What is the easiest, most efficient way to buy the global “agnostic” portfolio? Can you suggest some combination of ETFs (or other vehicles) that would do it? Should FDIC-insured savings accounts and/or CDs also be part of the portfolio? (It seems to be a good deal because the federal government is essentially subsidizing them by providing an implicit guarantee that you won’t lose money even if the FDIC exhausts its reserves.)
14% 30 year bonds
14% 10 year foreign bonds
There was some recent relevant discussion under one of Paul Christiano’s FB posts, which suggests that buying government bonds may not be a good idea unless one needs the unique features they offer (and I think most of us probably don’t?):
At a broad level, our evidence is consistent with theories that ascribe a unique value to government debt.
Bansal and Coleman (1996) present a theory in which debt, but not equity claims, are money-like and carry
a convenience value. They argue that the theory can account for the high average equity premium and low
average risk-free rate in the US.4 Our finding of a unique value provided by government debt relative to
private debt support theories such as Woodford (1990), Holmstrom and Tirole (1998), and Caballero and
Krishnamurthy (2006). In these papers, the government’s credibility gives its securities unique collateral and
liquidity features relative to private assets and thereby induces a premium on government assets.
Finally, how would this discussion change if say about every 10 years there was an opportunity to 10x your investment at the cost of .5 probability of it going to 0? (For context see this and this.)
There are a few ways to get something close to the global market portfolio, although they all require making small compromises. Betterment and Wealthfront will give you something like the global market, but each have skews that push them somewhat away from it. The ETF GAA holds the global market portfolio with small tilts toward value and momentum—I happen to think these tilts are a good idea, but it does move it somewhat away from a truly agnostic portfolio.
You could also buy a combination of VT, BND, and BNDX, which will give you the total market in stocks and bonds, although this does exclude smaller asset classes like gold.
Out of these options, I personally would probably invest in GAA, but which is best depends on which compromises you’re most willing to make. (I personally don’t invest in the global market portfolio, I just invest in VMOT and EQCHX, as discussed in OP.)
RE government bonds: in theory, if you want to increase risk, you should hold equities and bonds in proportion to the global market portfolio and then apply leverage as desired. But this theory assumes you can borrow money at the risk-free rate, which is false. To use leverage, you will probably end up having to pay about 1% on top of short-term interest rates, and given how small the spread is between short- and long-term rates, holding bonds with leverage guarantees you a negative long-run return. For that reason, I personally do not hold any bonds.
But note that it’s still possible to make positive return with bonds in the short run. For example, bonds have returned >10% over the past few months, so holding stocks+bonds with leverage would have worked out better than just holding stocks.
RE your last point on special opportunities: I think that’s a really important question, and I don’t know how to answer it. I don’t know how to reconcile the general observation that almost everybody fails to beat the market with certain special cases, e.g., bitcoin like you mentioned. You invested in bitcoin in 2011; I considered investing around the same time, but didn’t, in short because I didn’t expect to be able to beat the market. Clearly I should have invested in bitcoin, but I don’t know of any general strategy that would have led to me investing in bitcoin but wouldn’t have led to me making a bunch of other stupid investing decisions. How do you think it is that you have invested in 2-3 money-making special opportunities? What distinguishes those from other, similar-looking opportunities that failed? Have you made any special investments that didn’t pan out?
Thanks for your answers! I think I’ll probably stick with broad indexes, since as you said investing in factors and managed futures can dramatically underperform the broader market in short time horizons and it will be hard to convince myself that it’s a good idea to hold onto them. (This actually happened to me recently. I found a small factor-based investment in my portfolio, saw that it underperformed and couldn’t remember the original reason for buying it, so I sold it. Oh, it was also because I needed to raise cash to buy puts and that investment had the lowest or negative capital gains.)
My biggest question currently is about international equities. Looking at historical data it seems that international equities have underperformed (had worse Sharpe ratio than) the US while being strongly correlated with it in recent decades (which made me want to have 9:1 ratio of US to international exposure, as I said in the above FB thread), but a source you cited is predicting much better performance in the future, to the extent that they’re recommending 0% exposure to US equities(!) and mostly EM exposure which is super surprising to me. Can you summarize or link to a summary of why they think that?
What distinguishes those from other, similar-looking opportunities that failed?
I don’t have a good answer for this. Basically those opportunities just kind of came to me, and I haven’t really had to do much to try to filter out other, similar-looking but actually less promising opportunities. I think I just thought about each opportunity for a few days and invested after still thinking it was a good idea.
Have you made any special investments that didn’t pan out?
During the dot-com bubble I tried stock picking, which didn’t work out. Recently I put some time/reputation (but no money) into a cryptocurrency startup which didn’t go anywhere. I can’t recall anything else. But there was another investment that did work out in the 10-100x range that I haven’t mention yet, which is that shortly after college I took a year off from work to write a piece of software (Windows SSH server, which didn’t exist on the market when I started), then handed it to a partner to develop/sell/manage (while I went back to work for another company) and within about 5 years it started throwing off enough income that I could “retire”.
ETA: Oh, I also worked at a couple of startups that compensated partly in stock options that later became worthless.
RE international equities, I wrote about this here to explain why I think most people should underweight US equities.
Looking at historical data it seems that international equities have underperformed
First, if EMH is true, there is no reason to expect US equities to have a higher Sharpe ratio than international equities.
Second, US outperformance is only a recent phenomenon (see this tweet and its replies), and the outperformance is pretty marginal if you look over a long time horizon.
Third, the recent US outperformance is the exact reason why Research Affiliates (RAFI) projects worse returns in the future. The US stock market has outpaced its economic growth, so RAFI is counting on valuations to revert to the mean. There’s a lot of historical evidence that markets tend to mean revert like this over sufficiently long time horizons (3-5 years or longer). I haven’t read any of the primary research on long-term mean reversion, but apparently the original source was Jegadeesh and Titman (1993), and data is available from the Ken French Data Library (see “6 Portfolios Formed on Size and Long-Term Reversal”).
(I cited RAFI for expected return projections, but the analysis is pretty easy to replicate. Just use the discounted dividend model and add in an assumption that P/E ratios will partially mean revert.)
I don’t see where RAFI recommends holding 0% exposure to US equities?
RE international equities, I wrote about this here to explain why I think most people should underweight US equities.
A large part of your argument is that one’s salaries come from a US source, which doesn’t apply to me (the company that provides most of my income has a pretty international revenue source). Also, as I mentioned in the FB thread linked above, US and international equities have become highly correlated in recent decades so using international equities to provide diversification against US economy tanking will not have much effect.
First, if EMH is true, there is no reason to expect US equities to have a higher Sharpe ratio than international equities.
EMH probably isn’t true across national boundaries, due to “equity home bias”. The US could have a higher Sharpe ratio because of that in combination with things like lower savings rate (higher time preference), better monetary policies (or more cost-effective policies due to reserve currency status), better governance (it seems terrible to me but perhaps still better than most other countries?), sole superpower status (allowing its companies to extract rent across the global with fewer political consequences), etc.
Second, US outperformance is only a recent phenomenon (see this tweet and its replies), and the outperformance is pretty marginal if you look over a long time horizon.
The tweet says outperformance was after 2009, so I asked Portfolio Visualizer to maximize Sharpe ratio based on pre-2009 data, and it says to allocate 8.31% to “Global ex-US Stock Market”, but that drops to 0% if I allow it to include “Total US Bond Market” (in which case it says 11% US stocks 89% US bonds). If I also add “Global Bonds (Unhedged)” it says to include 4.38% of that but still 0% of international equities.
add in an assumption that P/E ratios will partially mean revert
“This expensing of intangibles, leading to their absence from book values, started to have a major effect on financial data (book values, earnings) from the late 1980s, due to the growth of corporate investment in intangibles,” they wrote. Speaking to II, Lev explains that this “madness of accounting” has dragged down the performance of value investors ever since.
“All the important investments like R&D and IT are immediately expensed, and people are left with highly misleading ideas about profitability and about value,” he says. “Especially with respect to small companies and medium companies that are not followed by a lot of financial analysts and not written up by the media, people rely on the financial reports. And they are terrible.”
I don’t see where RAFI recommends holding 0% exposure to US equities?
I think it’s pretty dangerous to reason “asset X has outperformed recently, so I expect it to outperform in the future.” An asset can outperform because it’s becoming more expensive, which I think is partly the case here.
This is most obvious in the case of bonds—if 30-year bonds from A are yielding 2%/year and then fall to 1.5%/year over a decade, while 30-year bonds from B are yielding 2%/year and stay at 2%/year, then it will look like the bonds from A are performing about twice as well over the decade. But this is a very bad reason to invest in A. It’s anti-inductive not only because of EMH but for the very simple reason that return chasing leads you to buy high and sell low.
This is less straightforward with equities because earnings accounting is (much) less transparent than bond yields, but I think it’s a reasonable first pass guess about what’s going on (combined with some legitimate update about people becoming more pessimistic about corporate performance/governance/accounting outside of the US). Would be interested in any data contradicting this picture.
I do think that international equities will do worse than US equities after controlling for on-paper earnings. But they have significantly higher on-paper earnings, and I don’t really see how to take a bet about which of these effects is larger without getting into way more nitty gritty about exactly what mistake we think which investors are making. If I had to guess I’d bet that US markets are salient to investors in many countries and their recent outperformance has made many people overweight them, so that they will very slightly underperform. But I’d be super interested in good empirical evidence on this front too.
(The RAFI estimates generally look a bit unreasonable to me, and I don’t know of an empirical track record or convincing analysis that would make me like them more.)
I personally just hold the market portfolio. So I’m guaranteed to outperform the average of you and Michael Dickens, though I’m not sure which one of you is going to do better than me and which one is going to do worse.
Thanks for engaging on this. I’ve been having trouble making up my mind about international equities, which is delaying my plan to leverage up (while hedging due to current market conditions), and it really helps to have someone argue the other side to make sure I’m not missing something.
This is most obvious in the case of bonds—if 30-year bonds from A are yielding 2%/year and then fall to 1.5%/year over a decade, while 30-year bonds from B are yielding 2%/year and stay at 2%/year, then it will look like the bonds from A are performing about twice as well over the decade. But this is a very bad reason to invest in A. It’s anti-inductive not only because of EMH but for the very simple reason that return chasing leads you to buy high and sell low.
Assuming EMH, A’s yield would only have fallen if it has become less risky, so buying A isn’t actually bad, unless also buying B provides diversification benefits. Applying this to stocks, we can say that under EMH buying only US stocks has no downsides unless international equities provide diversification benefits, and since they have been highly correlated in recent decades (after about 1990) we lose very little by buying only US stocks.
Of course in the long run this high correlation between US and international equities can’t last forever, but it seems to change slowly enough over time that I can just diversify into international equities when it looks like they’ve started to decorrelate.
If I had to guess I’d bet that US markets are salient to investors in many countries and their recent outperformance has made many people overweight them, so that they will very slightly underperform. But I’d be super interested in good empirical evidence on this front too.
US stock is 35% owned by non-US investors as of 2018 and had been going up recently. Meantime non-US stock is probably >90% owned by non-US investors (not sure how to find the data directly, but US investors only have 10% international equities in their stock portfolio). My interpretation is that non-US investors are still under-weighing US stocks but have reduced their bias recently and this contributed to US outperformance, and the trend can continue for a while longer before petering out.
A lot of my thinking here comes from observing that people in places like China have much higher savings rates, but it’s a big hassle at best for them to invest in US stocks (due to anti-money laundering and tax laws) and many have just never even thought in that direction, so international investment opportunities have been exhausted to a greater degree than US ones, and the data seems consistent with this.
Let me know if the above convinces you to move in my direction. If not, I might move to a 4:1 ratio of US to international equities exposure instead of 9:1.
I personally just hold the market portfolio.
BTW while looking for data, I came across this article which seems relevant here, although I’m not totally sure their reasoning is correct. I’m confused about how to reason about “market portfolio” or “properly balanced portfolio” in a world with strong “home bias” and “controlling shareholders”.
But in Corporate Governance and the Home Bias (NBER Working Paper No. 8680), authors Lee Pinkowitz, Rene Stulz, and Rohan Williamson assert that at least some of the oft-noted tilt is not a bias at all but simply a reflection of the fact that a sizeable number of shares worldwide are not for sale to the average investor. They find that comparisons of U.S. portfolios to the world market for equities have failed to consider that the “controlling shareholders” who dominate many a foreign corporation do not make their substantial holdings available for normal trading.
Take this into account, the authors argue, and as much as half of the home bias disappears. A more accurate assessment of globally available shares, they say, would show that about 67 percent of a properly balanced U.S. portfolio would be invested in U.S. companies.
I’m surprised by (and suspicious of) the claim about so many more international shares being non-tradeable, but it would change my view.
I would guess the savings rate thing is relatively small compared to the fact that a much larger fraction of US GDP is inevestable in the stock market—the US is 20-25% of GDP, but the US is 40% of total stock market capitalization and I think US corporate profits are also ballpark 40% of all publicly traded corporate profits. So if everyone saved the same amount and invested in their home country, US equities would be too cheap.
I agree that under EMH the two bonds A and B are basically the same, so it’s neutral. But it’s a prima facie reason that A is going to perform worse (not a prima facie reason it will perform better) and it’s now pretty murky whether the market is going to err one way or the other.
I’m still pretty skeptical of US equities outperforming, but I’ll think about it more.
I haven’t thought about the diversification point that much. I don’t think that you can just use the empirical daily correlations for the purpose of estimating this, but maybe you can (until you observe them coming apart). It’s hard to see how you can be so uncertain about the relative performance of A and B, but still think they are virtually perfectly correlated (but again, that may just be a misleading intuition). I’m going to spend a bit of time with historical data to get a feel for this sometime and will postpone judgment until after doing that.
Wei Dai has recently been looking into box spread financing which were around 0.55% for 3 years, 0.3% above the short-term treasury rate.
If you have a large account, interactive brokers charges benchmark+0.3% interest.
I suspect risk-free + 0.3% is basically the going rate, though I also wouldn’t be too surprised if a leveraged ETF could get a slightly better rate.
If you are leveraging as much as described in this post, it seems reasonably important to get at least an OK rate. 1% overhead is large enough that it claws back a significant fraction of the value from leverage (at least if you use more realistic return estimates).
Side note on tax considerations of financing methods (for investing in taxable accounts):
With futures you are forced to realize capital gains or losses at the end of every year even if you hold the futures longer than that.
With either box spread financing or margin loans, if you buy and hold investments that rise in value, you don’t have to realize capital gains and can avoid paying capital gains taxes on them altogether if you donate those investments later.
With box spread financing, the interest you pay appears in the form of capital losses (upon expiration of the box spread options, in other words the loan), which you can use to offset your capital gains if you have any, but can’t reduce your other taxable income such as dividend or interest income (except by a small fixed amount each year).
With margin loans, your interest expense is tax deductible but you have to itemize deductions (which means you give up your standard deductions).
With futures, the interest you “pay” is baked into the amount of capital gains/losses you end up with.
I think (assuming the same implicit/explicit interest rates for all 3 financing methods) for altruists investing in taxable accounts, this means almost certainly avoiding futures, and considering going with margin loans over box spread financing if you have significant interest expenses and don’t have a lot of realized capital gains each year that you can offset. (Note that currently, possibly for a limited time, it’s possible to lock in a 2.7-year interest rate using box options, around .6%, that is lower than IB’s minimum interest rate, .75%, so the stated assumption doesn’t hold.)
I haven’t done a deep dive on this but I think futures are better than this analysis makes them look.
Suppose that I’m in the top bracket and pay 23% taxes on futures, and that my ideal position is 2x SPY.
In a tax-free account I could buy SPY and 1x SPY futures, to get (2x SPY − 1x interest).
In a taxable account I can buy 1x SPY and 1.3x SPY futures. Then my after-tax expected return is again (2x SPY − 1x interest).
The catch is that if I lose money, some of my wealth will take the form of taxable losses that I can use to offset gains in future years. This has a small problem and a bigger problem:
Small problem: it may be some years before I can use up those taxable losses. So I’ll effectively pay interest on the money over those years. If real rates were 2% and I had to wait 5 years on average to return to my high-water mark, then this would be an effective tax rate of (2% * 5 years) * (23%) ~ 2.3%. I think that’s conservative, and this is mostly negligible.
Large problem: if the market goes down enough, I could be left totally broke, and my taxable losses won’t do me any good. In particular, if the market went down 52%, then my 2x leveraged portfolio should be down to around 23% of my original net worth, but that will entirely be in the form of taxable losses (losing $100 is like getting a $23 grant, to be redeemed only once I’ve made enough taxable gains).
So I can’t just treat my taxable losses as wealth for the purpose of computing leverage. I don’t know exactly what the right strategy is, it’s probably quite complicated.
The simplest solution is to just ignore them when setting my desired level of leverage. If you do that, and are careful about rebalancing, it seems like you shouldn’t lose very much to taxes in log-expectation (e.g. if the market is down 50%, I think you’d end up with about half of your desired leverage, which is similar to a 25% tax rate). But I’d like to work it out, since other than this futures seem appealing.
In a taxable account I can buy 1x SPY and 1.3x SPY futures. Then my after-tax expected return is again (2x SPY − 1x interest).
The catch is that if I lose money, some of my wealth will take the form of taxable losses that I can use to offset gains in future years.
This is a really interesting and counterintuitive idea, that I really like, but after thinking about it a lot, decided probably does not work. Here’s my argument. For simplicity let’s assume that I know for sure I’m going to die in 30 years[1] and I’m planning to donate my investment to a tax-exempt org at that point, and ignore dividends[2]. First, the reason I’m able to get a better expected return buying stocks instead of a 30-year government bond is that the market is compensating me for the risk that stocks will be worth less than the 30-year government bond at the end of 30 years. If that happens, I’m left with 0.3x more losses by buying 1.3x futures instead of 1x stock, but the tax offset I incurred is worth nothing because they go away when I die so they don’t compensate me for the extra losses. (I don’t think there’s a way to transfer them to another person or entity?) So (compared to leveraged buy-and-hold) the futures strategy gives you equal gains if stocks do better than risk free return, but is 0.3x worse if stocks do worse than risk free return. Therefore leveraged buy-and-hold does seem to represent a significant free lunch (ultimately coming out of government pockets) compared to futures.
ETA: The situation is actually worse than this because there’s a significant risk that during the 30 years the market first rises and then falls, so I end up paying taxes on capital gains during the rise, that later become taxable losses that become worthless when I die.
ETA2: To summarize/restate this in a perhaps more intuitive way, comparing 1x stocks with 1x futures, over the whole investment period stocks give you .3x more upside potential and the same or lower downside risk.
[1] Are you perhaps assuming that you’ll almost certainly live much longer than that?
[2] Re: dividends, my understanding is that equity futures are a pure bet on stock prices and ignore dividends, but buying ETFs obviously does give you dividends, so (aside from taxes) equity futures actually represent a different risk/return profile compared to buying index ETFs. I’m not sure how to think about this, e.g., can we still treat SPY and SPX futures as nearly identical (aside from taxes), and which is a better idea overall if we do take both dividends and taxes into account?
What is the easiest, most efficient way to buy the global “agnostic” portfolio? Can you suggest some combination of ETFs (or other vehicles) that would do it? Should FDIC-insured savings accounts and/or CDs also be part of the portfolio? (It seems to be a good deal because the federal government is essentially subsidizing them by providing an implicit guarantee that you won’t lose money even if the FDIC exhausts its reserves.)
There was some recent relevant discussion under one of Paul Christiano’s FB posts, which suggests that buying government bonds may not be a good idea unless one needs the unique features they offer (and I think most of us probably don’t?):
Finally, how would this discussion change if say about every 10 years there was an opportunity to 10x your investment at the cost of .5 probability of it going to 0? (For context see this and this.)
There are a few ways to get something close to the global market portfolio, although they all require making small compromises. Betterment and Wealthfront will give you something like the global market, but each have skews that push them somewhat away from it. The ETF GAA holds the global market portfolio with small tilts toward value and momentum—I happen to think these tilts are a good idea, but it does move it somewhat away from a truly agnostic portfolio.
You could also buy a combination of VT, BND, and BNDX, which will give you the total market in stocks and bonds, although this does exclude smaller asset classes like gold.
Out of these options, I personally would probably invest in GAA, but which is best depends on which compromises you’re most willing to make. (I personally don’t invest in the global market portfolio, I just invest in VMOT and EQCHX, as discussed in OP.)
RE government bonds: in theory, if you want to increase risk, you should hold equities and bonds in proportion to the global market portfolio and then apply leverage as desired. But this theory assumes you can borrow money at the risk-free rate, which is false. To use leverage, you will probably end up having to pay about 1% on top of short-term interest rates, and given how small the spread is between short- and long-term rates, holding bonds with leverage guarantees you a negative long-run return. For that reason, I personally do not hold any bonds.
But note that it’s still possible to make positive return with bonds in the short run. For example, bonds have returned >10% over the past few months, so holding stocks+bonds with leverage would have worked out better than just holding stocks.
RE your last point on special opportunities: I think that’s a really important question, and I don’t know how to answer it. I don’t know how to reconcile the general observation that almost everybody fails to beat the market with certain special cases, e.g., bitcoin like you mentioned. You invested in bitcoin in 2011; I considered investing around the same time, but didn’t, in short because I didn’t expect to be able to beat the market. Clearly I should have invested in bitcoin, but I don’t know of any general strategy that would have led to me investing in bitcoin but wouldn’t have led to me making a bunch of other stupid investing decisions. How do you think it is that you have invested in 2-3 money-making special opportunities? What distinguishes those from other, similar-looking opportunities that failed? Have you made any special investments that didn’t pan out?
Thanks for your answers! I think I’ll probably stick with broad indexes, since as you said investing in factors and managed futures can dramatically underperform the broader market in short time horizons and it will be hard to convince myself that it’s a good idea to hold onto them. (This actually happened to me recently. I found a small factor-based investment in my portfolio, saw that it underperformed and couldn’t remember the original reason for buying it, so I sold it. Oh, it was also because I needed to raise cash to buy puts and that investment had the lowest or negative capital gains.)
Some discussions I’ve had on Facebook recently (after writing my question here) that you may find interesting: international equities, cheap leverage, dynamic leverage, bonds, bankruptcy risk
My biggest question currently is about international equities. Looking at historical data it seems that international equities have underperformed (had worse Sharpe ratio than) the US while being strongly correlated with it in recent decades (which made me want to have 9:1 ratio of US to international exposure, as I said in the above FB thread), but a source you cited is predicting much better performance in the future, to the extent that they’re recommending 0% exposure to US equities(!) and mostly EM exposure which is super surprising to me. Can you summarize or link to a summary of why they think that?
I don’t have a good answer for this. Basically those opportunities just kind of came to me, and I haven’t really had to do much to try to filter out other, similar-looking but actually less promising opportunities. I think I just thought about each opportunity for a few days and invested after still thinking it was a good idea.
During the dot-com bubble I tried stock picking, which didn’t work out. Recently I put some time/reputation (but no money) into a cryptocurrency startup which didn’t go anywhere. I can’t recall anything else. But there was another investment that did work out in the 10-100x range that I haven’t mention yet, which is that shortly after college I took a year off from work to write a piece of software (Windows SSH server, which didn’t exist on the market when I started), then handed it to a partner to develop/sell/manage (while I went back to work for another company) and within about 5 years it started throwing off enough income that I could “retire”.
ETA: Oh, I also worked at a couple of startups that compensated partly in stock options that later became worthless.
RE international equities, I wrote about this here to explain why I think most people should underweight US equities.
First, if EMH is true, there is no reason to expect US equities to have a higher Sharpe ratio than international equities.
Second, US outperformance is only a recent phenomenon (see this tweet and its replies), and the outperformance is pretty marginal if you look over a long time horizon.
Third, the recent US outperformance is the exact reason why Research Affiliates (RAFI) projects worse returns in the future. The US stock market has outpaced its economic growth, so RAFI is counting on valuations to revert to the mean. There’s a lot of historical evidence that markets tend to mean revert like this over sufficiently long time horizons (3-5 years or longer). I haven’t read any of the primary research on long-term mean reversion, but apparently the original source was Jegadeesh and Titman (1993), and data is available from the Ken French Data Library (see “6 Portfolios Formed on Size and Long-Term Reversal”).
(I cited RAFI for expected return projections, but the analysis is pretty easy to replicate. Just use the discounted dividend model and add in an assumption that P/E ratios will partially mean revert.)
I don’t see where RAFI recommends holding 0% exposure to US equities?
A large part of your argument is that one’s salaries come from a US source, which doesn’t apply to me (the company that provides most of my income has a pretty international revenue source). Also, as I mentioned in the FB thread linked above, US and international equities have become highly correlated in recent decades so using international equities to provide diversification against US economy tanking will not have much effect.
EMH probably isn’t true across national boundaries, due to “equity home bias”. The US could have a higher Sharpe ratio because of that in combination with things like lower savings rate (higher time preference), better monetary policies (or more cost-effective policies due to reserve currency status), better governance (it seems terrible to me but perhaps still better than most other countries?), sole superpower status (allowing its companies to extract rent across the global with fewer political consequences), etc.
The tweet says outperformance was after 2009, so I asked Portfolio Visualizer to maximize Sharpe ratio based on pre-2009 data, and it says to allocate 8.31% to “Global ex-US Stock Market”, but that drops to 0% if I allow it to include “Total US Bond Market” (in which case it says 11% US stocks 89% US bonds). If I also add “Global Bonds (Unhedged)” it says to include 4.38% of that but still 0% of international equities.
From https://www.institutionalinvestor.com/article/b1j0mvcy9792vt/Why-Value-Investing-Sucks:
“This expensing of intangibles, leading to their absence from book values, started to have a major effect on financial data (book values, earnings) from the late 1980s, due to the growth of corporate investment in intangibles,” they wrote. Speaking to II, Lev explains that this “madness of accounting” has dragged down the performance of value investors ever since.
“All the important investments like R&D and IT are immediately expensed, and people are left with highly misleading ideas about profitability and about value,” he says. “Especially with respect to small companies and medium companies that are not followed by a lot of financial analysts and not written up by the media, people rely on the financial reports. And they are terrible.”
On https://interactive.researchaffiliates.com/asset-allocation#!/?category=Efficient¤cy=USD&model=ER&scale=LINEAR&selected=160&terms=REAL&type=Portfolios, on the left side-bar click on “Efficient” to expand it, click on “14.0% Volatility” or any other one there, on the right side-bar click on “Equities” to expand it, and it says 0.0% for “US Large” and “US Small”.
I think it’s pretty dangerous to reason “asset X has outperformed recently, so I expect it to outperform in the future.” An asset can outperform because it’s becoming more expensive, which I think is partly the case here.
This is most obvious in the case of bonds—if 30-year bonds from A are yielding 2%/year and then fall to 1.5%/year over a decade, while 30-year bonds from B are yielding 2%/year and stay at 2%/year, then it will look like the bonds from A are performing about twice as well over the decade. But this is a very bad reason to invest in A. It’s anti-inductive not only because of EMH but for the very simple reason that return chasing leads you to buy high and sell low.
This is less straightforward with equities because earnings accounting is (much) less transparent than bond yields, but I think it’s a reasonable first pass guess about what’s going on (combined with some legitimate update about people becoming more pessimistic about corporate performance/governance/accounting outside of the US). Would be interested in any data contradicting this picture.
I do think that international equities will do worse than US equities after controlling for on-paper earnings. But they have significantly higher on-paper earnings, and I don’t really see how to take a bet about which of these effects is larger without getting into way more nitty gritty about exactly what mistake we think which investors are making. If I had to guess I’d bet that US markets are salient to investors in many countries and their recent outperformance has made many people overweight them, so that they will very slightly underperform. But I’d be super interested in good empirical evidence on this front too.
(The RAFI estimates generally look a bit unreasonable to me, and I don’t know of an empirical track record or convincing analysis that would make me like them more.)
I personally just hold the market portfolio. So I’m guaranteed to outperform the average of you and Michael Dickens, though I’m not sure which one of you is going to do better than me and which one is going to do worse.
Thanks for engaging on this. I’ve been having trouble making up my mind about international equities, which is delaying my plan to leverage up (while hedging due to current market conditions), and it really helps to have someone argue the other side to make sure I’m not missing something.
Assuming EMH, A’s yield would only have fallen if it has become less risky, so buying A isn’t actually bad, unless also buying B provides diversification benefits. Applying this to stocks, we can say that under EMH buying only US stocks has no downsides unless international equities provide diversification benefits, and since they have been highly correlated in recent decades (after about 1990) we lose very little by buying only US stocks.
Of course in the long run this high correlation between US and international equities can’t last forever, but it seems to change slowly enough over time that I can just diversify into international equities when it looks like they’ve started to decorrelate.
US stock is 35% owned by non-US investors as of 2018 and had been going up recently. Meantime non-US stock is probably >90% owned by non-US investors (not sure how to find the data directly, but US investors only have 10% international equities in their stock portfolio). My interpretation is that non-US investors are still under-weighing US stocks but have reduced their bias recently and this contributed to US outperformance, and the trend can continue for a while longer before petering out.
A lot of my thinking here comes from observing that people in places like China have much higher savings rates, but it’s a big hassle at best for them to invest in US stocks (due to anti-money laundering and tax laws) and many have just never even thought in that direction, so international investment opportunities have been exhausted to a greater degree than US ones, and the data seems consistent with this.
Let me know if the above convinces you to move in my direction. If not, I might move to a 4:1 ratio of US to international equities exposure instead of 9:1.
BTW while looking for data, I came across this article which seems relevant here, although I’m not totally sure their reasoning is correct. I’m confused about how to reason about “market portfolio” or “properly balanced portfolio” in a world with strong “home bias” and “controlling shareholders”.
I’m surprised by (and suspicious of) the claim about so many more international shares being non-tradeable, but it would change my view.
I would guess the savings rate thing is relatively small compared to the fact that a much larger fraction of US GDP is inevestable in the stock market—the US is 20-25% of GDP, but the US is 40% of total stock market capitalization and I think US corporate profits are also ballpark 40% of all publicly traded corporate profits. So if everyone saved the same amount and invested in their home country, US equities would be too cheap.
I agree that under EMH the two bonds A and B are basically the same, so it’s neutral. But it’s a prima facie reason that A is going to perform worse (not a prima facie reason it will perform better) and it’s now pretty murky whether the market is going to err one way or the other.
I’m still pretty skeptical of US equities outperforming, but I’ll think about it more.
I haven’t thought about the diversification point that much. I don’t think that you can just use the empirical daily correlations for the purpose of estimating this, but maybe you can (until you observe them coming apart). It’s hard to see how you can be so uncertain about the relative performance of A and B, but still think they are virtually perfectly correlated (but again, that may just be a misleading intuition). I’m going to spend a bit of time with historical data to get a feel for this sometime and will postpone judgment until after doing that.
The Institutional Investor hyperlink is broken. Here’s one that works: https://www.institutionalinvestor.com/article/b1j0mvcy9792vt/Why-Value-Investing-Sucks
Not a huge deal, but it seems like the typical overhead is about 0.3%:
This seems to be the implicit rate I pay if I buy equity futures rather than holding physical equities (a historical survey: http://cdar.berkeley.edu/wp-content/uploads/2016/12/futures-gunther-etal-111616.pdf , though you can also check yourself for a particular future you are considering buying, the main complication is factoring in dividend prices)
Wei Dai has recently been looking into box spread financing which were around 0.55% for 3 years, 0.3% above the short-term treasury rate.
If you have a large account, interactive brokers charges benchmark+0.3% interest.
I suspect risk-free + 0.3% is basically the going rate, though I also wouldn’t be too surprised if a leveraged ETF could get a slightly better rate.
If you are leveraging as much as described in this post, it seems reasonably important to get at least an OK rate. 1% overhead is large enough that it claws back a significant fraction of the value from leverage (at least if you use more realistic return estimates).
Side note on tax considerations of financing methods (for investing in taxable accounts):
With futures you are forced to realize capital gains or losses at the end of every year even if you hold the futures longer than that.
With either box spread financing or margin loans, if you buy and hold investments that rise in value, you don’t have to realize capital gains and can avoid paying capital gains taxes on them altogether if you donate those investments later.
With box spread financing, the interest you pay appears in the form of capital losses (upon expiration of the box spread options, in other words the loan), which you can use to offset your capital gains if you have any, but can’t reduce your other taxable income such as dividend or interest income (except by a small fixed amount each year).
With margin loans, your interest expense is tax deductible but you have to itemize deductions (which means you give up your standard deductions).
With futures, the interest you “pay” is baked into the amount of capital gains/losses you end up with.
I think (assuming the same implicit/explicit interest rates for all 3 financing methods) for altruists investing in taxable accounts, this means almost certainly avoiding futures, and considering going with margin loans over box spread financing if you have significant interest expenses and don’t have a lot of realized capital gains each year that you can offset. (Note that currently, possibly for a limited time, it’s possible to lock in a 2.7-year interest rate using box options, around .6%, that is lower than IB’s minimum interest rate, .75%, so the stated assumption doesn’t hold.)
I haven’t done a deep dive on this but I think futures are better than this analysis makes them look.
Suppose that I’m in the top bracket and pay 23% taxes on futures, and that my ideal position is 2x SPY.
In a tax-free account I could buy SPY and 1x SPY futures, to get (2x SPY − 1x interest).
In a taxable account I can buy 1x SPY and 1.3x SPY futures. Then my after-tax expected return is again (2x SPY − 1x interest).
The catch is that if I lose money, some of my wealth will take the form of taxable losses that I can use to offset gains in future years. This has a small problem and a bigger problem:
Small problem: it may be some years before I can use up those taxable losses. So I’ll effectively pay interest on the money over those years. If real rates were 2% and I had to wait 5 years on average to return to my high-water mark, then this would be an effective tax rate of (2% * 5 years) * (23%) ~ 2.3%. I think that’s conservative, and this is mostly negligible.
Large problem: if the market goes down enough, I could be left totally broke, and my taxable losses won’t do me any good. In particular, if the market went down 52%, then my 2x leveraged portfolio should be down to around 23% of my original net worth, but that will entirely be in the form of taxable losses (losing $100 is like getting a $23 grant, to be redeemed only once I’ve made enough taxable gains).
So I can’t just treat my taxable losses as wealth for the purpose of computing leverage. I don’t know exactly what the right strategy is, it’s probably quite complicated.
The simplest solution is to just ignore them when setting my desired level of leverage. If you do that, and are careful about rebalancing, it seems like you shouldn’t lose very much to taxes in log-expectation (e.g. if the market is down 50%, I think you’d end up with about half of your desired leverage, which is similar to a 25% tax rate). But I’d like to work it out, since other than this futures seem appealing.
This is a really interesting and counterintuitive idea, that I really like, but after thinking about it a lot, decided probably does not work. Here’s my argument. For simplicity let’s assume that I know for sure I’m going to die in 30 years[1] and I’m planning to donate my investment to a tax-exempt org at that point, and ignore dividends[2]. First, the reason I’m able to get a better expected return buying stocks instead of a 30-year government bond is that the market is compensating me for the risk that stocks will be worth less than the 30-year government bond at the end of 30 years. If that happens, I’m left with 0.3x more losses by buying 1.3x futures instead of 1x stock, but the tax offset I incurred is worth nothing because they go away when I die so they don’t compensate me for the extra losses. (I don’t think there’s a way to transfer them to another person or entity?) So (compared to leveraged buy-and-hold) the futures strategy gives you equal gains if stocks do better than risk free return, but is 0.3x worse if stocks do worse than risk free return. Therefore leveraged buy-and-hold does seem to represent a significant free lunch (ultimately coming out of government pockets) compared to futures.
ETA: The situation is actually worse than this because there’s a significant risk that during the 30 years the market first rises and then falls, so I end up paying taxes on capital gains during the rise, that later become taxable losses that become worthless when I die.
ETA2: To summarize/restate this in a perhaps more intuitive way, comparing 1x stocks with 1x futures, over the whole investment period stocks give you .3x more upside potential and the same or lower downside risk.
[1] Are you perhaps assuming that you’ll almost certainly live much longer than that?
[2] Re: dividends, my understanding is that equity futures are a pure bet on stock prices and ignore dividends, but buying ETFs obviously does give you dividends, so (aside from taxes) equity futures actually represent a different risk/return profile compared to buying index ETFs. I’m not sure how to think about this, e.g., can we still treat SPY and SPX futures as nearly identical (aside from taxes), and which is a better idea overall if we do take both dividends and taxes into account?
Outdated infographic of global market sizes:
https://www.claconnect.com/-/media/cla-image-repository/general/illustrations_and_objects/the-investable-universe.jpg
Coincidentally, I asked this question here a couple of months before your comment and got some useful answers.