Submitted by Keith Decker of IceCap Asset Management
Asymmetrical Risk-Return Relationships
Want to know why the house always wins in Vegas? It’s because the odds, or probable outcomes are always in favour of the house, or put another way – the gambler always has the deck stacked against him. This concept is called the asymmetrical risk-return relationship, and it also exists in the investment world.
The average investor is told that stocks always go up over the long-run.
Although the long-run is rarely defined, and it’s never the same for every person or every market; this expression is effectively trying to describe an asymmetrical risk return relationship. This relationship is one where the expected positive returns from the stock market significantly exceed the expected negative returns from the stock market.
The same is also true for the bond market.
When bonds are paying you interest payments of 3% a year – you expect to receive at least 3% as your return, and never anything less than that – after all, it’s a BOND and bonds are safe.
And THIS is the key concept that the majority are missing, fail to understand, or are simply not allowed to discuss.
What we mean by this is that in the bond world, virtually every investor has been told that bonds are always safe, you’ll always get your money back, and they are meant for conservative investors, and investors who want to keep a little somethin’-somethin’ for a rainy day.
Of course – IceCap is telling you, this is wishful thinking. 2018 is not the same as 2008, 1999, 1989 or even 1982 for that matter.
The financial world we live in today is COMPLETELY different than any other moment in time ever experienced by anyone in the investment world.
For two reasons.
First over the last 38 years, long-term interest rates have steadily declined from nearly 20% all the way to 0%. This is important, because as long-term interest rates decline steadily – bond market returns increase steadily. This trend has reversed, and so too will the investment experience for everyone investing in the global bond market.
Second, the debt super cycle borrowing binge was all enabled by unchallenged, free wheeling governments fueled by low interest rates on borrowed money.
Yet these two, very easy to see and very easy to understand facts are completely missing from the investment industry, the investment media and most disappointing of all – the universities and colleges who are churning out CFA seeking millennials by the boat load. Recently, we’ve had several conversations with larger pension funds who all recounted how increasingly their bond fund managers have turned into 30 year olds. While there’s nothing wrong with a little youth movement every now and then – there is something wrong when these young guns are charging through fixed income presentations extorting their 10 years industry experience and pounding the table on the incredible opportunities they expect to occur in the land of bonds.
To be clear – there’s now an entire generation of investment professionals around the world who’s entire career (both professional and academic) has occurred during a period dominated by:
- 0% interest rates
- negative% interest rates
- QE and money printing
- bank bailouts
- and sovereign debt bailouts
Why is this important?
This is important because the industry as a group creates, forms and distributes risk-return expectations for every dollar in the investment universe.
When markets are charging dead ahead into an all-certain event, the investing public looks for leaders. It looks for dynamic wisdom. It looks for 5-dimensional thinking. Instead, the industry is increasingly being lead by fearless leaders who’ve earned exactly zero stripes, no investment scars, and who are not compensated to see the investment world for what it is – a complex, interconnected relationship between and amongst multiple factors which always move in sync (positive and negative correlations) during significant turning points.
While everyone today is closely watching equity markets – and justifiably so from a daily movement perspective, the majority do not realize the market magician is using the oldest trick in the book – distraction with the slight of hand. In the world of magic – there really isn’t any magic. Instead, the slight of hand, moves just enough to distract the audience from what is really happening.
And yes, corrections in equity markets are very unsettling and as described earlier, IceCap certainly does takes them seriously. Yet, unlike the majority, we have not taken our eye off the ball, nor have we become distracted by the emotional market churning noise. And we most certainly, have not been lulled into a sleeping comfort by the new generation of bond managers.
Instead, we share with you the market trick at hand – the asymmetrical risk-return relationship currently offered to every investor in the world.
Our diagram on this page illustrates the return expectations for the bond market.
The “A” column is representative of current global fixed income markets.
The upside to investing in low-risk bond strategies is approximately 3%. Yet, as IceCap’s expectation for a crisis in sovereign debt escalates, the expected losses will be 20% or more. We tell you with certainty – these are the kind of odds you normally would only find in Vegas. In bond markets today, the sellers of bonds are pulling the wool over the eyes of the buyers of bonds.
And we’re sorry to tell you, everyone today including mutual fund investors, target date funds, life cycle funds, and especially pension funds are set-up for long-term losses in their fixed income strategies. We’ll next show you why this fixed income market environment cannot be avoided. It will happen. That’s the bad news.
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