By David Snowball

Dear friends,

Welcome to May. May entered English in the 1050s from the Latin Maius, short for Maius mēnsis, “Maia’s month.” But who, you might ask, is Maia? She was a Greek god, eldest of the seven Pleiades, companion of Artemis, and mother of Hermes. The Romans, as was their habit, adopted and repurposed her as a goddess of the green and growing realm.

A long wet stretch in Iowa has me navigating the treacherous passage between Scylla and Charybdis: the siren call of the gardens which has sprung to life without my guidance, and the reality of mud and cold drizzle. I’d been muttering about “rewilding” parts of the yard; apparently, this is the year when nature takes me at my word.

You’re a fool if you invest in Aegis Value (AVALX) because it’s made 18% this year

Aegis Value is a rare and outstanding microcap value fund managed by Scott Barbee. We endorsed the fund in a profile published ages ago at FundAlarm.com and renewed the argument in a 2013 profile at MFO.

It is literally incomparable. Morningstar calculates its active share at 99.95 against the Russell 2000 Value index; as a matter of portfolio content, it has essentially nothing in common with its benchmark. Aegis calculates its active share at 98 against its preferred “Pure Value” index. If you look at funds with long-term returns comparable to Aegis’s, you get a stark sense of how different Mr. Barbee’s portfolio is.

Small cap value funds with the highest 20-year returns (10.3-10.9% APR)

	Average market cap (billions)	Portfolio p/e	Correlation to AVALX
Aegis Value	0.421	6.70	—
Morningstar small value peer	4,240	11.08	81
SPDR S&P 600 SCV ETF	1.89	12.54	79
Undiscovered Managers Behavioral Value	4.55	10.96	77
Invesco Small Cap Value	4.20	11.14	78
Hotchkis & Wiley Small Cap Value	2.61	10.48	80
Bridgeway Ultra-Small Co.	0.158	5.53	76

With the exception of Bridgeway Ultra-Small Company (BRUSX, closed to new investors), the “peer” funds buy stocks that are four-to-ten times larger than Aegis’s and are willing to pay 65% more for the stocks they own.

So why would it be foolish?

First, you can’t buy past returns. You can no more retroactively buy Mr. Barbee’s outstanding 12-month performance than you can now buy the 100% gains made by growth stocks in 2020.

Second, the recent performance is driven by a series of highly idiosyncratic portfolio calls. The current portfolio has huge stakes in energy, materials, and precious metals: 95% of the invested portfolio, compared to 12% of its peers. Nearly 60% of the portfolio are Canadian stocks, with about 10% US equity and 10% cash.

Third, portfolios are given to dramatic ups and given to dramatic downs. Focusing on the former will blind you to the latter. Aegis lost 26% in 2014 and 24% in 2015 before rising 70% in 2017. If you are purchasing because of short-term returns rather than an understanding of the long-term discipline and strategy, you’re going to get blind-sided again: you’ll arrive too late, get slapped, and leave in the midst of the inevitable dramatic reversal.

Fourth, portfolio managers hate “hot money” investors. That would, in this case, be you. They play hob with the manager’s ability to maintain their discipline on behalf of their long-term investors.

If that’s you, do yourself and everyone else a favor by staying away!

You’re a fool if you don’t consider investing in Aegis Value (AVALX)

Mr. Barbee has a nearly unparalleled record for discovering the value in spots where others fear to tread. He defines himself as a contrarian investor, and one of the few pure value investors left after a brutal stretch dominated by the Federal Reserve’s insistence on underwriting indiscriminate risk-taking. (Just saying.) His argument is that equity markets inherently overshoot, both on the downside and the upside, and that this phenomenon is most pronounced in the smallest stocks. His discipline is to buy solid companies when other investors are most disgusted with them and sell those stocks when other investors flock to them.

The problem with the strategy is that his ability to predict how disgusted other investors will be, for how long, is imperfect. So sometimes, he buys at objective “good” prices while the sell-off drives the ultimate price far lower, perhaps for far longer, than he’d anticipated before the inevitable reversion and rebound. Hence, substantial and sometimes sustained downside volatility.

Mr. Barbee’s January 2022 shareholder letter makes a bunch of prescient and powerful arguments:

• Conventional investors, intoxicated on recent returns, have been ignoring increasingly precarious financial conditions
• Bonds and the technology megacaps that have driven recent investor returns may be highly vulnerable to a tumble
• …overvalued tech stocks and long-dated credit sure don’t appear to be the right asset classes to hitch the investment wagon to today, given the current environment and potentially rocky road ahead … they are looking a bit old and more than a little tired.
• Fortunately, not all asset classes are in the same predicament …value stocks globally
• are currently trading at a 51 percent discount to growth stocks on a price-to-earnings basis, the widest since the telecom/media/technology bubble in 2000 … smaller value stocks, and indeed the Aegis Value Fund, are currently trading at historically wide discounts to the S&P 500.
• At the Aegis Value Fund, we have worked to hitch our own wagon to equities that we believe are among the most undervalued in the market today, particularly given the inflationary pressures building in the economy. We currently hold investments with good prospects for appreciation among precious metals mining, lumber and forest products, industrial materials, and energy companies.

We do not know what the future holds. Heck, we’re not even guaranteed a tomorrow. But if you allow for the prospect that inflation might be high and sustained and that broad market averages might end the decade ahead approximately where they began – that is, that “the market” in the aggregate goes nowhere over ten years – then it would be prudent to ask, “what options do I have for real, post-inflation gains?” You might find that answer in the odder corners of the market.

Access to First Sentier American Listed Infrastructure Fund (FLIAX)

In April, we featured manager Jessica Jouning in an Elevator Talk focusing on First Sentier’s American infrastructure fund. The logic of the fund is simple: especially now, in a high inflation / rising rate environment, infrastructure represents a compelling investment option, and American infrastructure represents the most compelling slice of that class. Year-to-date, for example, the fund is modestly in the black while the Vanguard Total Stock Market Index is down 11%. She’s pretty clear about the reasons.

The one great downside to the fund is its institutional minimum. In our early conversations with the team, they were pretty sanguine about the published minimum being pretty durn nominal, and that was reflected in our draft essay. As we went to press, about the best we could say is, “it’s a million-dollar fund … but maybe less if they like you.”

We’ve subsequently agreed on a clearer, more accessible statement of the minimum:

First Sentier American Listed Infrastructure Fund (FLIAX) nominally has a $1,000,000 minimum initial investment. As a practical matter, the adviser has approved investments as low as $10,000 and will continue doing so, especially given the desire to build fund assets to a large enough level to warrant inclusion on platforms beyond Pershing. The greater inconvenience, for the nonce, is that you will need to invest directly through an adviser. 

Dennis Baran, MFO contributor and reader and now FLIAX investor, confirms that the lower minimum is available.

A sort of special issue

The end of April is a period of remembrance and reconnection for me. My former president, Tom Tredway (1935-2022), passed away in mid-April after a short illness. In 1984, Tom approved hiring me as a member of the Augustana faculty and, in 1996, asked me to serve (briefly) as Dean of the College.

Tom was a historian by training, a listener by inclination, and a master at the (dying) art of “management by walking around.” He represented a vision of college presidents as scholars who led communities of scholars, young and old. That’s been replaced by a new and unwelcome reality of presidents as chief fundraisers and perpetual crisis managers, a reality that leaves little time for asking, “what’s actually important here?” That question, more than any other, might have captured Tom’s leadership.

In the last week of April, I spent time with old friends remembering and celebrating Tom and, in the last days of April, have traveled to Sacramento to speak of the life of my friend Nick Burnett, who moved on in December 2021.

In consequence, this issue is both exceptionally rich and rather short. Devesh has contributed two linked essays that guide investors through the challenge of asking, “what’s actually important here?” He looks, separately, at the year ahead and the decade ahead: “To Win Today” and “To Win Tomorrow.” He asks that you consider them as linked essays and consider one in light of the other.

The Shadow and I collaborated on a Briefly Noted that really should carry the sheepish tag, “Not Quite So Briefly Noted,” this month. There are two developments that might have warranted free-standing articles but which we’ve snuck into Briefly Noted. They are:

The liquidation of the first-tier Phaeacian Funds. Launched as FPA International Value and FPA Paramount, the funds were spun off from FPA and run in partnership with London’s Polar Capital. Pierre Py and Greg Herr, Phaeacian’s heart, served as the General Partner and provided the funds’ management. Polar served as a limited partner and provided its mid- and back-office services. That partnership deteriorated for reasons we’ll never know, and the funds’ board decided that continuing the funds was an untenable proposition. We spend a fair amount of time talking with manager Pierre Py, and we walk through the story of the funds’ disappearance and the implications for investors.

The merger of Zeo and Osterweis. Zeo Capital has managed a solid, value-oriented, short-duration income fund with an absolute return mission. We’ve twice profiled Zeo Short Duration Income (ZEOIX). Osterweis manages a series of adamantly independent, distinctive funds that invest flexibly in both stocks and bonds. In late April, the firms announced that Zeo was merging with Osterweis in a move that might strengthen both the funds’ management and their financial sustainability.

Not to mention, though I’m about to, the manager departure at Rondure, the liquidation of all three Friess funds, and the launch of Matthews Asia’s new line of ETFs.

Thanks …

Thanks to James (we’re glad April was a good month!), Michael from Vegas, and our friends at S&F Advisors. And, as always, thanks too, to our stalwart supporters, Gregory, William, Brian, William, David, and Doug. We appreciate you!

As ever,

By Devesh Shah

“Be careful what you wish for because it might come true” – someone wise

In this article, I lead by laying out the irony in today’s Federal Reserve behavior and the financial markets. Acknowledging a tough year for the 60/40 portfolio, I look at the worst of historical drawdowns in down market cycles. I benchmark my own expectations for the 60/40 in the current cycle and invite readers to do their own work. Finally, I discuss the psychological fallacies and toughness required to ride out portfolio volatility.

Tears instead of Cheers

For years market participants have been dissatisfied with the Federal Reserve’s mollycoddling of the financial markets.

They are destroying the saver’s retirement income by pegging interest rates to zero! They are killing the market’s ability for price discovery by selling a put under stocks every time the market goes down! The Fed owns all the bonds and signals from bond yields are meaningless!

For the first time in a while, and for reasons none of us like – high inflation – the Federal Reserve is determined to aggressively raise interest rates and liquidate its balance sheet. What’s more, instead of protecting stocks, Federal Reserve Governors are bullying the stock market lower.

Investors have been granted their wish of long-desired Central Bank virtuous behavior, but instead of cheers, there are only tears.

We might soon be calling out for another wish: God, make the Central Bankers chaste, but just not yet!

Not everything is down. Value stocks are a bright spot this year after a decade of underperformance.

Those of us who have done this long enough know that picking sectors, themes, and timing the market only works once in a while.

For the major parts of our investment capital, we have settled for some kind of a saner solution: a diversified and balanced portfolio. For many investors, this means a mix of 60/40, that is, 60% in stocks and 40% in bonds.

No investor has that exact same portfolio and also no one specifies whether those buckets should be passive funds, active funds, individual stock and bond picks, international funds, or whatever. But the 60/40 has a nice ring to it and what’s more, we can analyze past data from a 60% S&P 500, 40% US Bond portfolio rather easily (using MFO Search engine data). The idea of the 60/40 is that it’s somewhat of a balanced portfolio. When the economy is good, Stocks do well. When the economy is suffering, Bonds generally do well.

The problem: The uniform sell-off across ALL MAJOR ASSET CLASSES in 2022 means that the Balanced Portfolio has not worked. A 60/40 portfolio is down about 10-11% this year in 2022.

How should an investor who feels the pain from seeing the portfolio down 10% (or more) look at the situation and what should one do?

1. Were you prudent coming in? Then you are going to be fine.

First of all, know that if you came into the year diversified across a few asset classes, were not levered, and didn’t bet it all on one sector or one emerging market country, you did everything you were supposed to do. There is nothing you did wrong. Capital markets go down to shake off the weak and the overleveraged hands. If you are invested prudently, your portfolio will recover in time. There is not much you can do at this moment and biding time is important. Embrace the powerlessness.

Hopefully, this means that your portfolio is also within a down-10% zone. If you are down much more than that, it could mean your portfolio setup is wrong. Go to the doctor. If you came into the year owning a portfolio of T-Bills and Berkshire Hathaway, good job! Start writing for MFO.

2. Getting familiar with Down Market Cycles

Once we’ve mentally absorbed the loss, there is much to be learnt. Use the market selloff to educate yourself and get prepared for the next market cycle. It’s time to focus on the uglier side of the investment coin.

Yes, we know what attracts us to Risky assets. A 60/40 Balanced portfolio has earned ~10 % annualized return since 1960. But these assets are called Risky for a reason. After 3 stellar years of the Balanced Portfolio’s returns, 2022 is the give-back “risky” period.

Annualized Percentage Returns
	2021	2020	2019
US 60/40 (S&P 500/US BOND)	19	10.6	22.5

The MFO Search engine has pre-defined observation windows termed as Down-Market Cycles. We can take any fund, index, or portfolio and see its return over any of the down cycles. Here are the 6 worst market cycles of the last 60 years and the accompanying returns of the 60/40 portfolio.

Eval Start	Eval Stop	Cycle description	MAXDD %	Date Max DD	Recvry mo.
197301	197409	Stagflation	-35.4	197409	21+
200711	200902	Housing Crisis	-28.1	200902	16+
196812	197006	?	-26.3	197006	19+
200009	200209	Dot com bust	-17.4	200209	25+
198709	198711	1987	-16.9	198711	3+
202001	202003	Covid Pandemic	-11.2	202003	2+

Focus on the numbers in the MaxDD % Column for each cycle. The worst cycle was in the mid-70s when a bout of high inflation and a slow Federal Reserve devastated stocks and bonds. The Balanced portfolio would have been down 35%. No joke.

Cycle description	MAXDD %
Stagflation	-35.4
Housing Crisis	-28.1
Late 60s	-26.3
Dot com bust	-17.4
1987	-16.9
Covid Pandemic	-11.2

However, some of the other cycles – Covid Pandemic -11%, 1987 Crash -17%, Dotcom bust -17%, look better than I thought we would see.  It’s possible that the numbers are off based on the observation windows, but they are in the right ballpark.

What is the goal of looking at these negative scenarios?

1. We want to see what the range of negative outcomes looks like.
2. We want to use our judgment and our own market participation history to determine if the current cycle looks like a milder version of the down cycle or something far more sinister.
3. We want to compare where we are today (-10 to -11%) to our mental expectation of a likely worst-case scenario for this

For example:

1. I don’t think we are on the cusp of a 2007-2009 type crash because a lot of regulations have been put in place to curb excess banking leverage.
2. I don’t think we are in the middle of uncontrolled inflation, even though it feels like that right now. Let’s take a look at Crude Oil in the 1970s. Oil went up TEN-FOLD from $4 to $40. If we think $50-$60 oil was a neutral recent price, do I expect the price of oil to go to $500-600? I don’t.

3. I expect the Federal Reserve to aggressively tighten this time. Chair Powell has said that he wants to be remembered as not having lost control of inflation. I believe they mean business.
4. Unlike the 1970s, we have Assets like TIPS and Equity REITs, which behave very well during inflationary times. They can protect if inflation lingers and if the Fed is sloppy.

In conclusion, based on my expectation and my own portfolio constructions, I do not see a 60/40 portfolio having a 25-35% crash.

I think it’s possible the portfolio in this cycle could be down around 15%, which means the 60/40 could lose an additional 5% points from here. This is manageable and my worst-case expectation for this cycle.

Knowing the numbers – where we stand, what’s the worst case, how much of the way we are there – is very helpful in learning how to stay sane. Investors should have their own sense and know what they are rooting for over the long-term and should also know what’s at stake in any given bear market cycle.

3. Get tough and prepare for tomorrow

Constantly, I hear people say this time is different and the world feels out of control. I am not sure about the reader, but I can barely control my own mind, let alone control the world. It’s a psychological fallacy to think that today is more complicated than the past. We have had the time to wrap the past in convenient narratives, while today is still naked. Things are always complex in the present moment.

Learning to become psychologically tough is necessary to get the long-term returns offered by capital markets. We know there are no guarantees for the future. Statistics and past data are a way to bring sense into the present and prevent our minds from getting too imaginative or too dark. But there are no guarantees. Get tough.

Finally, there is the chance that things to do tip over, we get a hard landing or bad recession, and we get the big one. Do I want to sell all my long-term holdings and pay taxes today just because there is a possibility of a crash? I’d rather wait and see how the world develops and if the changing facts make me change my worst-case scenario. I am not in a rush.  

Conclusion

Over and over, I like to come back to who does this correctly? Is there anyone who gets this right? I keep coming back to Buffett and Munger model for one particular reason.

For all of the madness and all of the volatility, Buffett is not saying, “Hey Charlie, how about I liquidate the $500 billion portfolio today, and I’ll buy it back in six months!”

Federal reserve, politicians, wars, and even recessions will come and go. Owning good assets at good prices is the only thing in our control. We must let go of the need to control the outcome. We must learn to focus on the long-term returns while keeping a watchful eye on the worst-case scenarios.

By Devesh Shah

There is a risk that 2022 is just the beginning of a treacherous investment decade. If so, it may be time to question what we know about conventional investment practices. In this article, I first highlight the so-called risk of a lost decade of real returns. Then, I raise 4 Questions we need to ask ourselves:

(1) what should be the mix between risky and riskless assets
(2) what about the active vs passive debate
(3) which assets work well during inflation
(4) which investment habits might we want to leave behind if the returns are slim.

After proposing some answers, I suggest “other” ideas that might work for some but are difficult to implement with consistency.

To be clear: I am not predicting “a lost decade,” a call that is speculative and at and far beyond my mortal skills. There are investment firms such as Research Affiliates who project a 10-year real return of 0.1% for a 60/40 portfolio, and even that is powered solely by its bond holdings since they project negative real returns from its stock allocation. So this is not my base case scenario for the next 10 years, but a theoretical exercise for how to structure the portfolio to prepare for the possibility of such a lost decade.

1. Existential threat for Real Returns of the 60/40 portfolio next decade

The performance of the 60/40 portfolio in the year 2022 so far, at -10 to -11%, is bad. But, according to many market strategists, this poor performance is just the beginning! They predict that we could suffer an entire decade of poor real returns. They have history on their side. Let me show you what they mean:

This table from MFO Search engine is various combinations of the S&P 500 and US Bond Total Return Index in the Decade of 1970s. It didn’t matter what combination one held, the annualized returns on average per year for the decade, was about +5.5% nominal.

Symbol	Name	Decade 1970’s
SP500	S&P 500 Monthly Reinvested Index	5.9
US9010	90/10 SP500/USBOND TR Index	5.8
US8020	80/20 SP500/USBOND TR Index	5.8
US7030	70/30 SP500/USBOND TR Index	5.7
US6040	60/40 SP500/USBOND TR Index	5.6
US5050	50/50 SP500/USBOND TR Index	5.6
US4060	40/60 SP500/USBOND TR Index	5.5
US3070	30/70 SP500/USBOND TR Index	5.5
US2080	20/80 SP500/USBOND TR Index	5.4
US1090	10/90 SP500/USBOND TR Index	5.3
USBOND	Bloomberg U.S. Aggregate Bond TR (Modified)	5.3

Now, let’s look at inflation in the 1970s. The average year-on-year CPI was 7%.

“Real Returns” in the market parlance are defined as Nominal Returns (the APR from the MFO table) less the CPI, or, 5.5% – 7% = -1.5% per year!!

Comparatively, over the last 10 years, from 2012 to 2022, the 60/40 portfolio has earned an APR of 9.7% with an average CPI of under 2%. Investors blissfully earned a real return of +7.7% over the last 10 years (from 2012 to 2022).

The next decade, strategists predict, is far more likely to look like the 1970s and less likely to be the 10-years that just went by. In addition, investors pay taxes and fees and make mistakes, which means investors could be staring at a bleak picture, at least in inflation-adjusted terms, going forward.

Why do some strategists think stocks and bonds won’t provide adequate returns?

1. Stocks are at a much higher valuation today than 10-years ago, a headwind.
2. Interest rates on bonds are low compared to projected inflation, which will hurt bond returns going forward.

Why do they think inflation will be higher going forward? There are three broad reasons:

1. Unwinding globalization
2. Climate and ESG focus
3. Labor and wage implications of unwinding historic racial economic inequalities

The reader can decide if corporate earnings will keep up, if capitalism will be resilient, if inflation is going to be higher, the reasons, and whether these strategists are correct.

I want to focus on what to do if they are right.

2. Rewinding the clock to the 1970s

I always like to start my process by putting myself in the past and asking, “Now that you have perfect hindsight, what would you have done differently?” Again, these are just mental frameworks for thinking and evaluating. There are at least 4 different questions and related ideas that come to mind.

A. Question the right allocation between Risky Assets and Riskless Assets going forward for YOU.

If any combination of Risky and Riskless gave the same low nominal return in the 1970s, then what’s the benefit of carrying (extra) Risky equities. In addition, if one is older, has less time until retirement, needs the funds, is considering a career switch, and is underfunded for retirement, then it would be better to not hold as much in stocks.

David Snowball has long recommended the Equity Light Portfolio as correct for him, and for many others. Question the traditional mix of 60/40, or 90/10, or any other mix.

There are a million investment statistics and portfolio choices but there is only one investor you need to care about – YOU.

How many Risky assets are correct for you if there will be increased volatility for every extra point of return gained.

B. Question the Passive vs Active Debate for Investing

There is no doubt that Passive and index-based investing in large-cap growth stocks have left Active investors in the dust, especially over the last 20-years. The high-fee fund manager lost the race. I am mostly passively invested.

Small cap, value, quality, international has suffered to large cap, growth, not-quality, and US stocks. This move exaggerated the victory of passive over active funds. But what kind of investing works when markets become treacherous?  

When the markets get tough, we need thoughtful fund managers. We want people who have seen risk and volatility and who will behave responsibly. We are grateful to Buffett and Munger for sailing the Berkshire ship well in tough times, but there are other investors who also know a thing or two about investing.

To that end, I invite every one of you to pour over the 137 Profiled Funds in the MFO Database. David Snowball has thoughtfully put together a collection of funds and investment managers who are willing to step aside and not be bullied into the index hugging. You will find gems in there.

David’s note on the Profiled Funds list: I appreciate Deveh’s faith. Thanks! I wrote most but not all of the profiles. Most are flagged “positive” because of our long-ago realization that we didn’t need to waste your time denouncing bad ideas that, by virtue of the industry’s dynamics, were going to die a quiet and obscure death anyway. We only warned about funds that risked being bad ideas that were still going to pull in assets.

You’ll find gems there, but also some ideas whose risk aversion led them to disappointing returns in a decade that rewarded imprudence.

Finally, many of the profiles are quite old, which reflects the inherent limits of a tiny team. If you see a profile that you do think warrants an update, let us know and we’ll make it happen!

C. Question the Asset Classes. Are US Stocks and US Bonds the only game in town?

The 2020s are not the 1970s. Financial markets are more sophisticated and new Asset Classes have developed. We now have access to some of these asset classes which we did not have back in the ‘70s, and we can access them in public markets at reasonable fees. Namely, there are at least 2 Assets that I believe will protect the portfolio in Real Returns:

1. 1. 1. TIPS (Treasury Inflation Protected Securities)
      2. Equity REITS (Real Estate Investment Trusts)

These 2 assets perform favorably in inflationary times. I am re-linking my Feb MFO article on TIPS, which also has a link to a UPenn paper on Equity REITS performance during the 1970s.

D. Question the need and your ability to trade the market, to constantly pick successful stocks and bonds, and to engage in complex financial instruments.

Just because we can buy and sell from our smartphones in a fraction of a second, we don’t have to. There is no record of individual investors successfully trading the market year after year.

Picking a few good stocks over the lifetime is a gift each one of us should be granted. We should all be lucky enough to have bought a Walmart or an Apple and build inter-generational wealth. But we can’t expect to be lucky numerous times a month in finding great stocks.

Is it really important to trade levered and inverse ETFs? Do we really have to have an opinion on Oil and Copper every day? I know options trading is low risk (I co-invented the VIX Index!!) Precisely for that reason, I urge you to look at your cumulative options performance. Have you really made money?

If the investment landscape over the next decade will be choppy, we need to question everything we are doing today and decide how to improve going forward. We will need to minimize mistakes, keep our portfolios simple, and be incredibly humble.

Next, I would like to highlight a few other ideas. I am still evaluating these ideas and don’t know how to fit them into a holistic portfolio. I currently have some of these investments and some I have invested in the past. I will be candid that I don’t know if these solutions work. I am trying things, as I know, we all are in this world.  

1. 1. International Developed Market Stocks and Emerging Market Stocks:

We know good companies that live abroad. We know investing in them can be helpful and perhaps add a buffer to our US stocks portfolio. That’s the theory. But has it worked? Not really according to the data.

In a recent article, When Global Market Bets Went Wrong, Philip Cogan of the Financial Times quotes research by three London Business School economists. Here is the upshot:

While I own international assets, the high correlation with US stocks, and the underperformance has been disappointing. Within Emerging Markets, picking the right country is everything. I find picking the right Emerging market countries a difficult task and prone to luck. I believe David Snowball’s profiled EM funds can help here.

1. 2. Gold and Other Precious Metals:

Over millennia, gold had held its value. It is a commodity with no interest, no dividend, no rental income, and no guarantee of returns. But it’s worked. Why? I don’t know. Will it work in the future? I don’t know. There is no fundamental process to evaluate whether it will work or not. And should one hold it physically, in paper form, or through gold miners? Each one has its pros and cons.

Too many innovative products have failed in the last ten years. From concerns about commodity clearing houses failing to a disconnect between the paper value and the actual physical value of bullion, investors ought to be very skeptical.

Long-term capital gain taxes are punitive here. The bid offer for entering and exiting physical precious metals is even more expensive than buying and selling real estate. Gold commodity producers sometimes hedge, and sometimes the mines are appropriated by the national governments. The link between the commodity price and the commodity miners is not 1 to 1.

1. 3. Base Metals, Energy, Agricultural Commodities, niche commodities, and related companies:

This takes the gold problem to the next level. Presently, there is an enormous rush for all commodity-based hard assets. We saw a similar run-up in such hard assets during the 2002-2007 “rise of China” cycle. This time it feels different because the demand is global in nature and the supply is interrupted due to the Ukraine war, the pandemic, and the focus on climate change and ESG curbing mining and extraction. Inflation means the value of physical goods goes up. Commodities are physical. Ergo, invest. Hmm, ok, if you insist.

How does one participate in commodities? There are 2 ways:

1. 1. 1. Futures or Futures Products (ETNs/ETFs/Levered/etc.): Commodities do not have a natural rate of return. They are mean-reverting assets. Eventually, supply always comes when the price is high enough. Impeccable market timing and market sophistication are required to participate in futures products AND KNOWING WHEN TO GET OUT.
      2. Companies that produce commodities: This may be easier to digest for individual investors. There are enough ETFs and Mutual Funds that allow one to participate. This is a safer mechanism for participating in some kind of a commodity bull run, but also extremely prone to volatility from:
         1. The commodity cycles
         2. The company management’s execution
         3. Informed fast money and insider trading
         4. Nationalization of assets
         5. Accidents in mines

We will often hear glorious stories of successful hedge fund managers and bank trading desks who “made a killing” in commodities. In physical assets, small changes at the margin have an abnormal impact on prices. These funds are close to the action. They know the shipping, mining, production, and demand numbers at the margin. They know how to take risk adjusted for the volatility of each commodity. Be careful trying to ape them. It’s not trivial.

1. 4. Crypto Currencies:

There will be inflation. #Bitcoin solves that!

There will be deflation. #Bitcoin solves that!

Nothing cryptocurrencies apparently cannot solve. Ok then. 

Your dear author does not have enough conviction about them to either recommend or not recommend them. I find the stories of stolen wallets and hacks too risky for my money. I don’t want to understand why a Bored Ape is the solution to every future problem!

I like reading Aaron Brown on this topic, who has held between 1% and 3% of his wealth in crypto. That’s a reasonable level of money to invest if one chooses to go down this route. Anyone who suggests investing more than that might be under the influence of some pretty good stuff I don’t have access to.  

1. 5. Infrastructure

This is actually very interesting if one knows how to do this right. Such assets have inflation-linked clauses that protect their earnings stream. The problem is that tolls, bridges, and ports are usually held by private companies and privately structured funds. It’s difficult to find public funds that directly own these assets and no other assets. David’s recently profiled infrastructure fund, First Sentier American Listed Infrastructure Fund (FLIAX) is an interesting starting point that needs more analysis. Master Limited Partnerships (MLPs) own energy assets, pay substantial cash flow, and may also work to protect the purchasing power of the portfolio in inflationary times. The volatility in MLPs, and the lopsided compensation structure for management, is a barrier for many.

1. 6. A General Problem with Adding Asset Classes:

One of the problems with investing in Other Asset Classes is knowing how much to invest in them. This is far from clear. With 60/40, the numbers are known. The moment we add other Asset Classes we have to make room for them from the 60/40. Moreover, the substitution of assets in and rebalancing out of these assets requires some pre-set levels of benchmark weight ranges.

It’s difficult enough to do this with 2 asset classes. When one adds esoteric products with leverage like Futures, Leverage ETNs/ETFs, and Options, the calculation becomes extremely challenging for all but a handful of truly sophisticated investors. Tread carefully.

E. Conclusion

The quest for proper and thoughtful investing is not finite. Far more important than the information on an asset class is gauging one’s own psychological makeup and potential reaction to losses. Long ago, I learnt that in trading and investing, the more one can visualize the potential outcomes, and be prepared for them in advance, the less difficult it gets.

By Charles Lynn Bolin

The Federal Reserve is raising rates to slow the economy, reduce inflation, and reduce bond purchases (Quantitative Tightening). The International Monetary Fund and World Bank are lowering forecasts of global growth, and the Russian invasion of Ukraine is further disrupting supply chains and raising geopolitical tensions. I am at my neutral allocation of 50% to stocks but have shifted away from the most volatile funds and toward more defensive funds that do well during the late stage of the business cycle and higher inflation. This article describes five funds that I have added to my personal portfolios to provide some protection during these uncertain times.

The war in Ukraine is set to cause the “largest commodity shock” since the 1970s, the World Bank has warned… A new forecast said the disruption caused by the conflict would contribute to huge price rises for goods ranging from natural gas to wheat and cotton.

(Jonathan Josephs, “Ukraine war to cause biggest price shock in 50 years – World Bank“, BBC, 4/27/2022)

I set my retirement date in June after spending 35 years in commodity production, including coal, sulfur, copper, and mostly gold. My first exposure to commodities was in the 1970s when my grandfather, a farmer and rancher, hedged prices against bad weather and price declines. I have followed the impact of globalization on the prices of commodities with more than a casual interest. I have not invested significantly in commodities until recently because globalization has tended to reduce prices until the combined effect of COVID and the Russian invasion of Ukraine disrupted supply chains.

Figure #1 shows that unemployment (green line) is now at the lowest level in sixty years, and labor costs are rising. It also shows that imports of goods (red line) now make up 13 percent of gross domestic product, up from less than 5 percent in the 1960s. Commodity prices are as high as they were in the late 1970s.

Figure #1: Inflation, Unemployment Rate, and Imports of Goods and Services

The 5-Year, 5-Year Forward Inflation Expectation Rate, and the 5-Year Breakeven Inflation Rate hover around 3%. Inflation will likely gradually decline slowly from the current 8.5% because it is a global issue that is partly out of the control of the Federal Reserve. See Figure #2.

Figure #2: Global Price of Commodities

1. Slowing Growth and Rising Inflation

During a normal business cycle, economic growth slows in the late stage as inflation rises. This is because the labor approaches full employment, increasing labor cost pressures, and production is near capacity, so incremental costs to increase production rise. The persistent case of slower growth and higher inflation is known as stagflation. Are we there yet? COVID-induced supply shocks by themselves may not cause stagflation, but combined with geopolitical risks and some extent of deglobalization may.

Dr. Nouriel Roubini describes the current situation of slowing growth and higher inflation in “The Gathering Stagflationary Storm.” Nouriel Roubini, Professor Emeritus of Economics at New York University’s Stern School of Business, is Chief Economist at Atlas Capital Team, CEO of Roubini Macro Associates, and Co-Founder of TheBoomBust.com.       

The new reality with which many advanced economies and emerging markets must reckon is higher inflation and slowing economic growth. And a big reason for the current bout of stagflation is a series of negative aggregate supply shocks that have curtailed production and increased costs.

This should come as no surprise. The COVID-19 pandemic forced many sectors to lock down, disrupted global supply chains, and produced an apparently persistent reduction in labor supply, especially in the United States. Then came Russia’s invasion of Ukraine, which has driven up the price of energy, industrial metals, food, and fertilizers. And now, China has ordered draconian COVID-19 lockdowns in major economic hubs such as Shanghai, causing additional supply-chain disruptions and transport bottlenecks.

ESI Analytics Limited makes the point that there is still room to grow in “Macro Update: This Is A Correction And Not A Sustained Bear Market” and that a recession is not imminent.

• Historically reliable macro indicators signal growth for the U.S. economy.
• Our leading indicators weakened slightly during the past month but do not signal an imminent recession yet.
• Sustained bear markets in equities unfolded in recessions only.
• The S&P 500 remains on target for 5000-5200.

I reconcile the two views as a recession in late 2023 is becoming a higher risk, and inflation will be higher for longer than many investors anticipate. Below is my Investment Model, which maximizes returns over the past 27 years by adjusting allocations to stocks between 35% and 65%. The model is based on 27 indicators consisting of over one hundred sub-indicators. The solid blue line shows the model’s current allocation of 65%; however, I am at my neutral allocation of 50%. If the investment environment continues to deteriorate, then I will look for opportunities to reduce allocations to stock to a more defensive 35%. The dashed blue line shows the investment environment is strong but deteriorating rapidly. The red line reveals that not many of the indicators are negative, so the weakness is not broad-based. Anxiety over rising rates, inflation, reducing bond purchases (quantitative tightening), and the Russian invasion of Ukraine have greatly increased volatility.

Figure #3: Author’s Investment Model

Commodities and real assets provide some of the best protection against inflation, but as current performance proves, they can be volatile. The table below shows the performance of commodities, natural resources, and some of the defensive sectors compared to the S&P 500 over the past twenty-five years covering globalization and low inflation. With the exception of gold and commodities, returns are comparable to the S&P 500, but correlations are low. They perform differently over different stages of the business cycle.

Table #1: Twenty Five Year Performance of Defensive Sectors and Commodities

2. Rising Inflation and Normalization

Table #2 contains the average short-term performance of some of the better performing Lipper Categories that I track. The upper section contains categories of funds that have been doing well, and the lower section contains base case funds. Typical mixed-asset funds are down 7 to 10% year to date as of April 29th, while the S&P 500 is down 12%. Intermediate bond funds are down around 8% as well. Some of the funds that have done well year to date tend to be more volatile, as shown for the week ending April 29th.

Commodities and Natural Resources have performed best year to date, but volatility increased recently, and that they are near the 52-week high suggests that they may be overbought in the short term. Contrast this with bonds and mixed asset funds that suffered from the bond rout. Bonds have not provided the usual protection during market downturns as interest rates rise. Funds in the Flexible Portfolio category provide some protection.

Table #2: Best Performing Lipper Categories – YTD

The worst performing categories below are down about 21% YTD. This year investors have shed the growth and technology stocks for money market and defensive funds.

Table #3: Worst Performing Lipper Categories – YTD

3. Defensive and Inflation Protection Funds

Table #4 shows some of the better-performing funds that I track, sorted from highest one month return to lowest, with the S&P 500 shown as a base case for comparison. This year, I have added or increased allocations in moderate amounts to PQTAX, GLFOX, GPANX, REMIX, PIRMX/PZRMX, and FSRRX, while already owning VCMDX, EAPCX, FSUTX, and TMSRX. To reduce volatility further, I have increased cash by a modest amount.

Table #4: Top Performing, Lower Risk Funds for Defense and Inflation Protection

Table #5 shows the risk and risk-adjusted returns from Mutual Fund Observer for these funds for the past two years. The red shaded cells reflect the riskier funds or those with lower risk-adjusted returns. In general, they have been less volatile than the S&P 500 or the Vanguard Total Stock Market ETF (VTI).

Table #5: MFO Metrics – Two Years

Figure #4 contains an example fund from different Lipper Categories during the COVID recession. I like the low volatility of Grant Park Multi Alternative Strategies (GPANX), as seen in the dark green line, and the quick recovery of consumer staples (black line).

Figure #4: Fund Performance During COVID Recession

Table #6 shows some of the more volatile funds along with others that I have recently written about. I own modest amounts of VGELX/VGENX, FARMX, and FFGCX to protect against inflation and have reduced allocations to some of the more volatile funds such as CTFAX/COTZX and FMSDX.

Table #6: Top Performing, Higher Risk Funds for Defense and Inflation Protection

The risk and risk-adjusted returns from Mutual Fund Observer are shown for these funds for the past two years. The red shaded cells reflect the riskier funds or those with lower risk-adjusted returns.

Table #7: MFO Metrics – Two Years

4. Fund Strategies and Performance

I use the bucket approach to spread risk in selecting funds for protecting against inflation. I don’t invest more than 5% in any single non-traditional, derivative-based fund. I added or increased allocations to each of the following five funds this year. They have exhibited low to moderate risk and performed well in this volatile market.

Inflation Protection and Real Return

In general, short-duration, inflation-protected bonds have done relatively well with the lowest volatility, followed by real return funds. I invested in the Vanguard Short-Term Inflation Protected Bond Fund (VTAPX). For the MFO October 2021 newsletter, I wrote Comparing Fidelity Strategic and Multi-Asset Income Funds (FADMX, FMSDX, FSRRX). Fidelity Strategic Real Return (FSRRX) is one of my larger holdings. As the markets have become more choppy and inflation increased, I shifted some allocation from Fidelity Advisor Multi-Asset Income (FMSDX/FAYZX) to Fidelity Strategic Real Return (FSRRX). I have also added Allianz PIMCO Inflation Response Multi-Asset (PIRMX/PZRMX), which is categorized as a Flexible Portfolio.

The investment strategy of FSRRX is:

Allocating the fund’s assets among four general investment categories, using a neutral mix of approximately 25% inflation-protected debt securities, 25% floating-rate loans, 30% commodity-linked derivative instruments and related investments, and 20% REITs and other real estate-related investments. Investing in domestic and foreign issuers. Analyzing a security’s structural features and current pricing, its issuer’s potential for success, and the credit, currency, and economic risks of the security and its issuer to select investments. Using fundamental analysis of factors such as each issuer’s financial condition and industry position, as well as market and economic conditions, to select investments…

The investment strategy of PIRMX is:

The fund invests in a combination of Fixed Income Instruments of varying maturities, equity securities, affiliated and unaffiliated investment companies, which may or may not be registered under the Investment Company Act of 1940, as amended (the “1940 Act”), forwards and derivatives, such as options, futures contracts or swap agreements, of various asset classes in seeking to mitigate the negative effects of inflation. It may invest up to 25% of its total assets in equity-related investments.

Table #8 contains the performance of a short-term inflation-protected bond fund, FSRRX, and PIRMX/PZRMX, along with REMIX, which will be described later.

Table #8: MFO Metrics – Inflation Protection and Real Return – Two Years

Grant Park Multi Alternative Strategies (GPANX/GPAIX)

I have followed Grant Park Multi Alternative Strategies (GPANX/GPAIX) as a potential “All Weather” fund for a few years. I added it to help reduce expected higher volatility over the next few years.

I wrote Alternative and Global Funds during a Global Recession for the MFO September newsletter covering T. Rowe Price Multi-Strategy Total Return (TMSRX) and Grant Park Multi Alternative Strategies (GPANX/GPAIX). Grant Park Multi Alternative Strategies (GPANX/GPAIX) has returned 6% over the past eight years with a maximum drawdown of 14%. During the normalization period from December 2021 through March 2022, the average Alternative Managed Futures Fund returned -0.6%, while the Grant Park Multi Alternative Strategies (GPANX/GPAIX) returned over 3.9%, and during the three month COVID bear market, GPANX/GPAIX returned over 1.6%. During the current normalization period, GPANX outperformed both the T. Rowe Price Multi-Strategy Total Return (TMSRX) and the BlackRock Systematic Multi-Strategy (BAMBX) funds.

The investment strategy of GPANX/GPAIX is:

The fund seeks to achieve its investment objectives by allocating its assets among four independent, underlying strategies. Each strategy seeks to identify profitable opportunities across multiple liquid foreign and domestic markets. The fund seeks to achieve its investment objective by implementing aggressive diversification across these markets, coupled with risk management and position hedging strategies, which allows the fund to seek positive returns while seeking to protect it from unnecessary market risk exposure.

Table #9: Alternative Multi-Strategy Funds – Eight Years

Table #10: Grant Park Multi Alternative Strategies (GPANX/GPAIX)

Lazard Global Listed Infrastructure Portfolio (GLFOX)

To be honest, what attracted me to Lazard Global Listed Infrastructure Portfolio (GLFOX) was that it was in my employer-sponsored savings plan and doing well. I then researched other infrastructure funds and liked GLFOX as a good long-term performer. Lazard Global Listed Infrastructure Portfolio (GLFOX) is a 12-year-old fund with $7.5B in assets under management and fees of 1.23%. The 12-month trailing yield is 5.0%.

The investment strategy of GLFOX is:

The fund invests primarily in equity securities, principally common stocks, of infrastructure companies and concentrates its investments in industries represented by infrastructure companies. It invests at least 80% of its assets in equity securities of infrastructure companies, which consist of utilities, pipelines, toll roads, airports, railroads, ports, telecommunications, and other infrastructure companies, with securities listed on a national or other recognized securities exchange.

Table #11: MFO Metrics – Lazard Global Listed Infrastructure Portfolio (GLFOX)

Allianz PIMCO TRENDS Managed Futures Strategy Fund (PQTAX)

David Snowball pointed out the dismal record of managed futures funds in the June 2018 article, “If You Were A Manager, You’d Be Running A Managed Futures Fund.” It is a good cautionary note. During the normalization period from December 2021 through March 2022, the average Alternative Managed Futures Fund returned 8%, while the Allianz PIMCO TRENDS Managed Futures Strategy Fund (PQTAX/PQTIX) returned over 11%, and during the three month COVID bear market, PQTIX returned over 7%. Professor Snowball’s advice is:

Our recommendations for fund investors remain the same: make your plans before panic strikes, work backward from an understanding of the risks you face and the extent of losses you can bear, build an asset allocation that creates a margin of safety for you and your family and execute the plan with experienced managers who are shielding you from an unjustified risk now in pursuit of exceptional returns in the future.

The investment strategy of PQTAX is:

The fund seeks to achieve its investment objective by pursuing a quantitative trading strategy intended to capture the persistence of price trends (up and/or down) observed in global financial markets and commodities. It will invest under normal circumstances in derivative instruments linked to interest rates, currencies, mortgages, credit, commodities (including individual commodities and commodity indices), equity indices, and volatility-related instruments.

The Allianz PIMCO TRENDS Managed Futures Strategy Fund (PQTAX/PQTIX) is one of the better Alternative Managed Future funds with an MFO Risk of Moderate (3). It is classified as a Great Owl fund. While it has done well for the past eight years, its recent performance is at least partly related to the strong performance of commodities.

Table #12: Alternative Managed Futures – Eight Year Performance

Table #13: MFO Metrics – Allianz PIMCO TRENDS Managed Futures Strategy Fund

Standpoint Multi-Asset Investor (REMIX)

Professor Snowball wrote Standpoint Multi-Asset Fund: Forcing Me to Reconsider, and I purchased a small amount to test the water. It immediately lost 5%. I held on and later added to the position. Standpoint Multi-Asset Investor (REMIX) is classified as a Flexible Portfolio and invests in equities, fixed income, commodities, and derivatives. The fund is two years old and has $276M in assets under management. During the normalization period from December 2021 through March 2022, the Standpoint Multi-Asset Investor (REMIX) returned over 9%. It has had an MFO rank of Moderate Risk (3) for the past two years.

The investment strategy of REMIX is:

The Adviser pursues these returns by allocating the funds assets using an “All-Weather” strategy. All Weather Strategy: The All-Weather strategy is an asset allocation methodology that diversifies across geographic regions, asset classes, and investment styles. The strategy holds long positions in equity ETFs such that exposures resemble those of a global market-cap weighted index of developed markets.

Table #14: MFO Metrics – Standpoint Multi-Asset Investor (REMIX)

Closing

During uncertain times, I like to look at the performance of funds in a shorter time period as a possible window into how they will perform during a major correction. I can then make adjustments at my leisure. On Friday, April 29^th, the S&P 500 fell 3.6%. I use the bucket approach with the safest bucket containing living expenses, taking on more risk in Traditional IRAs where taxes have yet to be paid and concentrating most risk in Roth IRAs where taxes have already been paid. I am in my comfort zone. Figure #5 shows the funds that I have been adding or increasing allocations to.

Figure #5: Fund Performance – Two Years

I have become decidedly more defensive but not bearish. Utilities have become more volatile, and I have reduced holdings a bit. For May, I am considering exchanging more of a utility fund for one of the above. Time will tell, but at this point, I favor adding to PQTAX.

Best wishes during these uncertain times.