Face-Off: Buy and hold

Tony De Thomasis: In my mind nothing has changed. What happened in 2008 was like the Black Swan book. It’s something that happens once every 80 or 100 years. I’m not going to change the way I invest because of one event that was unavoidable. People always invest based on the most recent past experience. Many investors think bonds will return 7% like [they have] in the past 25 years—but this was one of the greatest bull markets in over 100 years.

Mark Yamada: Firstly, we need to define buy and hold in this context as buying, holding and rebalancing to an original fixed mix. That means that as the stock market is moving higher, and one has a 60% equity and 40% bond portfolio, some equities are sold and bonds are bought to maintain a fixed asset mix. In this regard, buy and hold really meant pain. In the case of U.S. pension plans, for example, funding ratios dropped from 111% to just 67% from September ’07 to March ’09. This really means that diversification, as an investor’s primary tool for fighting volatility, just failed miserably.

Did the events of 2008 change your investing strategy?

De Thomasis: It did not. What it did was encourage me to try and get more and better information for my clients. The reason why investors panic is because they don’t have enough information at hand that they can readily understand. There is so much data out there, but it’s not packaged in a way where 90% of investors can really say, ‘This is something that I can really understand.’

The minute there is something in the media that causes some concern, they want to change their strategy. I am trying to get in a four-to-five-page document information that they can really understand; and really know and realize that there’s no better alternative at the present time.

Yamada: No. But it did reinforce our belief that conventional thinking in the industry is flawed. The theory is that correlations between asset classes are assumed to be fixed. They are, in fact, dynamic. The year 2008 showed how dynamic they are!

Conventional investment thinking would have you believe that a truck 20 feet away speeding towards you will remain 20 feet away for all time; that isn’t realistic.

Future strategy

De Thomasis: There is no better alternative. I look at Berkshire. To me, Berkshire is a really big mutual fund. You have one guy who’s been there a long time and his strategy hasn’t changed in the last 30 to 40 years. When you go back in the early ’70s, that fund went down 40%, and actually lagged the S&P for about four years. If you look at data and studies, there is nothing better. What is important though is that my clients have to understand what they’re doing. And I don’t mean giving investors some wrap accounts and a 50-page report they won’t read. If the investor can read and understand a 50-page report, then they might as well be their own money manager.

Yamada: It’s more of the same. We manage to constant volatility. When volatility in markets starts to pick up, we reduce risk in the portfolio. When a client comes to us with a specific risk profile, we believe that it’s irresponsible not to adjust risk to stay within the client’s risk tolerance all the time.

How would you have handled client portfolios had you pre-empted the recession?

De Thomasis: I would have put 50% in U.S. government bonds, because when the world is collapsing the only currency that people are comfortable with is U.S. government bonds; and also maybe half in gold. You have the U.S. government bond for liquidity and gold for the protection of the capital invested. Those are the only two asset classes that actually held their own in the downturn.

Yamada: As mentioned, we manage to constant volatility. Volatility was climbing from late 2007. I must admit, we and others certainly didn’t think that volatility would spike the way it did in late 2008. We were moving clients into lower risk, but I suppose we could have done that more quickly.

When does buy and hold work?

De Thomasis: Always, because there is no better alternative. I have been around 30 years. I have seen Rothschild, one of the oldest and most respected world managers, handle money for Global Strategy funds and they didn’t last. How can you get a better money manager than Rothschild? In the early ’80s we saw Noram Convertibles, which bought bonds that would be convertible to stocks at a certain price. It was great for seven years and then produced nothing. There was a bond fund in the ’80s that was half in bond and half in gold. The deal was, if inflation picked up you’d be in gold but if it declined you’d be in bonds. It lasted for four or five years. I have seen everything, nothing else works.

I’m sure there are some great money managers out there, but for every one [Warren] Buffett there are a hundred managers who are not going to survive.

Yamada: In the long run, buy and hold may work. But to paraphrase Lord Keynes, in the long run we have to deal with the “third moments” and skewness that will kill you. If you are managing long-duration assets, buy and hold may work. But even in these cases, you’re better off managing to constant volatility.

When doesn’t it work?

De Thomasis: It always works. It’s important in terms of time frames and volatility. If you are my client and we are looking at a 10-to-15-year horizon, and all of a sudden you go to a three-year horizon, then there’s a major problem. Because everything you have done is based on 10-to-15 years. So it’s not going to work. If you don’t know how long you are going to buy it for, then we’ve got a problem.

Yamada: In the long run, because correlations will change over time and four standard deviation events happen more frequently than we expect. So while it is supposed to work in the long run, there are some challenges, too.

In the short run, if managing a defined contribution pension plan or an RRSP portfolio with the duration of that portfolio shrinking as you arrive at retirement, buy and hold is disastrous.

It is careless to manage these variable-duration portfolios with buy and hold, because you expose the client to the market’s full risk from the beginning to the end. Client risk profiles change with time and so should their portfolios.

What products or equities shouldn’t you buy and hold?

De Thomasis: I can’t think of any. But if you’re going to buy a one-sector investment – say, only technology, or only gold, or only precious metals—only one specific asset class, then that by itself is not a good buy-and-hold strategy. Because if that sector doesn’t do well, you have too much exposure and risk.

What’s happening in Greece is a good example. If your market study suggested Europe would do better than the U.S. and all of a sudden a country like Greece goes bankrupt, all the analysis you did goes out the window.

The question shouldn’t be, “do I think it’s going to perform?” but, “how much of your assets do you want to keep in Europe?” You have no idea what’s going to happen in the next six months. Diversification is key to making buy and hold work. If you want to keep all your assets in the U.S., then buy and hold will not work.

Also, we didn’t realize just how important it was to hedge for currency fluctuation. At least a certain portion of your portfolio must be hedged for currency risk.

Yamada: I guess that’s a trick question, because buy and hold doesn’t work, right?

You should be careful when buying and holding leveraged products because compounding can distort their returns over time. And certainly any short products, because there are no expected returns from the short side of the market.

Does buy and hold work in shifting time frame?

De Thomasis: Buy and hold can still work but you have to change the asset class mix. If you go from a longer time period to a shorter time period, you have got to shift your assets more to fixed income as soon as reasonably possible. Don’t do it in a down market, but do it in a market that is not that volatile.

Yamada: The time frame is very important, because if you’re managing those short or declining duration mandates, you’re exposing the portfolios to full market volatility without any adjustment. And if you’re a professional, there may be a case for negligence. Maybe I shouldn’t say that, because most portfolio managers buy and hold in some form or other. By and large, the industry adheres to the buy-and-hold approach.

How long is long-term?

De Thomasis: It depends on the portfolio. If 70% of your portfolio is going to be in fixed income, long-term is going to be about four years, but if 50% is going to be in fixed income, then long-term would be about six years. Similarly, if 30% is in fixed income, then long-term would be seven years, and if it is less than 30% it would be 11 years or more. Buy and hold works but the time frame is critical to how you structure the buy-and- hold strategy.

Yamada: Not long enough. While this is a relatively new area of research, it shouldn’t be. Volatility, diversification and correlations have always been with us. However, so much damage was done in 2008 and 2009 that it resulted in more focused research.