Sheep on the Serengeti - How Passive Investing Puts you on the Menu

Asset Allocation - Do not get eaten

We are collectively just over a month into the year of our Lord 2023 and the “animal spirits” swirl. FOMO, indeed.

The butter does not spread evenly though. The Adani “complex” has lost 1/2 its “value” in 2 weeks on a highly successful “hit piece” from Hindenberg Research. I hope they had a large wager on this. The report in voluminous and clearly took many man-hours (person-hours? work-hours? Chat GTP runs?).

Adani listed equities are down US$120bln from 1/1/2023 with Gautam Adani’s net worth dented by $48bln. Key India benchmark indices are approaching correction territory.

Adani Enterprises to be removed from Dow Jones Sustainability Indices. “It is tremendously concerning that the statements of an entity sitting thousands of miles away, with no credibility or ethics causes serious and unprecedented adverse impact on our investors.” Indeed. Latching the barn door after the zebras have left.

Clean animals (those acceptable as food) head for the ark. $VMFXX Vanguard Federal Money Market Fund. 4.32% (7-day SEC yield, MER 0.11%), headed higher as Fed Funds track to FOMC dot plot with a terminal rate starting with a “5”.

Links:

Vanguard VMFXX - Federal MM Fund

Gen X’ers ($)number65million,wedgedbetweenBabyBoomers($$) and Millennials ($1/2). Defined benefit pensions are a long shot ex the public sector, hence the defined-contribution model currently dominates. Build your own pension. Invest for the long haul. Steer clear of high fee active managers.

Enter Vanguard Retirement 2050 (aka Target Date Fund)

Vanguard VFIFX - Vanguard 2050 Target Date Fund

Young investors can “set it and forget it”, decades away! Enough time to weather the rough seas and eventual draw-downs that result from being heavily weighted in risky assets (aka public equities). Cheap at 8bp or 0.08% MER, but asset allocation: 53% USA equities ($VTI Total Stock Market ETF), 37% Vanguard Total International Stock ETF. That is 90% in risky assets.

Young, passive investors are contributing $3bln/day into fund complexes like Blackrock ($11tln AUM, the biggest asset mgmt “whale”), Vanguard ($7tln), State Street $3.3tln, Fidelity $10tln. You get the idea. The vacuum collects the $ regardless of the price of the underlying. It is estimated that upwards of $0.40 of each $1 are allocated in this manner (i.e. price agnostic). What do you need to demand in terms of return for such a trust exercise? Let’s dig in:

Portfolio Theory: CAPM (Capital Asset Pricing Model)

ERi​=Rf​+βi​(ERm​−Rf​)

where:

ERi​=expected return of investment

Rf​=risk-free rate

βi​=beta of the investment

ERm​−Rf​)=market risk premium​

For vetting equity investments, the correct risk-free rate benchmark is a default risk free rate (US debt ceiling a separate write up) such as 90 day T-bills, which currently yield 4.595%.

A 10 year project would benchmark the 10 year UST as the risk-free rate which currently yields 3.4%. The yield curve is > 1.00% or 100bp inverted, often taken as a signal of an impending recession (unknown timing and magnitude). A “normal” yield curve is upward sloping. Various factors of the term structure of interest rates dictate such (liquidity, preferred habitat).

The current equity risk premium (ERP) is approx. 5.4% (3-9% range noted in the graph above).

The beta of the market portfolio is by definition = 1.0.

$VFIFX Vanguard’s 2050 target date fund has a beta of 1.35.

Running this through the simple 1-factor CAPM formula nets a required rate of return on $VFIFX of 11.89% (4.595+1.35*5.4). Vanguard 2050 has returned 7.20% annually since 06/07/2006. Over very long period of time does a 37% allocation to international stocks make sense? 100%. Based on global GDP weighting one could even justify a 37% allocation to emerging markets (38% of Global GDP of $88tln presently). Caveat is EM is exposed to high energy prices (net importers). EM have taken on a lot of USD debt since the 2007 GFC. A softening DXY takes the sting out of this servicing headache for the moment, but many expect a spate of defaults as sticky structural inflation remains above global policy goals. China re-opening from a multi year slumber and have resumed vacuuming key global commodities, with higher prices all but assured.

$VFIFX is up just over 9% ytd in 2023 (through Feb 2nd, time of writing). Can this fund hold these gains through 2023 and potentially add in the face of an ongoing war in Europe, and global central banks draining the watering hole? I would bet not, and adjust my asset allocation accordingly.

$SPY, the oldest (30 year 1/23) and biggest $355bln AUM has a beta of 1, hence a required rate of return of 10% in comparison. The S&P is up 9% ytd in 2023, recouping 1/2 of 2022’s losses.

I have outlined how $VFMXX nets you 4.32% (spot yield, within 20bp of 90 day bills).

Do not be a sheep and run headlong into this sheering (slaughter?) passive investing machine. Most fund complexes allow for tactical asset allocation changes for free with some periodicity (i.e. qtly). Side-stepping a large equity draw-down can have a huge effect on long term return. Being out of the market for even a short period of time can also be a disaster. Timing the re-entry is key. The good news is you net > 4% while you wait. When global rates were pegged at the zero bound, being in risk free assets were meant to be punitive and hurt. Powell has promise pain, and he has the tools to inflict it. The market is choosing to ignore the dangers that lurk at the shrinking watering hole.

Nominal risk-free yields approaching 5% are a salve for hot sands (price risk) and meagre returns.

Remain diligent in your financial matters.

Caleb Gibbons, CFA (The Other Prof G)