It has been a torrid start to 2022 for bonds. Spiralling inflation has transformed the long-moribund interest rate environment and yields have risen substantially in most major markets. Not only are most bond investors nursing losses, but these losses have been registered at a time of equity market weakness. Bonds have seemingly lost their diversifying properties, produced poor returns and face into a prevailing market narrative that paints an unremittingly bleak outlook for their prospects. Given this, is it fair to question why anyone would hold bonds in this environment? No, it is not.

The unremitting negativity around bond investing reflects several major behavioural failings we face as investors – we greatly overweight the recent past, are overconfident in our ability to predict the future and struggle to accept the behavioural realities of diversification.

Rather than obsess over short-term performance and negative sentiment, it is far more important to think about the features of bond investing, the role they play in a portfolio and what recent market activity means:

– Rising yields should mean higher future returns:

The best predictor of bond returns is their starting yield. The significant rise in yields mean that future performance prospects are now brighter than they were. I would much prefer a 3% yield from a ten-year treasury (nearly) than the close to 0.5% it reached in 2020. It is incredibly common for investors’ return expectations to perversely increase as valuations become more expensive (it happens in equity markets consistently) but it is more puzzling in bonds where the interest and principal payments are contractual.*

– The chances of losing money in bonds in any given year have reduced:

Aside from those with negative yields, at the start of each year our expected return from a bond investment is positive – we will receive our coupon and roll down the yield curve (for the sake of simplicity let’s assume the curve is not inverted and there is no credit risk). The higher the yield and steeper the curve, the more yields need to rise for bonds to lose money. The considerable increase in yields means that our chances of losing money in bonds over the course of a year have reduced significantly. Higher yields give us greater protection from the threat of rising interest rates. This was detailed in this typically excellent Verdad post.

– The market has the same information as us:

The concerns about the prospects for bonds – central bank rate hikes, rising inflation etc… – are generally expressed as if the market is blithely unaware of these risks. It isn’t. The behaviour of bond markets in 2022 reflect the attempt of market participants to accurately price them. What is it we know about inflation and rates that the market does not?  

– Bonds represent a diverse range of security types:

Although I am guilty of discussing bonds in incredibly generic terms here, we should not forget the diverse range of securities that are encompassed by this broad definition. The features and sensitivities of floating rate notes are distinct from a treasury bond (real or nominal) as they are distinct from a CCC high yield credit.  It is important to understand both the similarities and distinct features of the various areas of the market and the specific role they might play in a portfolio.

– High quality bonds are excellent diversifiers

High quality bonds are an excellent portfolio diversifier when held alongside risky assets. Despite recent returns they are likely to remain one of the most effective protections against equity market risk. No asset class works against all backdrops and in a stagflationary environment where inflation is rising and equities are weak, nominal bonds may fare poorly – but that is just a single specific scenario. In a more typical equity sell-off or economic slowdown, it is reasonable to expect higher quality bonds (particularly sovereigns) to be an effective component in a portfolio. **

– Rebranding government bonds

Government bonds have something of an image problem – the common complaint is that yields are so low that there is no point in holding them compared to other asset classes (this is less true than it was a year ago). But rather than thinking about low returns, it pays to reframe their role.

High quality government bonds are typically (though not always) lowly correlated with equities, and they often make profits when equity markets suffer severe declines. This sounds like a reasonably effective portfolio diversifier and unlike a tail risk hedge there is no burn cost, in fact we get paid somewhere close to 3% (US ten year) for owning it.

From a portfolio perspective, it is critical not to focus solely on an asset’s expected return but how it behaves relative to other positions in a portfolio. The value of something that can protect value or even make money when equities are losing heavily is not simply about lower drawdowns and volatility. It is about the ability to rebalance and reallocate from your defensive asset into much more attractively valued risky assets. The compound impact of this through time can be profound.  

Of course, it is worth restating that nominal government bonds are not always a good diversifier against equities, but they often are and being paid to own those characteristics can be a compelling option from a portfolio perspective.  

– The future is unpredictable and we are overconfident

Given the inflationary backdrop and recent losses, it is not surprising that sentiment around bonds seems uniformly negative. In the current environment it is incredibly easy to take strident views about the direction of yields from here (higher) and claim that owning bonds is nothing more than a wilful destruction of value. We should ignore such perspectives.

A call to give up on bonds is nothing more than an aggressive market / macro-economic forecast and we all know how successful investors are at making those. Prudent diversification is about owning assets and securities that will deliver in different market environments because the future is unknowable.

At any given moment it always feels like we are on a single inexorable path based on recent information, but that is never the case. There is always a range of potential outcomes.

Let’s map out a future scenario – inflationary pressures remain and central banks hike rates aggressively to subdue it. The rising cost of money leads to significant pressure on consumer demand and results in a recession. This is a highly stylised and simplified example but does not have a zero probability and it is an environment where exposure to high quality bonds might be valuable.

There is another scenario where inflation runs further away from central banks and bond yields must rise substantially to reflect a new reality even as equities decline. The point is we cannot know with any confidence how the economic picture will play out, nor how asset class relationships may alter.

We should make investment decisions based as much on what we don’t know, as what we think we do.

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Current concerns about bonds are simply a reflection of our behavioural struggles with diversification. Diversification means that at any given point in time elements of our portfolio won’t be working, which is dissonant with our inescapable desire for everything to be performing in unison.***

If all holdings in our portfolio are successful at the same time, we should prepare ourselves for the time when they all struggle at the same time.  

Highly concentrated positioning or the abandonment of certain asset classes is little more than a reflection of dramatic overconfidence.  Either we believe in maintaining diversification, or we believe that we can predict the future.  

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* It is important to remember the distinction between owning an individual bond – with set characteristics and, typically, a fixed maturity – and a bond fund which usually has an evolving set of fixed income exposures.  

** Bonds are by no means a requirement for all types of investors, but for an investor whose risk appetite would usually involve holding fixed income securities abandoning them would be nonsensical.

*** Diversification applies across asset classes and strategies, not bonds alone.

There are few things the active fund management industry likes more than a tale of a manager consistently outperforming the market, year after year. It seems that there is no better sign of investment acumen than to overcome the odds and produce excess returns with unerring regularity.  The problem is that this notion is entirely spurious. Patterns of consistent outperformance are exactly what we would expect to see if results were entirely random. It is a measure that alone tells us nothing, but a belief in its significance is likely to lead us toward an array of investing mistakes.

Throughout my career there has been a fascination with hot streaks of outperformance from active fund managers. The careers of most star fund managers have been forged on seemingly rare runs of good form. Performance consistency is also often used as a tool for rating and filtering active fund managers – with skill linked to how regularly they beat their benchmarks over each year, or even each quarter or month.

Although it instinctively feels that consistent outperformance should be a marker of skill, it pays to think through the underlying assumptions that must hold for this to be true.

To think that the delivery of regular benchmark beating returns is indicative of skill we need to believe one of two things:

1) A fund manager or team can consistently predict future market conditions.

For a fund manager to outperform on a consistent basis and for us to consider it evidence of skill, then we must suppose that some individuals or teams can accurately predict the forthcoming market environment. If they cannot, then how they possibly position their portfolio to outperform through a constantly evolving backdrop?

2) Financial markets will consistently reward a certain investment style.

If we do not accept that a fund manager can predict the prevailing market backdrop each quarter or year (which we shouldn’t, because they can’t) then we must believe that a fund manager has an unimpeachable approach that always outperforms – no matter what the market conditions. It is a strategy that is impervious to cycles and styles.

It is difficult to discern which of these claims is more incredible, but if we are using performance consistency to inform our investment decisions then we are implicitly making (at least) one of them.

Stories over randomness

The overarching problem is one of narrative fallacy. We refuse to accept a randomly distributed set of performance numbers, instead we must build a compelling story to explain and justify them.

If we had a universe of 500 fund managers and each selected their portfolios based on the names of companies that they picked out of a hat we would still witness spells of consistent outperformance. We could easily create a captivating backstory about why a certain fund manager was able to beat the market with such regularity even if the results were based entirely on chance.

If there was no persistent skill or edge in active fund management (which is not an heroic assumption to make) and all results were entirely random, performance consistency would still make it appear as if skill existed.

The existence of consistent outperformers is almost certainly the result of fortune rather than skill.  

In any activity where there is a significant amount of randomness and luck in the results, outcomes alone tell us next to nothing about the presence of skill. The only way of even attempting to locate skill is by drawing a link between process and outcomes.

If we are claiming that performance consistency is evidence of skill then we must also show which part of the process leads to the delivery of such unwavering returns.  

Consistently poor behaviour

Unfortunately, the obsession with performance consistency is not just a harmless distraction, it is an issue that leads to poor outcomes for investors. There are three main problems:

1) It leaves investors holding entirely unrealistic expectations about what active funds can achieve. Consistent outperformance is unlikely to occur in the fund we own and, if it has occurred in the past, we should not expect it to persist into the future. A better rule of thumb would be if a fund has outperformed the market for five years straight then at some point it will underperform for five years straight.

2) If we buy funds following an unusually strong run of performance, we are increasing the odds of walking into expensive valuations and painful mean reversion. Rather than consistency being an indicator of skill, it is more likely to be a sign of more difficult times ahead.

3) The narratives that are weaved around consistent outperformance foster a culture of undue adulation for star fund managers. Adulation which always ends well…

Fund investors should stop focusing on and thinking about consistent excess returns – it tells us nothing meaningful – and instead concentrate on consistency of philosophy and process. In a complex, unpredictable system that is all that can be controlled.

A belief that consistent outperformance from an active fund manager is an indication of skill that is likely to persist is not only wrong, but also dangerous. Flawed expectations about the realities of active fund management inevitably lead to poor behaviours and disappointing outcomes.

It is easy to get lost amidst a sea of ambiguous definitions when considering different investment styles and approaches. Not only can it be difficult to discern the true rationale of another investor, it might also be unclear what our own underlying motivations are for a particular decision. If we step away from the jargon however, we can see that it doesn’t need to be this complex. Virtually all active investment decisions are made for one of two reasons. Either we believe the valuation of a security is wrong or we think that the price will go up*. These are not the same thing and this distinction matters for investors.

Investors can be valuation-led or price-led.

Valuation-led investors are focused on the features of the underlying asset in which they are invested. They believe that it is mispriced relative to its fundamental attributes. They are not concerned about the behaviour of other investors.

Price-led investors do not care about the valuation of the underlying asset, they are focused on the behaviour of other investors. This is akin to a Keynesian beauty contest.

Valuation-led Investing

Berkshire Hathaway is a prime example of the valuation-led approach. Here the focus is on the robustness of the business in which they are invested, not how other investors might move the price.

It is critical to grasp the distinction between valuation-led and value investing. They are not synonymous. A value approach is just a subset of the broader church of valuation-led investing. If we invest in a security because we believe it is fundamentally mispriced, then we care about valuation.

A company might be considered undervalued because its market price doesn’t reflect its stellar earnings growth prospects, or its ability to earn and reinvest high returns on capital, or the fact that its earnings are temporarily depressed. These are all broad and distinct investment styles (growth / quality / value) that can be defined as valuation-led, but they are not all value approaches as we might broadly define it.

Price-led Investing

At the other end of the spectrum is a simple price-based trend following strategy. Here, there is no consideration of the valuation of the underlying security, it is merely seeking to exploit price patterns driven by investor behaviour.

Price-led strategies can be more of an ambiguous area. Not many investors like to say that they are investing because of what they think other investors will do or have done (apart from trend following where it is explicit). Obvious areas where price movements or the actions of other investors are paramount include thematic equities and macro strategies.

Thematic equity funds rarely launch without strong historic price momentum and the investment case often resides more on how compelling investors find the story rather than a robust fundamental case. Macro investing is often much more explicit about its intentions in attempting to decipher how other market participants will react to new developments.

Approaches which are price-led are typically incremental in nature. They are focused on how investors are currently positioned and their expected behavioural response to new information.

A Spectrum

Few things in investment are binary and most investment approaches will sit somewhere on the spectrum between valuation-led and price-led. A valuation-led investor might, for example, seek to identify a catalyst that will realise the mispricing they have identified. The foundation of the investment rationale is about the valuation of the business, but they are also attempting to understand when other investors might understand this and bring about a revaluation. Many price-led investors are interested in valuations insofar as they can draw inferences about prevailing market expectations.

Where investors sit on the spectrum is not only critical because it provides a clear insight as to why a decision is being made, but it can have significant implications for other vital aspects – most notably time horizon and risk.

Time Horizon

The shorter our investment time horizon the more likely we are to be a price-led investor. If we are basing our trades on the anticipated behaviour of other investors, then we are worried about what is happening now and tomorrow. We cannot make predictions about how investors will react in a year’s time. The purer our valuation-led approach the further our time horizon stretches into the future – we have no view on how other investors will behave, just the fundamental attributes of an asset.

The most dangerous scenario is where our environment defines what type of investor we are. We might think that we are biased towards a long-term, valuation-led approach, but if we face significant short-term pressure about results then, by default, we become a price-led investor. A disconnect between what type of investor we think we are and what our environment allows us to be is toxic.

Risk

The risks faced by investors at opposite ends of the spectrum are also distinct. Price-led investors not only have the challenge of anticipating the behaviour of others, but the stark danger of a reversal of sentiment. Market dynamics can change swiftly and sharply, and without any valuation discipline the floor can be a long way down.

The central challenge for valuation-led investors is being accurate about the fundamental mispricing in a business or asset. To make matters worse even if the analysis is correct they might be on the wrong side of investor opinion for years.

As with time horizons, a major problem arises when investors misclassify the approach they are adopting. An investor in a thematic fund who believes that they are exploiting a valuation-led opportunity could be in for a nasty surprise if the prevailing narrative shifts.

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Understanding what type of investor we are (and are able to be) is absolutely paramount to making prudent and behaviourally consistent choices. If we don’t know or are mistaken, then we really have no chance of making good decisions.

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* Or down, if we are short / underweight etc…