Devesh Shah and David Sherman engaged in a free-range conversation that touched on benchmark-free investing over hot drinks and fresh pastries. Benchmark-free investing starts with the question, “If you simply didn’t care about ‘the conventional wisdom’ concerning which assets you were supposed to own, what assets would you own?”
Mr. Sherman and Oaktree’s Howard Marks seem to endorse the same conclusion: “likely high-yield bond, surely not stocks.” That’s certainly contrary to conventional wisdom, which is centered on Jeremy Siegel’s chant, “Stocks for the long run!”
The case for stocks is driven by The Great Distortion, the period from the point that the Fed moved heaven and earth to stock the Global Financial Crisis (2007-09) from spiraling into a second Great Depression.
Let’s test the stock hypothesis, starting with …
Two quick quiz questions:
- would you want an investment with the highest returns (that is, the bottom line regardless of volatility) or the highest risk-adjusted returns?
- In the long term, which asset class gives you the highest risk-adjusted returns?
If we ask the first question of the “average investor,” their declared answer is, “Show me the money!” But if we measure their actions, their actual answer is, “I’m fearless as long as markets are rising steadily! Roooar! (But when things get scary, I’m outta here!).” That’s the consistent finding of Morningstar’s “Mind the Gap” research: “poorly timed purchases and sales of fund shares, which cost investors roughly one-fifth the return they would have earned if they had simply bought and held.” In general, investing in more volatile funds or asset classes (e.g., sector funds) led to vastly larger gaps in performance.
If we ask the second question of our same investor, the answer is likely to be “stocks! Stocks! Stocks for the long run!” That is, we all agree that short-term volatility in equities is the price of their dominance for long-term investors.
The simplest test of that hypothesis is to look at Fidelity’s family of Asset Manager funds. The funds vary from one another primarily in the degree to which they invest in stocks. Asset Manager 20% is … well, 20% equities, while Asset Manager 85% is 85% invested in equities all the time. Otherwise, the same manager, same underlying investments, comparable expense ratios.
Using the MFO Premium fund screener, we pulled the 15-year record for all six Asset Manager funds. That roughly corresponds with the age of the group’s newest funds. The three columns with blue headers are the good news: the average annual return, the performance of the fund relative to its peers, and the average annual return for an investor willing to buy and hold for three years.
The orange/peach headers are the bad news: the fund’s biggest drop in the past 15 years, its typical volatility (called “standard deviation”), and its volatility in falling markets.
Finally, the green columns give the risk-return trade-off. The Sharpe ratio is the industry’s standard measure; with Sharpe, higher is better. The Ulcer Index is pretty much distinctive to MFO Premium: it combines measures of how a fund falls and how long it stays down. Here, lower is better since a higher number corresponds with a bigger ulcer.
Finally, the 60/40 capture ratio is a sort of “bang for the buck” measure, measured against the performance of a simple and unchanging 60% stock / 40% bond portfolio. It divides the percentage of the benchmark’s upside your fund captures against the percentage of its downside. So, a fund that captured 10% of the benchmark’s upside but only 1% of its downside would have a capture ratio of 10. If you captured 20% of the upside and 20% of the downside, or 47% of the upside and 47% of the downside, or 150% of the upside and 150% of the downside, you’d have a capture ratio of 1.0. With capture ratios, higher is better.
Fidelity Asset Manager performance of 15 years, sorted by highest Sharpe ratio
| Fidelity Asset Manager | APR | APR vs Peer |
APR Avg 3-yr Roll | MAX Drop | Std Dev | Down- market dev | Sharpe Ratio |
Ulcer Index |
60/40 Capture Ratio |
| 20% | 4.0 | -0.5 | 4.6 | -12.7 | 5.2 | 3.5 | 0.62 | 3.3 | 1.1 |
| 30% | 4.9 | 0.4 | 5.7 | -15.4 | 6.8 | 4.6 | 0.60 | 4.2 | 0.99 |
| 50% | 6.4 | 0.5 | 7.6 | -20.8 | 9.9 | 6.7 | 0.57 | 5.6 | 0.92 |
| 60% | 7.0 | 1.1 | 8.3 | -23.1 | 11.4 | 7.6 | 0.55 | 6.2 | 0.90 |
| 70% | 7.6 | 0.4 | 9.2 | -27.4 | 13.0 | 8.8 | 0.52 | 7.0 | 0.88 |
| 85% | 8.4 | 1.0 | 10.3 | -31.1 | 15.2 | 10.2 | 0.50 | 8.1 | 0.87 |
Source: MFO Premium fund screener and Lipper Global data feed
And here, we highlight the winner in each column with bold green text:
Fidelity Asset Manager performance of 15 years
| Fidelity Asset Manager | APR | APR vs Peer |
APR Avg 3-yr Roll | MAX Drop | Std Dev | Down- market dev | Sharpe Ratio |
Ulcer Index |
60/40 Capture Ratio |
| 20% | 4.0 | -0.5 | 4.6 | -12.7 | 5.2 | 3.5 | 0.62 | 3.3 | 1.1 |
| 30% | 4.9 | 0.4 | 5.7 | -15.4 | 6.8 | 4.6 | 0.60 | 4.2 | 0.99 |
| 50% | 6.4 | 0.5 | 7.6 | -20.8 | 9.9 | 6.7 | 0.57 | 5.6 | 0.92 |
| 60% | 7.0 | 1.1 | 8.3 | -23.1 | 11.4 | 7.6 | 0.55 | 6.2 | 0.90 |
| 70% | 7.6 | 0.4 | 9.2 | -27.4 | 13.0 | 8.8 | 0.52 | 7.0 | 0.88 |
| 85% | 8.4 | 1.0 | 10.3 | -31.1 | 15.2 | 10.2 | 0.50 | 8.1 | 0.87 |
Misleading takeaway: in every measure of returns, more equity is better. In every measure of risk and of risk-adjusted returns, less equity is better. Several earlier MFO essays on the discreet charm of stock-lite portfolios found the same relationship is true for periods dating back 100 years. Lightening up equity exposure reduces your volatility by a lot more than it reduces your returns, so it always seems like the best move for risk-conscious investors.
Until TINA (There Is No Alternative – to stocks) came along. The Fed’s decision to zero out interest rates for the better part of a decade killed the returns on cash and cash-like bonds. Then the US bond market, which peaked in July 2020, entered “the worst bear market in the nearly 250-year history of the U.S., according to Bank of America’s Michael Hartnett” (Joseph Adinolfi, “Treasury-market selloff has become the worst bond bear market of all time, according to BofA,” MarketWatch, 10/9/2023). At the same time, zero interest rates underwrote radical risk-taking in the stock market. Rupal Bhansali, then-manager of Ariel Global, decried a period when we went from “a market on steroids to a market on opioids!” Those two historic disruptions have skewed all of the historically stable relationships between asset allocations and risk-adjusted returns. We could call it The Great Distortion.
Risk–return trade-offs during The Great Distortion
For each of the following periods, we examined the risk-return profiles for all seven Fidelity Asset Manager funds for every trailing period from one to fifteen years. The 15-year record captures only the beginning of The Great Distortion, while the 20-year record captures the years before the distortion began.
| Best Sharpe ratio | Best capture | Worst Sharpe ratio | Worst capture | |
| 1-year | 85% | 85% | 20% | 20% |
| 2-year | 85% | 85% | 20% | 20% |
| 3-year | 85% | 85% | 20% | 20% |
| 4-year | 85% | 85% | 20% | 20% |
| 5-year | 85% | Virtual 7-way tie | 20% | Virtual 7-way tie |
| 6-year | 85% | 85% | 20% | 20% |
| 7-year | 85% | 70% | 20% | 20% |
| 8-year | 85% | Virtual 7-way tie | 20% | Virtual 7-way tie |
| 9-year | 85% | 20% | 20% | 50% |
| 10-year | 85% | 20% | 20% | 85% |
| 11-year | 85% | Virtual 7-way tie | 20% | Virtual 7-way tie |
| 12-year | 85% | 20% | 20% | 60% |
| 13-year | 40% | 20% | 20% | 85% |
| 14-year | 40% | 20% | 20% | 85% |
| 15-year | 30% | 20% | 85% | 85% |
| 20-year | 20% | 20% | 85% | 85% |
Outside of The Great Distortion, the risk-adjusted returns of a stock-heavy portfolio wane. The most interesting comparison builds on Mr. Sherman’s and Mr. Marks’ argument: high-yield bonds are actually the more rational choice.
To test that guess, we looked at the long-term records of three Fidelity funds: one is heavy on stocks (FAM 85%), one is heavy on investment grade bonds (FAM 20%), and the third is heavy on high-yield bonds with just a dash of high-yield stocks: Fidelity Capital & Income, a Great Owl fund.
From Fidelity.com:
Fidelity Capital & Income Fund is a diversified high-yield bond strategy that seeks income and capital growth by investing primarily in the bonds of non-investment-grade companies.
We apply an opportunistic investment approach, which results in tactical positions aimed to capitalize on relative value across a company’s capital structure, including high-yield bonds, stocks, convertible securities, leveraged loans and preferred stocks.
In particular, we seek companies with strong balance sheets, high free cash flow, improving business/industry fundamentals and sharp management teams that are motivated to reduce debt. In doing so, we take a longer-term investment outlook and also may take advantage of opportunities based on where we are in the credit cycle.
20-year records for high-yield heavy, investment-grade heavy, and stock-heavy funds
| Name | APR | APR vs Peer | MAXDD | STDEV | Sharpe Ratio | Ulcer Index | 60/40 Capture Ratio |
| Fidelity Capital & Income | 7.6 | 2.0 | -35.3 | 10.4 | 0.60 | 6.7 | 1.1 |
| Fidelity Asset Manager 20% | 4.1 | -0.5 | -16.8 | 5.0 | 0.55 | 3.7 | 1.1 |
| Fidelity Asset Manager 85% | 7.5 | 0.4 | -49.2 | 14.4 | 0.42 | 11.7 | 0.85 |
Hmmm … over the past 20 years, through three stock market crashes, a bond market crash, and a cash crash, a heavy investment in high-yield bonds produced essentially the same returns as a heavy investment in stocks but with a reduction of about one-third in the volatility. In consequence, high yield produced far stronger risk-adjusted returns than stocks on all three of the risk-adjusted metrics we’ve used.
Bottom line: If you suspect that The Great Distortion – zero interest rates, zero inflation, a permanent bond bull market, and an infinitely accommodative fed – is unwinding, you need to reconsider the automatic impulse toward 60% US large cap stocks and 40% investment grade bonds. One place to look is at managers who have the ability and the flexibility to look at other sources of gain.
Four distinguished opportunities
“Great Owl” funds are an MFO designation for funds with uniformly excellent risk-adjusted returns. Technically, the standard is “top quintile risk-adjusted returns, based on Martin Ratio, in its category for evaluation periods of 3, 5, 10, and 20 years, as applicable.”
These are funds whose styles are largely at odds with the risk-on, highly speculative style favored during The Great Distortion. They rejected both style boxes and speculative risk, stuck with their discipline, and thrived. They represent different strategies for addressing a fundamentally changed environment and are worthy of attention.
10-year performance (through 10/2023)
| Great Owl | The Game | Verdict | Avg annual return | Std dev | Max draw down | Sharpe ratio |
| Fidelity Capital & Income | High-yield bonds plus some equities from high-quality corporations | Great Owl, five-star, 45-year record | 6.0 | 9.2 | -17.5 | 0.53 |
| FPA Crescent | An absolute value fund that aims to protect capital first and create long-term equity-like returns second. They invest across the capital structure, asset classes, market caps, industries, and geographies. We are willing to hold cash. | Great Owl, five-star, Gold rated, 30-year record | 7.0 | 12.1 | -20.5 | 0.49 |
| Osterweis Strategic Income | They want to preserve capital and earn long-term total returns through a combination of income and moderate capital appreciation. The base is high-yield bonds, but they shift to higher quality or shorter duration securities and cash as circumstances demand. | Great Owl, four-star, 20-year record | 3.8 | 4.7 | -9.6 | 0.57 |
| RiverPark Strategic Income | Opportunistic, but loss-averse mix of shorter-term high-yield bonds with some investment grade and some equities as market conditions demand. | Great Owl, five-star, 10-year record | 3.7 | 5.3 | -13.6 | 0.49 |
| Benchmark | An average of the high-yield and flexible portfolio groups | 4.0 | 9.0 | -18.0 | .34 |