Q2 2019 Market Commentary: Winning The Loser’s Game


June 27, 2019

Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer

To view and download a PDF of this commentary, click here.

Anyone who has either played sports or watched children play sports knows that valuable life lessons can come from the experience. Sports can teach teamwork, strategy, the joy of winning, the frustration of losing and, along the way, can lead to the development of lifelong friendships. While the experience and enjoyment of sports can be similar no matter who you are and what sport you play, a distinct difference exists between success at the professional level and success at any other level. Dr. Charles Ellis, founder of the investment advisory firm Greenwich Associates and the former chair of the Yale University Endowment fund, has spoken about this difference many times, and he has related it to our experience as investors in the book “Winning the Loser’s Game”.

Dr. Ellis would suggest that we consider the game of tennis. Regardless of the level, the rules are the same. However, the difference between tennis at the professional level and tennis for everyone else is that professionals win points, and amateurs lose points. Professional tennis players make strong, well aimed shots and seldom make errors. They win by scoring more points than their opponents. Amateurs, on the other hand, rarely beat their opponent, but often beat themselves. They hit the ball into the net or out of bounds, or they try to make plays that are beyond their capabilities. An amateur who wants to win should focus not on making great shots but on avoiding mistakes. By being conservative and keeping the ball in play, an amateur allows his opponent more opportunities to make mistakes than he makes and, ultimately, he ends up winning by not losing.

Dr. Ellis relates the concept to investing in that most investors, to be successful, should focus on making as few mistakes as possible, as opposed to attempting to outsmart markets or other investors. Trying to win in investing is trying to guess when markets will go up or go down, or concentrating portfolios in certain areas or sectors. As humans, we tend to make these decisions far too late anyway. We have a tendency to “buy high” and “sell low” instead of the opposite. A great example is the recent enthusiasm around gold as an investment. The excitement of gold is not because it has hit an all-time low or looks cheap on a relative basis, but because it is at its highest price since 2013. Does this happen in any other area of our lives? Do we buy a new 70-inch tv because it just doubled in price, or a new car because the advertised price is $10,000 more than it was last week? Only in the investment world do people get excited about buying things at higher and higher prices. When we try to win in investing, greed and fear of missing out lead to poor decisions.

“Offense Sells Tickets but Defense Wins Championships.”

This quote has most often been attributed to Bear Bryant, the former head coach of the University of Alabama football team, who finished his career with six national championships. The quote has been used thousands of times by countless others in sports to emphasize that successful teams focus on defense, not on offense.

Dr. Ellis, in an interview with AQR Capital Management, spoke specifically about the Yale Foundation and its phenomenal track record of investing. Yale is far and away the best performer among college endowments, as measured by rate of return. However, Dr. Ellis would tell you that the magic of how Yale invests is that it has always been defensive:

“Really strong defense makes the offense easy. Most of the trouble in investment management is not because you came just a little short of having superb investment results. It’s because you made a mistake.”

(Ilmanen & Sullivan, 2015)

He then goes on to speak about a conversation he had with the Chief Investment Officer of the Yale Endowment, Dr. David Swensen, just prior to the financial crisis. In 2006-2007, the U.S. economy was very strong, there were few reasons for concern, and investing appeared easy. Undoubtedly, Dr. Ellis and others were concerned about Yale not keeping up with other endowments or the market in general. The conversation probably wasn’t a surprise to Dr. Swensen because in the 2006 Yale Endowment annual report he wrote a commentary called “The Futility of Diversification”, which stated:

“Sticking with portfolio diversification can be painful in the midst of a bull market. When mindless momentum strategies produce great returns, market observers wonder about the time and effort expended in creating a well-structured portfolio. During a roaring bull market, diversification seems to punish investors. For the five years ending June 30, 2000, the S&P 500 returned an amazing 23.8 percent per year. Indeed, institutional investors who sought diversification’s free lunch by holding foreign equities saw those diversifying assets lag terribly. During the five years when the S&P produced 20-percent-plus returns, developed foreign markets, as measured by the MSCI EAFE Index, generated an 11.3% annual return, while emerging markets, as measured by the MSCI EM Index, returned 1.0% annually. Alternative asset classes, like absolute return and real assets, fell hopelessly behind the blistering U.S. stock market. By the late 1990s, many investors questioned the wisdom of owning any assets other than U.S. equities, especially high-flying technology stocks, asserting the inherent superiority of American companies and the inevitable dominance of high-tech businesses. Making the mistake of extrapolating future returns from a strong historical base, investors picked the absolute worst time to abandon diversification and increase allocation to U.S. equities, as the stock market’s remarkable run had brought valuations to unprecedented heights.”

(Yale University, 2006)

Returning to Dr. Ellis, he recalled having the following conversation with Dr. Swensen sometime in 2006-2007:

“David, this is going to surprise you, but I’m concerned that you may be too careful, too defensive, too protective. I just wonder; should you be a little bit more assertive and take a little bit more risk?”

Dr. Swensen replied “Honestly, I don’t know. But I do know one thing. Just about the time you think there’s never going to be a horrific negative surprise, one comes barreling along. I may be too careful. I may be too protective. I may be too defensive. Though knowing history, I think it’s probably a good idea.”

Dr. Swensen ended his commentary in the 2006 Yale Endowment report as follows: “In spite of the opportunity costs of diversification in the late 1990s, the University continued to believe in the importance of a properly diversified portfolio with superior risk and return characteristics. Each asset class that had dampened returns in the late 1990s – bonds, foreign equities, absolute return, and real assets – drove the Endowment to a series of positive returns in the face of an equity bear market. In fact, the University’s discipline of sticking with a diversified portfolio contributed to the Endowment’s achievement of the top long-term record of any college or University endowment.”

When people think about the long-term success of the Yale Endowment, they immediately attribute it to the amount of alternative assets or the manager selection, or Yale’s ability to invest in top tier managers given its network and reputation. Yet we believe both Dr. Ellis and Dr. Swensen would attribute the long-term success to a focus on defense over offense.

Maybe This Time is Different?

If one re-reads Dr. Swensen’s recap of the late 1990s above, it is difficult not to conclude that it sounds eerily similar to the world we live in today. Howard Marks, founder of Oaktree Capital, spoke about the commentary they’re hearing about why “this time is different” and why the current environment may last in perpetuity. Among those reasons:

  • There doesn’t have to be a recession.
  • Continuous quantitative easing can lead to permanent prosperity.
  • Federal deficits can grow substantially larger without becoming problematic.
  • National debt isn’t worrisome.
  • We can have economic strength without inflation.
  • Interest rates can remain “lower for longer”.
  • The inverted yield curve needn’t have negative implications.
  • Companies and stocks can thrive even in the absence of profits.
  • Growth investing can continue to outperform value investing in perpetuity.

(Marks, 2019)

Again, these are justifications Marks and his team are hearing from seasoned investment professionals on why there should be no concern about the current environment. Any reader of this list should be confused by at least one of those statements. Several of them sound completely irrational. In recent years, the U.S. has simultaneously experienced economic growth, low inflation, expanding deficits and debt, low interest rates, and rising financial markets. As Marks says, it is important to recognize that these things are essentially incompatible. They generally haven’t co-existed historically, and it’s not prudent to assume they will do so in the future.

It’s Not a Video Game

For investors in diversified portfolios (which is almost everyone who has hired an advisor), returns over the last several years have been lower than expected. International equity markets haven’t contributed, bond returns are low, and many other diversifying asset classes have not contributed much to return. Diversified investors have chosen to play defense with their money in a period of time when markets appear to have video game-like ease (most of us can really only be Serena Williams or Andre Agassi in a video game). Have we all been too careful? Have we all been too protective? Have we all been too defensive? Maybe we have.

At MRA, we are charged first with protecting our client assets, and second with growing those assets. Over-aggressive investing can lead to a fatal mistake, especially for investors who are taking withdrawals from their portfolio. Enduring the full impact of a bad equity market while making withdrawals can compound the effects so dramatically that they may never be recovered. Our approach in managing portfolios has resulted in prioritizing defense over offense. It seems like forever since we’ve experienced a bad market and, in July, it will officially be the longest U.S. recovery on record. However, as Dr. Swensen said, just about the time you think there’s never going to be a horrific negative surprise, one comes barreling along. Our defensive approach is not selling many tickets, but our goal is to win, and winning in investing is all about lasting through good and bad markets.


Works Cited

Yale University (2006). 2006 Yale Endowment Annual Report. Retrieved June 25, 2019 from https://static1.squarespace.com/static/55db7b87e4b0dca22fba2438/t/578e42a5e58c629352d75dc1/1468940966928/Yale_Endowment_06.pdf

Ilmanen,A. & Sullivan R. (2015, June). Words From the Wise: Charles Ellis on Challenges Facing Investors. Retrieved June 15, 2019 from https://www.aqr.com/Insights/Research/Interviews/Words-From-the-Wise-Ellis-Executive-Summary

Marks, H. (2019, June). This Time It’s Different. Retrieved June 25, 2019 from https://www.oaktreecapital.com/docs/default-source/memos/this-time-its-different.pdf

Written By

Mark Feldman

Nathan Erickson

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