Guest User

April 21, 2022

Episode 197: The Immortality of Bonds

Guest User

April 21, 2022

Many people have been contemplating the death of bonds, which is why for the main topic of today’s episode we’re going to be talking about their immortality. After a vicarious trip to The Masters, an overview of The Art of Insubordination, and an explanation of why we’re concerned about the changes that WealthSimple has made to their business model, we get into the world of bonds. Bond returns have not been good this year, and bond index funds are down all round, but that doesn’t mean that bonds are necessarily the riskier choice of investment in the long term, or that you should be feeling disheartened about them. Tune into our conversation today to hear why!

Key Points From This Episode:

The incredible experience of attending The Masters, and how you can win a ticket. [0:02:21]
Three business-focused TV series that we highly recommend. [0:02:27]
Upcoming guests, and some very positive listener reviews. [0:03:34]
An overview of The Art of Insubordination. [0:09:16]
Why change is challenging for most people, and the value of creating environments that encourage dissent. [0:11:12]
How dissenters can make their actions more impactful, and what leaders can do to encourage dissent. [0:13:16]
Key takeaways from The Art of Insubordination. [0:16:39]
Why we are disappointed with the changes that Wealthsimple has made to their business. [0:18:47]
Nuances that Wealthsimple has left out of their venture capital analysis. [0:23:51]
Today’s main topic: the immortality of bonds. [0:33:38]
Statistics which highlight the fact that bond returns have not been good this year. [0:33:51]
Why volatility is not the only risk that matters. [0:35:06]
How Ken French defines risk. [0:37:51]
Some of the pros and cons of bonds and stocks. [0:38:56]
Calculations which show that stocks are not necessarily less volatile than bonds in the long run. [0:40:48]
The five components of long-run predictive variance. [0:43:23]
An explanation of a model we created for the dispersion of outcomes. [0:45:10]
Why now is the time to get excited about bonds. [0:49:27]
Today’s first misconception: high growth sectors/regions/companies are good investments. [0:53:52]
Today’s second misconception: you can lose all of your money in stocks. [0:55:57]

Read the Transcript:

Ben Felix: This is the Rational Reminder podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We are hosted by me, Benjamin Felix, and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore: Welcome to episode 197. Since we last spoke, I and Lisa and two good friends made it to the Masters golf and back, which is pretty incredible. I just thought I'd share because I know I've had a bunch of people ask me online like, "How do you do that? How do you get to go?" It's a lottery that we won our practice round tickets for the Monday. It's a one-day set of tickets that we got.

We actually won them two years ago and they kept being brought forward due to the pandemic. The lottery for 2023, I believe opens up in May, then closes sometime this summer. If you want to go, that is one way to try. I have no idea how many people are in the lottery. I'm guessing it's a lot. It took me probably 15 years for my number to come up. Anyway, it was an incredible experience. Whether you're into golf or not, the whole event is unbelievably well-organized.

The property is simply incredible. The organization of moving that many people around effectively is brilliant and we really lucked out. We ended up at the practice driving range. We had front-row seats by luck in the small gallery, and maybe 15 minutes after we sat down who shows up but Tiger Woods right in front of us. We got to watch him go through all his irons and his drivers.

It's just incredible to watch him swing a club and shape his shots and ham it up with a lot of the other players. It was incredible experience. If you're into golf at all or into the Masters, I highly recommend you enter the lottery and try your luck. Two weeks ago, you asked me a question after we talked about Mary Childs' book, The Bond King. Remember in the title was how one man made a market, built an empire and lost it all.

Anyways, I gave you a terrible answer when you asked me, "How did he lose it all?" He lost it all by being thrown out of the company. He ended up quitting before he was terminated. He went and joined Janice, but that's how he lost it all. I would argue his reputation didn't exactly come out great from it but that's how he lost it all.

Ben Felix: Interesting. Wait, why was he thrown out? Do you know?

Cameron Passmore: Oh, that's what the book's about.

Ben Felix: Oh, I see.

Cameron Passmore: The book's about his personality and he's obviously a brilliant bond manager and had enormous amounts of influence, but there's a lot of stuff that went on over the years that caused a divergence of views in how the firm should go forward. Speaking of crazy business stories, we finished up Super Pumped, which is the story of Uber and Travis Kalanick. We finished up Dropout, which is the Theranos, Elizabeth Holmes story.

Unbelievable, crazy stories of what appeared to be at the time wildly successful companies. Of course Uber still is, but their stories in business are wild. Then WeCrashed the story about Adam Neumann and WeWork. I think the last episode comes out on Apple this Friday coming up. Another incredible, incredible business drama story. Three of them I highly recommend. Have you caught any of them yet?

Ben Felix: No, I've not watched any of those. They all sound good. I listen to podcasts on Elizabeth Holmes. I think I've listened to two different ones. I think there's a podcast called WeCrashed that I listen to. They're fascinating stories to listen to. I haven't seen anything about Uber. Yeah. Those flame-out business stories are very interesting.

Cameron Passmore: How Elizabeth Holmes pulled off this fraud and like got into like Walgreens, it's unbelievable.

Ben Felix: Yeah. The story is crazy.

Cameron Passmore: Had George Shultz on the board and there's no evidence whatsoever. Quite something. Upcoming guest next week is Gerard O'Reilly will be joining us, who is the co-CEO and chief investment officer Dimensional Fund Advisors. In three weeks, so episode 200, as everybody knows, we welcome Nobel Laureate Professor Eugene Fama. Safe to say that was a good conversation, Ben.

Ben Felix: I thought it was a really good conversation. I don't know. What did you think?

Cameron Passmore: I thought it was amazing. I mean, I think we got in 60 questions with really solid crisp answers from Professor Fama. I thought it was amazing.

Ben Felix: Yeah. We anticipated that his answers would be succinct because he's often is that way. So we prepared many more questions than we typically would just in case and figured we would cut some as we went if needed, but it ended up being that we didn't cut any. We in fact asked a bunch of extra follow-up questions that were unplanned. It was by far the highest number of questions that we had answered by a guest in an episode.

Cameron Passmore: By far, Fama holds the record. Then two weeks after that from AQR, Antti Ilmanen and will be here, who just released his new book, Investing Amid Low Expected Returns. I'm holding up for the YouTube viewers. Have you dug into this book yet, Ben?

Ben Felix: No. That's going to be the next thing that I dig into.

Cameron Passmore: We've had some really nice reviews on Apple. Torkmada from Canada called it a weekly treat and said, "The information is presented in a non-condescending manner." That's very kind of him. Then KWPHI from Switzerland gave a really nice review and said that our concern for the listening audience is palpable.

Ben Felix: Well, they also said that we're the most financially literate podcast on the web. I thought that was nice.

Cameron Passmore: Pretty bold statement, but yeah.

Ben Felix: Yeah. I'm not saying it's true, but it's a nice compliment.

Cameron Passmore: Then R. Novia from Spain said that we deliver value to professionals and retail alike and said that they teach modern portfolio theory and learned a couple of things in that episode. Great job. That was really nice. Then Dan FFA for the United States said, "It's a leading podcast for financial education." Said, "Looking to improve your life or financial situation, we discuss a vast range of topics and professionals that will consistently help you do that and more. The interviewees are extraordinary people with equally extraordinary topics."

Ben Felix: Dan's someone that's been a listener for a long time and is very active in our Rational Reminder community. He's one of the moderators there. When I saw that he wrote a review, I kind of thought, "There's probably lots of other people who have listened for a long time and haven't left a review." If you're so inclined, it's nice for us to read them.

It's fun to see what people think, but our understanding is that it actually helps with the reach of the podcast and helps Apple figure out what to recommend. Yeah. Reviews are helpful.

Cameron Passmore: I also got a nice email from an advisor in Brussels saying that he loves that we've been going beyond the mechanics of investing into the realm of happiness, goal-setting, motivation and living a meaningful life. Said that we're a great inspiration and that we constantly make them think about what ways that they can help their customers get more out of their investment journey.

Ben Felix: I think they run a online robo-type service, if that's who I think it is.

Cameron Passmore: Interesting.

Ben Felix: Anyway.

Cameron Passmore: Yes. It's neat. A lot of people have been reaching out like Philippe in Brussels, Patrick in London, England, Ryan in Naples. This is all just last week. Joshua in Brisbane, Australia. People across Canada, Daniel in San Francisco and Lincoln in Sydney, Australia. Speaking of Sydney, do you watch Selling Sydney on Amazon?

Ben Felix: You can always assume the answer's no.

Cameron Passmore: They just came out with a new season I think yesterday. Oh, the houses on the coast, on the cliffs of Sydney are unbelievable and it's this crazy bidding frenzy because there's obviously so few properties on the cliffs so prices are just going through the roof. Something to watch. As always, you can connect with us on LinkedIn, Twitter, #RationalReminder on Peloton, I'm CP313 on Peloton. Angelica gives an update on the reading challenge.

Over 1200 books read so far, almost 1800 badges have been earned 465 participants. I think I'm up to 250 friends. I don't know how many you're up to or not. Angelica asked everyone if they want to share their friend code on Twitter and Instagram using the $RR22in22, you can connect with Ben or I. Don't know if we read out our codes or not if people get anything out of the code, but mine's all caps N62iPTX and you are 7XWESMK, all caps.

Ben Felix: We post them in the show notes. That's probably easier.

Cameron Passmore: Yeah. Or you go to the-

Ben Felix: Copy and paste them.

Cameron Passmore: ... can go to the community board as well. It's in there. Have you seen these new green shirts they got in the store?

Ben Felix: No.

Cameron Passmore: Very nice. I wish I'd known. I would've worn them with my Masters hat, but there's new Rational Reminder green t-shirts in the store. Only 25 bucks, free delivery in North America.

Ben Felix: Same print for the same Rational Reminder logo thing?

Cameron Passmore: Same logo. Just nice bright green shirts for spring.

Ben Felix: Awesome.

Cameron Passmore: Yeah. Apparently almost 7,000 members in the community.

Ben Felix: Yeah. Community continues to be a pretty cool place to hang out and talk about pretty geeky stuff.

Cameron Passmore: Okay. Anything else?

Ben Felix: No, I think that's good. Let's go ahead to the episode. Welcome to episode 197 of the Rational Reminder podcast.

Cameron Passmore: Okay. I have a good book review for you this week. I remember reading this and I texted you when I was reading it saying, "This book makes me think a lot about you." You said, "What do you mean?" Anyways, the book is called The Art of Insubordination: How to Dissent and Defy Effectively by Todd B. Kashdan. As listeners know, I've been trying to learn as much as I can about organizations and leadership. This week's book is certainly in that stream of research.

It comes down to the question of where does change in an organization come from? Where does creativity come from? What are some of the characteristics of organizations that really do embrace change and innovation, many companies, including ours say this, but where does it really come from? What happens on the ground that causes change and innovation to happen? Anyways, that's what this book is about.

The argument the author makes is that one of the causes of change is people dissenting, insubordination, which is the definition of insubordination is defines an authority refusal to obey order. When you think about creativity and innovation, this is exactly what insubordination is. Something new, something different, trying something different, but how do organizations capitalize on this?

How do people that have nonconforming ideas effectively get those ideas across and how should leaders behave in an organization to get the most new ideas out of people? That's what this book is all about. It's basically a guidebook for companies to reap the benefits of dissent in the workplace, to permit it, to embrace it, to get people, to effectively express unpopular different ideas and how to manage the discomfort that humans feel when new different ideas get presented.

That's what the book is all about. It's really how to create more change in your organization. I thought I'd give some of the highlights about what causes the resistance to change, how to lead an organization for change, how employees and team members can bring forth more change. Then actually some tips for parents too. Bottom line, the issues we face when dealing with change is that people don't like losing control.

People love control. People love fitting in. People have a very strong status quo bias. We tend to evaluate evidence, not in a perfectly objective way, but we review evidence based on what we hope to conclude in any question. We tend to feel overconfident in our positions. We tend to fail to see the need for change. We underestimate the costs of an action. There's a whole pile of biases.

I'm not going to go through them all. We've talked about them on the podcast in the past, but we've confirmation bias, familiarity bias, projection bias, authority bias. All these biases that we as humans have that make bringing forth change hard, make convincing people of the change you want to make hard, make managing organizations that embrace change hard. We have all these built-in biases.

What should an organization do to encourage more dissent among the team? Number one, welcome and encourage people who disagree with us. We should desire useful information regardless of where it originates. We should realize that groups of people perform better when principled insubordination is encouraged. He talks a lot about the principles. You don't want to be a dissenter just for the sake of being the bad guy.

You want to come forth with valuable creative ideas. You also want to make sure that and realize that teams need psychological safety to be open-minded to different types of thinking. Don't robotically default to assuming the dissenter is right. This is a key. Instead, become motivated to contemplate an issue carefully and consider that the dissenter might have a valid point.

This ends up creating a team that is much more open and much better at critically thinking and more balanced in taking a look at new ideas. The reason for me texting you is that you're often very good at bringing forth different points of view. If you were to bring something different to a team, what should you as a dissenter do for greater impact? Number one, the dissenter must understand the group's hardwired biases that I mentioned earlier.

They should point out the cost of inaction. Makes sense. You also want to make sure you're not viewed as an outsider. The people you're trying to change and present new ideas to are more likely to listen to you if you're really perceived as a member of the group. Spark curiosity, don't spark fear. Do not try to frighten or alienate the group. You also want to project an aura of objectivity, make sure that your statements appear objective and verifiable.

Lastly, be extremely patient. Principal insubordinates often initially fail to change other people's attitudes, but over time, they can have a very profound impact. As a leader in an organization that wants to have this kind of change, you want to devote energy to establishing bonds with other group members. This makes the group much more open to different views.

You want to signal your courage by demonstrating this openness to dissent, and you want to find out people that are different from you. People who are interesting, challenging, and are a source of enlightenment. You want people that will blow your mind with new ideas and perspectives, but clearly this is hard, right? Because we're wired to not want that, or many of us are.

When you're confronted with an idea, so if you come to me with a new idea, so when you're confronted with an idea from a nonconformist, you want to always remember what and who is important to me. You have to go back to your objectives and your values. You also want to be hyper aware of how you feel and what are you thinking and feeling when that new idea comes up? Often you'll feel anxiety as one byproduct.

Be aware of the possible opportunity that's being presented to you and the opportunity to change and the opportunity on the rest of the organization. Resist the belief that we know enough on our own to arrive at the right decisions. This is a big one. You don't know everything. Ensure to not resent the dissenters for making us aware of our own limitations. Then this last one goes back to remember we talked about the book, Ambitious.

Force yourself to remain deliberately humble and stay open to criticism and new ideas, all pretty sensible advice. The book does a great job of packaging it all really. There's also some really good ideas for developing dissent with kids. I think to think back to when I was a kid, so many of these are contrary to how I was raised. Number one, don't lecture your kids.

Instead, spend time listening to them. Find moments for kids to enjoy independence, offering them space to work on problems and puzzles in their own way. This next one, provide your kids with frequent speaking opportunities. Give them the floor to speak for themselves when around other adults. I was always told you have two ears and one mouth for a reason. When you're around adults, don't talk.

Note indicators that your child is improving or mastering a skill and call it out. Try to connect what they do to their personal goals. Don't bark out commands at your kids. Instead, encourage them as they work. When your kid gets stuck in a problem, don't offer solutions, but instead feed them helpful hints. Acknowledge your kids' perspective and experience. Show compassion for the difficulty of a task.

This last one I think is interesting and probably doesn't just avoid to kids, but avoid statements with words like should and ought, as these suggest that there is a right and wrong way of arriving at solutions. Anyway, my key takeaways from this book, number one, be deliberate and disciplined with dissent and dissenters. Know the difference between reckless and principled insubordination. Principal rebellion is vital for improving society.

Creativity. I love this one. Creativity is not an innate gift. It's a way of thinking and dissenters help. Make openness to new ideas your default. Treat rebels as uniquely valuable contributors. Fight back against confirmation bias and always remain deliberately humble.

Ben Felix: Really good takeaways.

Cameron Passmore: Phenomenal book. It just shows the impact. We live this all the time and I think it is a lifetime skill to really develop to become deliberately open-minded as new ideas come up. I think we're pretty good at it. You have to be, especially with younger generation that thinks of different ways of tackling different problems.

Ben Felix: Yep. Very cool. That was a good one.

I don't have to read the book because I think I got the takeaways just now, but-

Cameron Passmore: I think you did too. That's okay.

Ben Felix: I'm glad I got them though. It's good stuff.

Cameron Passmore: All right. Recent news.

Ben Felix: Yeah. I feel bad talking about Wealthsimple again. I mean, we got rid of bad advice for a reason. We didn't want to be picking on stuff. They keep doing stuff that's worth talking about. I think if I could go back, I would've not talked about them last time and would talk about them this time. Because last time it was just, they made a small change to their portfolios, whatever, but they've recently launched a venture capital product.

I thought it was worth just touching on. Not only because they make a lot of noise when they launch a product, like they market it very well. But probably because of that, we get questions about it from clients. This is something that we've gotten questions about so I wanted to address it. I was also thinking about why did I feel the need to bring up Wealthsimple in our last non-guest episode? Because we never talk about BMO or RBC who also have robo-advisor services.

Maybe they're doing stuff in portfolios too, but we never comment on that. I was thinking about this. Why do I care about what they're doing? When they first launched, I can't remember when that was, it was years ago now, I was very excited to have a low-cost alternative to send people to for just simple, low-cost, hands-off, no-knowledge-required portfolios, index fund portfolios.

You got to remember, when I started at PWL, which is a while ago ... I mean, not that long ago, I guess, but it's almost nine years now. It's a while. When I started at PWL, if somebody couldn't be our client, there weren't a whole lot of options to send them to. You had Tangerine Bank, which had hands-off, one-decision asset allocation index mutual fund portfolios.

They were charging 1.07%, which today it's like, you can't believe that somebody would pay that much to own index funds. Back then that was the thing. The next option was TD e-Series, which were ... I can't remember how much. Like 40 basis points or something maybe. But with the TD e-Series mutual funds, you had to go in and buy the individual funds and do your own rebalancing.

It was a big jump for somebody who was new to investing to go from Tangerine to rebalancing and you have to have a spreadsheet and all this stuff.

Cameron Passmore: Absolutely.

Ben Felix: To go from Tangerine to save the fees in TD e-Series was a big jump. Then the next sort of step I guess in complexity, was to use ETFs. This is back when asset allocation ETFs weren't a thing. Not only did you have to learn how to trade, you also had to do all the rebalancing and maintenance and do it while the market was open and all this stuff. It was a big thing.

Being an index investor was not nearly as easy then as it is today. Wealthsimple shows up and it's like, great. There's an easy hands-off option to send people to with reasonably low fees. Cheaper than Tangerine, a little bit more expensive than TD e-Series, but you're getting low-cost index funds. You're getting customer service representatives to talk to.

Cameron Passmore: Yeah. Good digital experience.

Ben Felix: Right. Nice online interface and all that stuff.

Cameron Passmore: Yep.

Ben Felix: I used to do corporate seminars where I'd go and give a talk about index investing and just the basics to 20/30 people at a time. I would do that once a month, I think. Part of that presentation was to say, "Here's how you can do index investing yourself." I added Wealthsimple as one of those, here's how you can do it yourself options. Then that was great.

Then I also used to do one-on-one sessions, again, at corporations, and we still do this, where we meet with employees one on one and people who probably wouldn't be a PWL client. We just do it as a service. We would've to direct them to, again, here's how you can go and implement this advice that we're giving you. We've probably referred like hundreds of people to Wealthsimple since they launched. Anyway, they've changed a lot since then.

Their low-cost index fund portfolios have changed materially. They've obviously launched other products that encourage trading and cryptocurrency investing. Then most recently they've introduced this venture capital product. Anyway, I just felt the need to say that. Why do I care about what Wealthsimple is doing? Because when they launched, I thought it was a really great initiative for Canadians. I think that they've changed a lot since then, which is fine.

I mean, I don't blame them as a company for not staying true to the mission of low-cost index investing. That's probably just a really bad business to be in. As we've seen with all the other robo advisors in the States, who've had to make substantial pivots into doing other stuff. All right. I just wanted to get that off my chest.

Cameron Passmore: That's interesting though. It might just be bad business. Like you might attract the people that don't give the kind of margin that companies want.

Ben Felix: You start a business where you have no account minimum, you earn revenue by managing assets, which is what they were doing originally. You're going to get small accounts with low-knowledge people who by nature of being low-knowledge need a lot of customer service help. That's a bad business.

Cameron Passmore: Or high knowledge and realize and go pick up a balance ETF for half the price perhaps.

Ben Felix: Oh, eventually. Sure. Yeah. Yeah. The asset allocation ETFs could have hurt some of their business, but they've diversified and they've become a more diversified financial services business, which from the perspective of growing a business makes a lot of sense. They took a lot of funding. I mean, that was very public. They took big rounds of equity funding early on. I mean, of course they have to scale their business.

I don't blame them, but that's why I pay attention to what they're doing and it stings every time I see they're doing something that I wouldn't advise somebody to do because I have told so many people that Wealthsimple is a great alternative as a hands-off option. Anyway, they've come out with a VC product on their landing page for this new product.

They explain that venture capital and particularly top quartile venture capital offers a potential for outsize investment returns. That's true. It's true. It's a lot more nuanced than that. The landing page on their website makes it seem pretty great and it can be, but again, I want to just touch on the nuance for a minute. They show on their website 12% as the return back to 2000 for venture capital.

I couldn't replicate that number. They reference a PitchBook report, which I downloaded and looked through it. Anyway, I've asked somebody there for clarification, but they say 12% returns for VCs in asset class, 24% for top quartile managers, which those are believable numbers. I wasn't able to verify the source.

Anyway, I'll report back on that if I get more information, but more generally, so not just that report that they're referencing, more generally what do we know about venture your capital returns? There's a 2015 paper from Harris, Jenkinson and Kaplan. Kaplan is Steve Kaplan who's at Chicago. It'd be cool to have him on eventually. He's done a massive amount of work in private equity and venture capital research.

Him and Antoinette Schoar came up with the PME, the public market equivalent, which is basically the universal measure that people use to look at private equity returns, just because it's hard to compare a monthly return series of public equities to private equity because the cash flows are irregular in private equity and venture capital. Anyway, that's more nuance for another day probably.

In terms of venture capital performance from this 2015 paper, in the '90s venture capital funds outperformed public equities, pretty substantially. Funds that started in the '90s, tended to outperform by a wide margin and then VC funds that started since 2000 have generally underperformed. That's one of the findings from this paper using the public market equivalent, the PME, VC funds started in the '90s, had mean average PMEs of 2.05.

That means that they doubled the return of if you had invested those same cash flows into public markets. That's great obviously. The median though, and this is one of the characteristics of venture capital. The mean 2.05. The median 1.26, so much lower on the median. That's because there's enormous skewness in VC returns, which we'll come back to. Then funds raised in the 2000s, and it went up to 2010, I believe, 0.96 was the mean.

In that case, the mean fund raised in the 2000s up to 2010, underperformed public equities, and the median was 0.81. So underperformed public equities even more substantially. Again, a lot of skewness in there. For the full sample in this paper, 1984 to 2010, and this is more in the skewness, the bottom quartile VC funds had an average PME of 0.41. That's pretty bad. The top quartile funds were 2.58, which is phenomenal, of course.

There you can see that skewness. Now another important characteristic of venture capital. Like, Cameron, when I said at the beginning of the segment that top quartile funds had 24% returns, you kind of nodded, "Well, yeah, yeah, the best funds would have the best returns." The interesting thing about venture capital is that there's actually persistence.

Unlike with public mutual funds, public equity mutual funds, and unlike with buyouts, more mature private equity, venture capital funds do actually tend to have persistent excess returns. That's interesting. Bill Janeway, a recent guest has a 2011 paper, Venture Capital Fund Performance, and their data set was two large LPs. They looked at a bunch of investment that these two large LPs had made over a period of time.

They found that venture capital partnerships can provide an average return that is superior to the public equity market. But similar to what we were just talking about, the individual fund returns are highly positively skewed. If you take those outliers out, the level of fund performance is actually in line with public equity returns. That's really the story of VC, is that if you're not in with the best VC managers, you don't expect to do that well after costs.

Recently, remember that paper that I was talking about was from 2015, with data ending 2010. More recent VC fund returns have rebounded relative to earlier in the 2000s. A lot of that value, a lot of the recent positive returns in venture capital, and this is something else that Bill Janeway talked to us about, a lot of it is unrealized value. Bill said that 80% of the returns of the good recent VC returns are mark to market, but not actually distributed.

That means that what we're looking at there is the net asset values as evaluated by the funds, not as realized through acquisitions or in the public market. That shows up in the PitchBook data that Wealthsimple references on their website, because their data goes right up until 2021. A lot of those investments are going to be unrealized. There's nothing wrong with that. It's just the nature of VC.

They use the ending NAV as a cash outflow in the last reporting period to calculate their returns that they're reporting. Bill talked to us a lot about this. If assets are overvalued in the private markets like Uber being an example, I guess, a lot of recent IPOs actually have gone on to perform quite horribly. If assets are overvalued in the private markets, you'd expect them to either add or after the IPO to drop, to drop substantially.

If an asset's mark to market at a price that is too high in private markets, you maybe wouldn't expect the current reported VC returns to represent the returns that they will realize when those securities are actually sold-

Cameron Passmore: Exactly.

Ben Felix: ... in the market. It could be an upward bias in the recent positive VC returns. Now, another thing that comes out at the Kaplan paper that I mentioned, or might have been a different Kaplan paper, I looked at a few of them, but there's a significant statistically and economically relationship between flows into private markets and returns. For VC funds, there's a big negative relationship between capital commitments and performance.

In periods when there are large capital commitments, there tend to be future not as good returns, lower returns, negative relationship. In a 2015 paper, Kaplan suggests that the roller coaster ride of VC performance in the last two decades seems highly related to the sector's difficulties in absorbing large amounts of capital. Where does this all leave investors? This is just a light overview.

I think it'd be fun to do a deeper dive, like a full episode on this one day, but just wanted to touch on it. Where does it leave investors? I think that there is truly potential for excess returns with the top managers in venture capital, but there's also a relationship between flows and returns across all manager quartiles and venture capital had a record year.

That's another thing Bill Janeway told us. Record year in 2021. There was $120 billion raised in venture capital in 2021, which was a record. A lot of that is coming from nontraditional investors like mutual funds, private equity investors who are moving into venture capital, sovereign wealth funds. I think Wealthsimple fits into that bucket. I think that they would be considered a nontraditional VC investor like Vanguard too going into private equity.

Same kind of idea. The big questions to think about are whether you can truly access the best manager's best funds. It's one of the things Bill talked to us about is that the Sequoia is doing something unprecedented that's never been done before. They're starting a perpetual fund. Bill kind of says, "I don't know if I'd bet against Sequoia because they've had such a successful track record, but it'll be interesting to see how this turns out."

Because they're raising huge amounts of capital and they're trying out a structure that's never been done before. Anyway, can you get into the best managers best funds? It's like a special currency for very wealthy people, allocations and venture of capital funds. It's really hard to get in. Even if you can get in to the best funds, you typically can't get a meaningful allocation-

Cameron Passmore: Exactly.

Ben Felix: ... relative to your wealth. I mean, it's the selection bias problem that the venture capital has. Then the other thing to think about is how are VC returns going to do across all manager quartiles given the record inflows into venture capital last year? I don't know how attractive that asset class is in general because of the skewness and the selection bias. Right now, given private market valuations and massive flows into that sector.

I don't know. I don't think I would touch it in general and we haven't for our clients because of the selection bias. Anyway, I'll finish with a quote from Bill Janeway. When we talked to him he said, "The way to put it is very simple. If you're a new player and you want to put new money into venture, the ones you want to invest in, don't need your money and the ones who need your money, you don't want to invest in."

Cameron Passmore: Pretty quote.

Ben Felix: I thought that was pretty good. Anyway, it's interesting. Retail access to venture capital, similar to Vanguard getting access to private equity. Don't know how good of an idea it is.

Cameron Passmore: But there's so much demand and this links to the main topic today, but there's so much demand for alternatives in this new environment. Those alternatives just captures all these other different, be it hedge funds or alternative types of investments, VC, private equity.

Ben Felix: Have you read Ilmanen's book at all? Antti book?

Cameron Passmore: Not yet. Not yet.

Ben Felix: That's what it's about. There's probably a bunch of good stuff in there.

Cameron Passmore: Yeah. Well, the demand is there for sure.

Ben Felix: Yeah.

Cameron Passmore: Okay. Main topic.

Ben Felix: I got a few emails last week about the death of bonds. I thought we would talk instead about the immortality of bonds as opposed to their death. Bond returns have not been good this year, that's a fact. XBB the iShare's Core Canadian Universe Bond Index Fund was down 9.2% year to date as of Friday, April 15th when I checked, before we recorded.

The Dimensional Global Fixed Income Portfolio that we use for the fixed income allocations in our client's portfolios was down 6.7% as of the same date. In both cases for a safe asset, those were meaningful drops.

I think that the articles that people were sending me, which was where these questions were coming from about bonds being dead, I think the idea is that because these inevitable interest rate increases that are going to be coming, bonds are going to be a dead asset for a long time. Either that or bond expected returns are just too low to serve a purpose in portfolios.

Cameron Passmore: Therefore dot dot dot I want to take on more equity exposure...

Ben Felix: Well now, that's the implication, right? Is that you should invest in stocks, not bonds, but I think we got to think back to what Dave Plecha from episode 163 said when we asked him, "Has the role of bonds in portfolios changed because expected returns are low?" He asked back, "Well, what is the role of bonds?"

His suggestion was that it's always going to have to do with some kind of risk control, but risk control is different for everybody. Like what is risk even is a question that we have to ask. Risk is different for a pension fund than it is for an individual, than it is for a hedge fund. They've all got different ways to think about risk, different exposures to different types of risk.

I really liked what Ken French wrote in a recent essay on the Dimensional site. Ken explained five things that he knows about investing. It's pretty cool to read something like that from Ken. I thought it was overall a very insightful post, but on risk I thought he had really good comments.

Before hearing what Ken said, we got to remember that we had the recent episodes on modern portfolio theory and the Intertemporal Capital Asset Pricing Model and how portfolio theories changed since mean variance optimization. I think since 1973, when Robert Merton came up with the ICAPM, I think since then volatility has not been risk. We can show that in a model. There is portfolio theory that defines risk as something other than volatility.

Volatility is still risk. All else equal, investors want a less volatile portfolio for a given level of expected return, but it's not the only risk that matters. Capital asset pricing model or mean variance optimization is single-period thinking where the only thing investors care about is mean and variance. Now, we know that CAPM is not empirically not a good way to look at the world because it fails as a model in many ways.

In the ICAPM, the Intertemporal Capital Asset Pricing Model, investors care about how their wealth varies with future state variables, like labor income, the prices of consumption goods and future investment opportunities. When we talked to Fama, I asked, "Is there any way to know what the state variables that people care about are?"

He was like, "Well, what do you mean? Can we get inside their heads and know what they worry about? Oh, okay. That's what you mean by unknown state variables. We really can't know what they are because it's what's going on in individual people's heads." But we can observe how assets behave relative to what ... It's basically like what might be going on in people's heads. There are systematic patterns in how assets behave that might be related to that.

I thought that was pretty interesting. What are the state variables? Yeah, we really can't know unless we can get inside of every individual's mind. In an ICAPM world, as opposed to a CAPM world, investors care about volatility still, but they also care about state variable sensitivity. We know that there are systematic risk factors that seem to respond to those unknown state variables.

With that in mind, how can French define risk? This is a quote, "I define risk as uncertainty about lifetime consumption broadly defined. People invest because they want to use their wealth in the future. Some might plan to spend all the money on themselves for things like food, shelter, travel, recreation, and medical care. Others may plan to spend some of their wealth on political contributions, charitable donations, or gifts and bequests to their children."

This is continuing the quote, Ken's definition of lifetime consumption includes all these and any other anticipated uses of wealth. Investors like a high expected return, because it increases the expected wealth that will be available to spend or give away. Everything else the same, risk-averse investors prefer less uncertainty about their future wealth. I thought that was pretty powerful.

He's not talking about volatility. He's talking about uncertainty about future wealth. All else equal, risk-averse investors prefer less uncertainty about their future wealth. Bring it all back to bonds now, yes, they have lower expected returns in stocks, but they also have less uncertain future payoffs, much less uncertain. Bonds aren't risk-free. Don't get me wrong here.

For long-term investors, long-term government bonds anyway, which is what we have good data on, they've had some really bad periods in real terms, going back throughout history. But the variance of bond returns has been much, much smaller than the variance of stock returns. It's like the distribution of outcomes for stock returns has been much wider than the distribution of outcomes for bond returns.

Then the other thing we have to remember is that I just mentioned the terrible periods where bonds have done really poorly historically, but that's for long-term government bonds. Today, if you're owning an aggregate bond index, I don't know if it's obvious that that would do as poorly in those same periods, because as we know there are independent risk premiums in fixed income. One of them is credit. One of them is term.

We know term has gone through some very long periods of poor performance in real terms. It's not obvious to say that credit would've done the same over those periods. XBB is the bond fund that I talked about to kick this off. It has exposure to both. I think it's reasonable to expect that would perform differently. Now, I'm talking about risk premiums.

Of course, you've got to be able to take on that state variable sensitivity, just like we talked about with tilting toward value stocks and stuff like that. For a long-term investor, shouldn't be a problem. Now, one of the arguments for what I just said for bonds, giving you less uncertainty about feature consumption. One of the counter arguments is that stocks in the long run are much less risky, even less risky than bonds is an argument that I've seen.

If you look at the standard deviation of returns over long periods of time, of stock returns, it does appear to decrease monotonically. Longer horizons, less variability in outcomes for stock portfolios. If we assume that returns are IID, independent and identically distributed, and we'll revisit that assumption in a minute, the standard deviation of returns over a long horizon is calculated as the annual standard deviation divided by the square root of the time horizon.

You can see just by that calculation, as the horizon increases, the long-term standard deviation of returns decreases proportional to the square root of the time horizon. Of course, that's going to look pretty good, but this is one of the most basic ... I don't know about that. I was going to say one of the most basic errors, but it's a little bit advanced, I think. The math isn't that obvious.

While the standard deviation of returns declines with horizon, that's a mathematical fact, the standard deviation of ending wealth, like the dispersion of wealth outcomes, which is related to consumption, increases proportional to the investment horizon or the square root of the investment horizon. The standard deviation of any wealth is calculated as the standard deviation multiplied by the square root of the horizon, not divided by.

In one case, from a standard deviation perspective, we get a narrowing range of standard deviation outcomes, but on the wealth perspective, which is what actually matters to investors, we get an increasing dispersion of outcomes over time. There's a chart from a paper on this topic that we can put in the YouTube version, but it shows side by side, here's the standard deviation over time, boop, getting more narrow. Then here's the distribution of wealth outcomes.

It's doing the opposite thing. That's important. Now, empirically ... So that's if returns are IID and I said we'd come back to that assumption, which is what we're doing now. Empirically we know that return variance does not always increase in proportion to time horizon in the way that we would expect if returns were truly random. That tells us that there could be some mean reversion in returns. The data on that is mixed.

It doesn't hold the same way for all countries. It holds in the U.S., which is what everybody looks at and says, "Hey, look, stock returns are safer in the long run." But I don't know if we can count on just the U.S. data. Now, even beyond that, if we said, "Hey, there is mean reversion. Let's bet on that happening." That doesn't make stocks safe in the long run. There's a paper from Pastor, Stambaugh and Taylor, Are Stocks Really Less Volatile in the Long Run?

We talked to Lubos Pastor about this in episode 124. When we talked to him about this, it was one of those mind-blowing things where it's like, "Okay. That totally changed my perspective."

In this paper, just a quick quote from it, "We show that mean reversion ..." Remember I just said, mean reversion makes stocks safer in the long run, "We show that mean reversion is only one of five components of long run predictive variants. All five components are IID uncertainty, mean reversion, uncertainty about future expected returns, uncertainty about the current expected return and estimation risk."

Continuing the quote, "Whereas the mean reversion component is strongly negative. The other components are all positive and their combined effect outweighs that of mean reversion." They're basically saying even if stock returns are mean reverting, all of these other uncertainties outweigh that. If we said, "Okay. We know what historical data looks like, great. Let's assume stocks are mean reverting and that they're going to revert to unknown mean."

Then yes, stocks are less risky in the long run. What Pastor, Stambaugh and Taylor are saying is that there are a whole bunch of other sources of uncertainty about the distribution of returns, about what the mean is, about what the return-generating process looks like. We don't know any of that. You can't really say just because of mean reversion stocks are less risky in the long run. You still have a massive amount of potential variability in long-term outcomes.

I mean, this is a lesson that we've talked about many times. It goes back to even the 4% rule of stuff where you can show that the 4% rule is safe in the U.S.. It's like, hey, great, but it fails everywhere else. It's the same kind of thing. If we look at successful stock markets like the U.S., it gives us an impression of, hey, returns are pretty high and they're mean reverting, and they're pretty safe in the long run.

But you look around the rest of the world and that's not really the case. Even beyond looking at the rest of the world, looking at the historical record globally, there's a whole bunch of sources of uncertainty that we've got to be very, very careful with. Now, just in terms of the dispersion of outcomes in the long run, I did a very simple model. I looked at a 40-year horizon for a million dollars invested in stocks.

I just used the distribution of past data and then simulated normally distributed outcomes. 40-year horizon. You expect 90% of your outcomes for a $1 million investment in stocks to fall over 40 years between $2 million in real terms and $30 million in real terms, it's a pretty wide distribution.

Cameron Passmore: I was going to say it's a heck of a band.

Ben Felix: With bonds, you expect between 1.2 million and 3.5 million, much tighter distribution. Now, no doubt people listening will notice that the 10th percentile in those two examples, stocks still look better. $2 million instead of 1.2 in bonds.

If we push that out to the 99th percentile stocks start to look worse, and then the other problem with observing, based on my little example here, is that I just used a normal distribution just to show how wide the distribution gets, but we know stock returns are skewed and they have fat tails so the normal distribution's going to overstate the benefit of investing in stocks. There's more upside.

There's no question about that, but there's also a lot more left-tail risk in stocks and a lot more just variability in the outcome. In the historical global stock data from 1900 to 2020, at the 90th percentile for historical rolling periods, the equity risk premium was 7.4% on average. At the 10th percentile, it was 2% on average. That's using rolling historical period, which maintains any mean reversion that did exist in the historical data.

Cameron Passmore: That's right.

Ben Felix: If we bootstrap instead, which kills serial correlation, the 90th percentile is 8.4%. So it's higher. And the 10th percentile is 1%. It's quite a bit lower. Again, there, you can see how important that assumption about mean reversion is. A lot of that mean reversion was driven by U.S. stocks because they make up such a large part of the world portfolio. Again, do we want to bet on past mean reversion repeating because of how well the U.S. did?

I don't know. That's not super obvious to me. Then for individual country returns, which I think is another interesting way of slicing up this data, the 90th percentile using 40-year rolling periods is 8%. That's the 90th percentile of individual country returns for 40-year rolling historical periods, is 8% and the 10th percentile is 0.5%. That distribution's actually about the same as what we saw for bootstrap data.

I don't know, it just shows if we're not just focused on how well the U.S. has done and you look at how other individual countries have done, that distribution of outcomes can be exceptionally ... Well, not exceptionally, as wide as you'd expect if returns were random. Now, maybe that's fine for some people, like I own a 100% stock portfolio and maybe I'll continue doing that for a very long time.

I don't know. I haven't thought too much about it, I guess. In speaking with clients, there are a lot of people who are comfortable with the wide distribution of outcomes, but there are a lot of other people who are not comfortable with a wide distribution of outcomes in terms of terminal wealth, but also in terms of consumption over time. I think one of the big takeaway is that even if you don't care about volatility ... Because this is the argument.

The argument is stocks are less risky in the long run. Therefore, short-term volatility doesn't matter. That's the argument. Bonds are less volatile in the short term, but they have really bad returns in the long term therefore they're actually riskier. I've said that before too. I've made that statement before. I'm maybe disagreeing with myself a little bit.

From the perspective of consumption, stocks are unequivocally riskier than bonds. Even if you don't care about short-term volatility, the distribution of consumption outcomes is going to be wider with stocks than it is with bonds. There's just a lot more uncertainty in general with stocks. Has the role of bonds in reducing the uncertainty about future consumption changed? I don't think it's changed at all, but there's one more important point that I want to make on bonds.

I mentioned at the beginning that bonds have dropped in price, bond returns have been negative year to date, but what happens when prices go down? Expected returns go up. Not the opposite. People always declare assets dead after they've had negative returns, but it's like, no, no, no, that's the opposite. You should be excited now. Now bonds are a more attractive investment.

I looked at the yield to maturity on XBB. The yield to maturity is currently 3.28, and break even inflation, which is like theoretically, the rate of inflation that the bond market is pricing in, is currently 1.9%. That puts the real yield to maturity for XBB at around 1.4%. Now, if you look back for the last 121 years, long-term government bonds in Canada and the U.S. have returned a real 2%, roughly.

A little bit higher for ... I can't remember which one. It's like 2.1% and 1.9%, whatever, call it 2%. On bills, so like short-term government debt, in Canada they have returned 1.3% real, in the U.S. 0.6% real for the last 121 years. XBB is a combination of short, medium, and long duration fixed income assets. It's going to fall somewhere between in those long term ... Well, that's got credit too.

But you look at those historical returns and the current expected return from the yield to maturity on XBB, it actually looks pretty normal. The expected real return actually looks pretty normal. Now, if you define the real return instead of using break even inflation, if you instead use current CPI changes, then yes, fixed income returns have been even more negative.

But in terms of expected returns, I think it probably makes sense to use the market implied because that's what the market is pricing in. The big thing to remember is that bond prices already fell based on the expectation of future rate increases. They fell and then rates increased as the market was expecting them to. On the day that the Bank of Canada announced that rate increase bond returns were positive. I'm pretty sure. I checked like near the end of the day.

I didn't check at the end of the day, but they were at least not very negative, but I'm pretty sure they were positive for the day, which would make sense if that information was already in the price. I'm not saying though that bond prices can't fall further, of course. Bonds are risky assets, just like stocks are risky assets. The thing is, nobody knows that that will happen.

People declaring the death of bonds based on all of these coming rate increases that are going to just keep on rolling through destroying bond prices, maybe, but that's a prediction. If we knew that was going to happen, it would've already happened. If we knew prices were going to get wrecked by rising rates, the prices would've already been wrecked by the expectation of-

... rising rates. Unless you know more than the market, unless you know more about future rate increases than the market knows, I don't think that you could say, well, bond expected returns are negative because of the coming rate increases. That's a bet that you know more about future rate increases than the market. Once an asset class is declared dead, that's probably the best time to invest in it. Maybe we're there with bonds.

I don't think bonds are dead. I think they serve the same purpose that they always have. Even beyond that, I don't even think that their expected real returns are so out of line with history. We're not going to get stock-like returns with bond-like volatility. We've had it for the last 30 or so years. I don't think that bonds look ... I don't think they look that bad.

Cameron Passmore: Yeah. That was a great wrap-up on fixed income. A lot of great answers and you're right, the bond market is pretty smart and that's what your basic message is.

Ben Felix: Well, it's twofold. The bond market's pretty smart is a big one. The other big one is why do you own bonds in the first place? Is it because you expect to have high returns from them or is it because you have a preference for more certainty about future consumption? If that is the objective, which I think for most individual investors holding bonds, uncertainty about future consumption is exactly what you're trying to hedge by owning bonds. That role in a portfolio has not changed.

Cameron Passmore: It's not going away. Cool. Do you want to knock off another one of the remaining misconceptions that we talked about two weeks ago?

Ben Felix: Yeah. There's maybe two quick ones we can knock off and then we'll save the last few for a future episode. I should have numbered them. I don't have numbers. The next misconception in our list that we didn't get to last time is that high-growth sectors or regions or companies are good investments. We talked about growth stocks a lot. We talked about emerging markets in episode 91.

We talked about thematic ETFs in episode 1805. We talked about the good company is a good investment fallacy in episode 174. We've covered this concept a lot, but the general concept is investment returns don't come from economic growth. Fundamental growth is profitable for investors only if it exceeds market expectations, but that tends to happen to value stocks, not to growth stocks.

Value stocks are the ones that tend to have positive surprises. That's one of the places that value premium comes from. Growth stocks actually tend to have the opposite. The premise of investing in high growth from the perspective of investors lends itself more to investing in value stocks than growth. Typically, the stuff that everybody expects to do well has high ... I mean, it has those high expectations in the price.

Benefiting from a high unexpected return in an asset that everybody expects to do well is much less likely. I think the other thing is that with growing businesses or sectors, being in good positions in their markets, they typically have low costs of capital, which means that they have low expected returns. Investors are willing to supply capital to them at a low cost because the companies are dominant in their position in the market.

Betting on high growth market segments being a good investment is effectively betting on expectation errors strong enough to overcome the otherwise low expected returns of the asset. That works sometimes. I mean, we're coming out of a period where large growth has done quite poorly this year, but for the last little while it did exceptionally well.

Those were, I mean, expectation errors, and maybe it was a lot of positive fundamental surprises I think, and increasing valuations. Those are both unexpected sources of return, not expected sources of return. One more?

Cameron Passmore: Sure. One down. Do another one.

Ben Felix: You can lose all of your money in stocks.

Cameron Passmore: That's a misconception.

Ben Felix: I think so. Well, it's sort of. It's true. You can lose all of your money in stocks. In Bessembinder's paper, Do Stocks Outperform Treasury Bills? He finds that the single most frequent outcome observed for individual common stocks over their full lifetimes is a loss of 100%.

Cameron Passmore: What a stat.

Ben Felix: The most frequently observed decade buy and hold return, buy and hold return for individual stocks is -100%. Individual stocks, they also tend to have short lives. The median time that a stock is listed on the CRSP database between 1926 and 2016 is seven and a half years.

Cameron Passmore: Wow.

Ben Felix: More than half of CRSP's common stocks deliver negative lifetime returns. Not negative a hundred percent, but just negative. In bootstrap simulations, a strategy that holds one stock selected at random during each month from 1926-2016, underperforms evaluated market over the full 90 years in 96% of simulations. I mean, who would ever invest in that strategy? Hopefully nobody. But it underperforms.

For small-cap stocks, at the decade horizon, 58% of them have negative returns compared to just 19% for large stocks. Pretty bad. If you're going to pick individual stocks, be better to pick large ones than small ones. The solution to all of this, all these total loss statistics is of course, simply just not to try and pick individual stocks, but especially not small caps.

I think a well-diversified stock portfolio is pretty unlikely to go to zero other than in the case where all assets have become worthless, which would be a pretty dire situation. It's really like, yes, you can lose all your money in stocks. If the world ends and you own index funds, it's possible.

If you own individual stocks and the world doesn't end, it's possible and dare I even say probable, if you're in small caps, to lose all of your money in stocks. But it's just a story about diversification.

Cameron Passmore: Right.

Ben Felix: All right. Save the rest for next time?

Cameron Passmore: We'll save the rest for next time. As always, thanks for listening.