Of Apples, Oranges and Performance

Comparisons are a core part of the human existence.

Keeping up with the Joneses’ is a well known saying. The basic idea is that whatever we have is enough, until we see someone else who has more.

I’m not here to have a philosophical debate the role that comparing has in one’s happiness or feeling of fulfillment. But I will point out that it happens in the markets as well.

There are two different types of comparisons in financial markets. Comparison mistakes, which can lead to remarkably bad decisions; and comparison advantages, which can allow you to gain an edge by seeing a part of the picture that is obscure to most.

One of the biggest comparison mistakes that investors make is constantly comparing their performance to a benchmark index thinking that it is something they must beat.

Feel free to blame Wall Street and the media for this comparison. For 40 years, investors have been told that they should compare their annual performance to a single benchmark, most likely the S&P 500, or to a combination of indices meant to mimic a specific asset allocation.

Comparison in finances is the main reason clients have trouble patiently sitting on their hands, letting whatever process they're comfortable with work for them. If they get a 13% return they're ecstatic until someone at a cocktail party says they got a 15% return or the S&P 500 returned 14%. Then they want to know what went wrong.

The problem with chasing performance, is that once you fall behind you tend to take on more risk to try and catch up. This increased risk level tends to lead to bigger mistakes that cost you.

It’s no wonder that the average investor severely underperforms most of the major asset classes on an annual basis and even the returns of the mutual funds that they hold.

The chart below shows the annualized performance of all the major asset classes over the last 20 years. You can see that the average investors has underperformed all but 3 of those asset classes including 3-month Treasuries.

Comparing your performance to an arbitrary benchmark or Morningstar style box leads to getting into investments at the wrong time, getting out at the wrong time and chasing whatever the hottest fund or sector is at the time, the proverbial flavor of the month.

For instance, a current example of this comparison phenomenon that has run amok is theWisdom Tree Europe Hedged Equity Fund (HEDJ). This fund, as the name implies, is a Eurozone equity fund that is hedged against a decline in the Euro. HEDJ has handily outperformed its unhedged counterpart, Vanguard’s Europe ETF (VGK).

So far this year, HEDJ is up 17% versus 4% for VGK. Obviously, being long Eurozone equities and short the Euro has been massively successful this year. That’s why HEDJ has already brought in $4.6B in new assets in the first 2 months of the year.

That new capital inflow accounts for 34% of the fund’s entire asset base, which means that HEDJ has increased assets by 50% in just 8 weeks. Comparison chasing much?

Now, I’m not saying that HEDJ’s strategy won’t continue to outperform being long Eurozone equities in Euro terms. But whenever outperformance is that dramatic and money flows in that quickly, it gives me cause to pause. 

In addition, I’ve mentioned repeatedly how the Long USD trade is the most crowded trade in the world right now, based on how large and small speculators are positioned in the futures markets.

HEDJ is simply a derivative play on the bullish posture of the USD. So what happens to HEDJ’s absolute and relative performance if last week’s USD rally proves to be an intermediate term top for the greenback? Nothing good. What happens to those investors who ran headlong into HEDJ AFTER the outperformance? Nothing good.

Another comparison mistake, which I touched on last week, is this notion of evaluating economic data points in relation to what the consensus expectations were for the particular data point. This comparison mistake is yet another one that is perpetuated by the media daily.

Last week, one of the larger finance blogs published an article on the state of the global economy. The article had a negative tint as to how bad the world economy looks right now.

As part of the evidence to support this thesis, they published a list of 48 US economic indicators that had been released during the month of February. They split the list into those indicators that had beaten expectations and those that had not.

Of those 48 indicators, 42 of them, or 88%, had failed to beat expectations and the remaining 12% had reported better than expected.

Does this comparison to the consensus really tell us anything about the data itself? Absolutely not.

Forecasts in all arenas of society are notoriously wrong, and nothing could be more true in finance. Financial forecasts are useless and as such, comparing what actually happens to what a group of economists thought was going to happen is equally useless in trying to gain an edge over other market participants.

As I routinely say, what matters most in global macro happens at the margins. A comparison advantage can be had when you compare an economic data point to itself over a particular time frame, like one year. Is the economic data trending up or down? How quickly is that particular data point accelerating higher or decelerating lower?

Analyzing data in this way can help you paint a picture that very few people are able to see. Of those 48 US indicators that I mentioned earlier, 36 of them, 75%, are showing signs of acceleration from a year ago.

Which evaluation seems more helpful to making investment decisions? The one that shows 75% of the indicators have improved from a year ago and 25% look worse? Or the evaluation that says 88% failed to meet expectations and 12% exceeded?

Fortunately for us, most of the world would say evaluation #2. This is evidenced by the fact that for 2 months I’ve been saying that it looks like the Eurozone has turned a corner and up until the last couple of weeks, I heard virtually no one saying that.

To whit, everyone has been talking about the US, yet Eurozone equities have outperformed US equities by 300 basis points. That’s a massive outperformance over just a 2 month time period.

The “margin” comparison advantage is not limited to just economic data points but can also be used when evaluating asset class returns. One of my bread and butter comparison advantages I use when it comes to asset class returns is looking at how assets that perform well when the US is growing are performing relative to assets that generally perform well when the US is slowing.

Historically, this has helped me get a fairly good grasp on the trajectory of US growth well before GDP announcements and the like, which are typically done on such a lag as to be completely useless in making forward looking decisions.

It was well documented last year how well US Slow Growth Assets outperformed both US High Growth assets as well as the broader US equity market.

However, so far in 2015, that script has flipped. US High Growth asset are up 233 basis points, the S&P 500 is up 98 basis points and US Slow Growth assets are down 191 basis points.

What is this telling us?  Remember that economic data points are backward looking while real-time market price action is a discounting mechanism and as such is forward looking. This comparison is telling us that the markets are pricing in that US growth should start to accelerate higher.

Based on the way I evaluate markets, this relationship between High and Slow Growth assets will continue to diverge.

You can’t control comparisons, you can only hope to contain them. Focus more on the comparisons that provide an advantage and less time on the comparison mistakes. You will see a noticeable, tangible difference in your investment returns, if for no other reason that it’s the path least taken.