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There’s a popular joke in financial circles that says you can’t eat risk-adjusted returns. In other words, while it might be interesting mental gymnastics to calculate things like a Sharpe Ratio the statistical output isn’t something you eat. In other, other words, if a hedge fund is touting a 9% return with 10% volatility vs a 10% return in the S&P 500 with 20% volatility the thinking says that the investor who owned the S&P 500 can eat more despite the fact that the S&P 500 created more volatility and worse risk-adjusted returns en route to those returns. You can eat total returns, but you can’t eat the Sharpe Ratio. While I am a critic of high-fee active strategies, I also think this is wrong. Let me explain why.

In the lens of the Defined Duration strategy, everything is viewed through very specific time horizons. I think our industry does a terrible job of explaining time horizons to investors in part because most of the commentary in the industry is about stocks and stocks do not have a defined time horizon. That’s part of the problem I’ve tried to solve with this approach by quantifying an implied equity duration and then helping investors understand a reasonable time horizon over which they might expect a certain return. This allows investors to build temporally structured portfolios, much like a traditional bond ladder, where they understand how each piece corresponds to a specific financial plan. In this model, the global stock market is currently a 16-year instrument that will generate about 5-6% real returns on average if you hold that instrument for 16 years. A global 60/40 stock/bond portfolio is about an 11-year instrument that will reasonably generate 4.75% real returns.

The problem with the 16-year global stock instrument is that it will not pay out that 5-6% every year in a predictable manner. It will average 5-6% over 16 years, but in the meantime, it will be up 20% many years and down 20% many years. Consider the chart here which shows two return streams. They end up at the same point in the future, but one is perfectly stable while the other is highly volatile. The red line is the way the stock market generates returns over 16-year periods. The black line is the way everyone wants the stock market to generate returns over 16-year periods. So, when someone takes an all-stock portfolio and tries to optimize it for risk-adjusted returns they are trying to turn the red line into the black line. The problem is that the stock market cannot in aggregate generate this type of return because it is comprised of inherently long-duration instruments that have high levels of near-term uncertainty and volatility. So the investor who tries to optimize stocks for risk-adjusted returns is essentially trying to turn water into wine – they are trying to turn a long-duration instrument into a short-duration instrument. This is one of many reasons why most highly active investors fail – they are engaged in an endeavor that is quite literally impossible in the aggregate.

One of the things I focus on with the Defined Duration strategy is that it’s specifically designed to help people eat their returns better. That is, it’s designed with a financial planning foundation which then matches assets accordingly and helps people plan for their future with greater predictability. You can plan your future meals better because the return streams become more predictable over very specific time periods. And that’s essentially what a hedge fund is trying to do when they take a diversified portfolio of assets and try to optimize the risk-adjusted returns. It just doesn’t work out that well on average because they’re trying to take a long-duration portfolio and make it predictable over short-term periods. But for the handful of hedge funds and active funds that are able to do this, they do actually help their clients eat better because they are creating a more predictable return stream. But this is extremely hard to do and study after study shows that you very likely won’t find a hedge fund that achieves it with consistency.

The real problem with most high-fee stock-picking strategies or multi-asset strategies is they are inherently long-duration buckets in our financial plans. In the Defined Duration model most homogenous diversified portfolios end up being 10+ years in duration because they’re a blend of stocks or stocks/bonds and other instruments. So these investment managers are trying to turn water into wine and help you consume out of a long-term bucket. They fail for two reasons:

1. The evidence clearly shows that lower-cost alternatives have a strong tendency to outperform over long periods of time.
2. You cannot make an inherently long-term instrument act like a short-term instrument on average.

The result is, when you buy the ABC Multi Asset Stocks Bond Hedge Fund with a 1% expense ratio you’re probably buying an instrument that has a duration of about 10+ years (because bonds will average 5+ year duration and stocks are 15+ years). And when you compare that to something like a boring low-cost 60/40 index fund you’ll find that the funds don’t outperform over long periods of time because they cannot in aggregate and their taxes/fees end up eating too much of the total return to outperform. But more importantly, you cannot predictably consume out of this bucket because it creates too much short-term uncertainty. That is, after all, why diversified multi-asset funds like a 60/40 stock/bond fund work in the long run – you have to be willing to sacrifice short-term liquidity to allow long-term cash flows to accrue to the underlying instruments.

None of this means that the pursuit of high-risk adjusted returns is irrational though. It just shows that it’s very hard to achieve. Still, it does display what we all want – we want stable returns over specific time periods. And we want stable returns because you can eat those returns. In other words, you can plan your life more clearly if you know how much money you’ll have at specific times in the future.

So here’s the thing the big conclusion – the pursuit of stable and steady returns is a good goal. And you can absolutely eat risk-adjusted returns (assuming you can find them, which, you probably cannot). So, you can either choose to try to turn water into wine or you can just choose to drink sparkling water from a series of predictably placed buckets using a strategy like the Defined Duration approach. We can’t guarantee you’ll generate better risk-adjusted returns, but you will generate stable returns consistent with your financial goals.

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