Selling the Sizzle: Risk-Adjusted Returns

Selling the Sizzle: Risk-Adjusted Returns

Jerry Seinfeld is one of my two favorite comedians. (Mitch Hedberg is the other in case you’re wondering.) He has a great bit about dry cleaning where he says,

The whole problem with dry cleaning is that we all believe that this is actually possible. They’re cleaning our clothes, but they’re not getting anything wet. It’s all dry. I know there’s got to be some liquids back there, some fluids that they’re using. There’s no such thing as “dry” cleaning.

It’s great – it starts at 0:18…

I feel much the same way about “managed-volatility” or “low-volatility” funds. Their tagline is basically, “We’ll give you equity returns with less market risk.” Who doesn’t want that, right?

Nick Murray, a prolific financial writer, states a rebuttal to this strategy this way,

“All strategies to “mute” and/or “manage” equity volatility founder on the same immutable truths: (a) anything that suppresses temporary volatility must, in an efficient market, concomitantly suppress permanent return; therefore (b) in order fully to capture equities’ quite spectacular permanent returns, one must be prepared ride out their temporary declines.”

The primary intrigue of “managed volatility” or “risk-adjusted return” strategies surrounds the fact that many investors are still fighting the last battle – even if the last battle was 10 years ago. And what do you think sells best coming out of a panic like the one we experienced in 2008? Well, of course, any course of medication that will reduce the symptoms that type of panic encouraged. Below is an actual headline and tagline from an article from InvestmentNews – a financial media company I actually respect contrary to many others.

Their take on this issue has some merit, yet it takes the simple philosophy of diversification and makes it far more complicated than it needs to be. Not surprisingly, however, it appeals to many advanced level investors because it sounds intellectually possible. Surely somebody is smart enough to do this effectively. Can it be done effectively over the short-term? Yes. Can you get something for nothing over the long-term? I’ll bet against it.

Immediately following a market meltdown, these types of strategies show relative outperformance – meaning they beat whatever equity index they wanted to compare themselves against. Over time, ironically, “risk-adjusted return” becomes an explanation for underperformance.

Yes, that particular fund has trailed the overall market over the last 5-10 years, but look right here, you can see you’re only taking this much risk so it’s “risk-adjusted return” is actually better.

– Every advisor that sold these strategies immediately following the 2007-2009 panic.

Probably not much comfort to be found there if you’re the investor.

Ten years later, the fund company that sold these strategies based on relative performance will now refuse to be compared to the same benchmark that “won” them all the business because it’s just not the same thing once the market inevitably recovers. Because it can’t keep up over time thanks to immutable truth (a) above.

Not because the manager isn’t skilled, but because you can never get something for nothing. Whatever you “gain” in a down market using these types of strategies, you must give back in an up market. There is just no way around this in an efficient market.

And, for those paying attention, the market is up about three out of every four years. In other words, what we’re saying is, hypothetically, we’ll take three years of potential underperformance (possibly) for one year of outperformance (hopefully).

Over time, these strategies become the dead weight of your equity exposure when a slightly higher percentage of bonds in your portfolio could have offered similar downside protection with less hoopla and less cost.

If that’s the case, why do these strategies persist? Because we want to believe it’s possible. And, again, who doesn’t want equity returns with less risk? I’d love it too, but I’ll just eat my vegetables instead.

It’s like I tell my son, if you want to grow big and strong, you must eat good foods. Donuts and Doritos won’t do it for you. If you want equity returns, you must accept equity volatility.

As an alternative to these low-vol strategies, think of the same idea in simpler, easier to implement terms. If there is a risk that needs to be “managed,” then perhaps the best way to manage that risk is to own less of whatever you are seeking to mitigate risk from.

If you get just one thing from this article, just know that what your mom told you growing up was true – “If it sounds too good to be true, it probably is.” You can’t get something for nothing. They’re selling the sizzle, but the steak was overcooked.

Thanks for reading.
Ashby Daniels

If I can answer any questions for you, feel free to Contact Me. Or if you think you might be a fit for our practice, see Who We Serve.


Any opinions are those of Ashby Daniels and not necessarily those of Raymond James. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Past performance is not a guarantee of future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.

Raymond James is not affiliated with and does not endorse the opinions of Nick Murray.

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