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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
JPMorgan has 240,000 employees worldwide. One of them, managing director Jan Loeys, writes about investment strategy in a way that can sound like a subtle dig at how the other 239,999 choose to spend their days.
In this week’s edition of his long-term strategy strand, Loeys offers a Q&A on how to build an investment portfolio. He recommends buying some stocks and some bonds. That’s it. Everything else, he says, is needless complication.
Here are a few highlights, with his emphasis:
1. How many assets do you really need in your long-term portfolio?
In principle, you do not really need more than two: a global equity fund and a broad bond fund in your own currency, with the relative amounts a function of your return needs, ability to withstand short-term drawdowns, and need to control long-term risk on your ultimate portfolio. This gives you very good diversification, clarity and simplicity on what you are holding, and high liquidity with minimum costs if held through passive funds, mutual or exchange traded (ETFs).
One could argue that your bond fund should be global, but that would add foreign-currency risk that is generally not well compensated. If you then have strong views on what asset types, countries, or sectors to have more of than is in these broad funds — say you fancy Technology — you can simply add a Tech ETF to these two funds. It is harder when there are certain assets you want to have less of, or not have at all — say oil companies. You would need a fund that excludes oil companies, but that may not exist if there are not enough investors like you who do not want to hold oil. If such a fund does not exist, then you will have to build a portfolio bottom up by trying to buy all the other sectors, for which funds will surely not all be available. Hence, it is much easier to execute overweights than underweights in a simple portfolio. In short, you will do quite well with holding only two funds: a global equity one and a local bond one.
2. Are there any superior assets left that you should systematically overweight in a strategic portfolio?
We used to think so, yes. The Empirical Finance literature has found troves of high-Sharpe ratio assets that have high returns to risk and thus lie above the standard risk-return trade-off line of local-currency bonds and global equities, which is the standard of a simple, well-diversified portfolio. If markets are perfectly open, global, and frictionless, such superior assets should not exist, because everyone will buy them, bidding up their price and pushing down their likely future return, until they have been brought down to the global risk-return trade-off line, and are no longer a superior asset class. The opposite happens for assets with inferior returns to risk as nobody will buy them, pushing down their price until they move back up in return. We thus need market inefficiencies, as we call them, typically brought on by market segmentation, to produce superior assets.
We always thought this was the Holy Grail of strategic investing. And for years, we joined the search and testing of these high-Sharpe assets, in Value, Small Caps, Momentum, High Buybacks, and Fallen Angels, to name just a few [ . . . ]. But it has gradually been dawning on us the last few years that the majority of these show a fading pattern of outperformance, doing well decades ago, but then not doing any better than the broad markets over the past 10 years or so. A most plausible explanation is that “everyone knows everything” nowadays and has access to the same broad Finance Literature. Academic researchers after all are paid to get their results published and not to hoard them. As all this information spread out and markets became ever more global, the excess returns on these high Sharpe assets almost all dissipated.
Hence, we are now starting from a belief that there are very few superior asset classes left and that you might as well just stick to a simple portfolio of a global equity ETF and a bond fund in your own currency.
Nearly everyone should just buy a cheap global equities fund for diversification and a locally denominated corporate bond fund to minimise FX volatility, he says. Government bonds are only useful for managing drawdown requirements, so they have no place in your long-term strategy. Commodities don’t generate income so it’s probably not worth bothering with them either, unless you have strong feelings about extreme climate change or have some specific risk to hedge.
Tinker to your heart’s content with strategic asset allocation and time your trades to when a market feels cheap or expensive, says Loeys, but you’re probably going to get stuff wrong so don’t sweat it:
The danger is that many of us tend to overrate our ability to call the market short term. It is our perception that the most successful investors over time tend to be the ones that base their decisions on what they can be quite confident about, which is generally the yield/value of an asset or asset class and its historical long-term relative performance. Hence, a “realistic” individual investor is in our mind probably best off sticking with long-term value-based allocation and to ignore the temptation to trade the market on short-term beliefs. The general perception that “retail” tends to buy high, after a market has rallied for some time, and sell low, after that asset class has gone through severe losses, would be consistent with many of us overrating our trading skills.
And more than anything, cut the crap:
Our industry does seem to love complexity and to abhor simplicity. The more complex the financial world is seen to be, the more managers, analysts, traders, consultants, regulators, and risk managers feel they add value and expect to be paid. But there is a lot of benefit to the ultimate buyers of financial services and products to keep things simple.
For one, one should not buy assets that are too complex to be easily understood as the risk is then that the asset will not be appropriate for one’s financial objectives. Second, the fewer the assets one has in one’s portfolio, the easier it is to judge risk on them, the easier it is to gauge one’s exposure, the easier it is to manage one’s portfolio, and the less time it takes.
Time is indeed money. And probably the greatest benefit of simpler products is that they are cheaper, in terms of management fees and the costs of buying and selling them. Simpler products that are well understood by everybody will likely also be more liquid. The simplest investing rules, like “buy and hold” and do not move assets around much, are also easier to follow, save on taxes and other transaction costs, and reduce the trap all of us are at risk of falling into, which is to sell when markets have been going down a lot and to buy when they have been going up (ie, the risk of buying high and selling low). Finally, we have found that the simplest valuation rules, like using an asset class IRR, bond yields and equity yields, or mean reversion in real exchange rates, have had a much better record in judging future long-term returns than more complex systems.
Overall, then, we feel that keeping things simple in finance, fewer assets, simple valuation rules, simple investment rules, is an underrated strategy and one that too few of us actively pursue as the mainstay of their strategic allocation.
Loeys’ LinkedIn videos include avuncular talks on minimalist portfolio building, the pointlessness of overthinking asset selection, how to choose bonds and not commodities, timing markets, and the overriding principle of KISS, along with lots of macro-type stuff like managing long-term risks and whether to care about debt-to-GDP ratios. The homely style will no doubt rile up a lot of masters-of-alpha types but for anyone who needs a reminder of how to tell the difference between wood and trees (inside and outside JPMorgan) it’s an invaluable resource.
Further reading:
— Loeys’ laws on asset allocation (FT, 2017)
— Why is finance so complex? (Interfluidity, 2011)
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