Sunday, January 6, 2013

Bill Gross and CCI - Agree then Disagree

The holidays provided CCI a chance to catch up in some general reading of the financial press. One item readers might find worthy of reading in its entirety is Bill Gross (of Pimco) December Investment Insight letter. It can be found here

Overall the article is consistent with his and Pimco's “new normal” view of the world. More specifically, the article provides an excellent description of why deleveraging, globalization, technology, and demographics are macro level forces which could likely mean global GDP may only be 2% for quite awhile. Consequently he concludes that “Investors should expect future annualized bond returns of 3–4% at best and equity returns only a few percentage points higher. “ I agree with Mr. Gross's assessment of the future. If that forecast is accurate, it has dire consequences for investors, as it makes it increasingly unlikely that an individual investor (or even professional investors like pension funds) will ever be able to accumulate enough assets to fund a retirement.

The article then briefly discusses what an investor might do to react to this environment. Specifically, it lists some picks and pans for various asset classes. Generally speaking, this seem like good, traditional, investment advice. However, after very nicely articulating the rationale for a new investment landscape, it is disappointing that these actionable ideas are based only in the traditional components of asset allocation. Perhaps that is not too surprising since Mr. Gross and Pimco are primarily in the business of traditional portfolio management. However, it seems logical that if there is a new macro level environment reality, that investors should think about new ways to generate returns.

Some vehicles and techniques that might be considered by investors preparing for a new normal include:
  • Options – As Warren Buffet has said, speculating in derivatives can be “financial weapons of mass destruction”. Conversely, when used as hedges, options can provide portfolio protection against draw downs and generate income. This is especially true when selling options as opposed to buying them. The volume of options traded in the markets has steadily increased over the years. Someone is increasingly using this vehicle to reconfigure their portfolios. An individual investor not using options might be trying to compete without using all the tools available to them. Hence, individual investors should be determining how they want to utilize options in this new environment.
  • Margin/Leverage - Margin and leverage is a double edged sword that can help or hurt returns.
    Leverage can achieved be achieved via options strategies. Also, with low borrowing costs, perhaps now is one of the best times in history to consider carefully using small amounts of margin as a way to strive to increase return without increasing costs too much. Further with seemingly easier access to portfolio margin accounts an individual investor may have new opportunities to utilize these capabilities.
  • Market Neutral/Long-Short – Rule number one for many investors is don't lose money. This rule has always made sense because big draw downs in portfolios require even a bigger upside moves to get back to even. If overall returns from traditional portfolios are potentially muted in the future, it will even be harder to recover from big losses. That makes rule number one even more important, and that means investors may be well served to place more emphasis on striving to achieve more stable absolute returns. A portfolio configured to try to achieve more stable absolute returns will likely need to deploy some market neutral, long/short oriented strategies in their portfolio,

These techniques, like any other, are not guaranteed to produce the results an investor desires. They also bring with them their own set of risks. Investors deploying these techniques for the first time will have to take the time to learn these areas and find ways to mange the risks they bring. However, the risks of these approaches need to be compared to the risk of achieving traditional investment returns in the forecast of the future that Mr. Grosses suggests. If that forecast is accurate, there is not just a risk, but almost a guarantee, that just deploying traditional portfolio management techniques will not provide sufficient returns to meet long term goals. Hence it seems very risky to be 100% committed to only traditional portfolio theory. If there is a reasonable chance that Mr Gross's forecast is correct then it seem like some reasonable portion of a portfolio should be allocated to techniques that is designed to succeed in that type of environment. Perhaps now is the time individual investors need to learn how to invest in a new way for a new normal. CCI plans to put more focus on these techniques in 2013.

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