rebalance if needed, and stay calm.

If you are going to be tactical, do it the better way, not the worse way.


post-script (generic glide path):

Bitcoin Bubble Warning Follow-Up

Friday, December 22nd, 2017

We wrote to you on the December 12th warning to stay away from Bitcoin.

We posted that comment on our blog and received some outraged comments from Bitcoin “fanboys”. That is the price of skepticism expressed about any bubble.

We said we can’t be involved in Bitcoin as fiduciaries, and have been recommending to clients that they not become involved on their own.

As Bitcoin went from less than $500 to more than $18,700, our concern was increased, while some people felt we should not have missed the boat.

We are in good company with those who warn about involving in Bitcoin, including the CEO of  JP Morgan; the CEO of the largest hedge fund in the world; the CEO of the largest pure short-only hedge fund, the founder and former CEO of Vanguard; the former CIO of Harvard Endowment, the CEO of the largest money manager in the world, a Nobel Laureate in Economics, and Warren Buffet.

Bitcoin may bounce back to new highs, but it is simply not investable. It may be better than roulette as a fun thing to play, but is not an investable asset.

Maybe just dumb luck, but we did call at least an intermediate top on December 12th. We continue to believe it is not a good idea to own Bitcoin, and advise clients not to see the current decline as a buying opportunity.

Prices that go up vertically (an unsustainable pace) almost always turnaround and go down vertically until the speculative element is washed out.  That appears to be happening now with Bitcoin.

Futures may amplify that process, because now there is a way to be short, whereas before one could only be long.

Our warning post “Clients Ask, Should I Own Bitcoin?” can be found here.

Here is the chart of Bitcoin price on December 12th.

(click images to enlarge)

Here is the chart of Bitcoin today, December 22nd