No magic in Sharpe’s world, Nobel Laureate explains
Nobel Laureate William Sharpe has shared his ideas on the arithmetic of investment fees, the education of investors, expectations for equity returns and financial innovations.
William Sharpe is one of the few Nobel Laureates in economics known to most investors.
The ‘Sharpe ratio’ that relates investment returns to their risks remains a ubiquitous measure in fund fact-sheets and investment presentations. Naturally, Sharpe is less intrigued by outstanding return opportunities, and more by the increased risks investors have to take to achieve them.
“There is a lot of talk about free lunches, but most of it does not add up,” says Sharpe.
The 79-year-old remains a sceptic of the investor hunt for yield in an environment of lower interest rates. For Sharpe, investors just have to adjust their return expectations to fit what the market has to offer: “Take equities, for instance. When you agree that the risks associated with equities are roughly the same as before, but acknowledge that the risk-free rate is three percentage points lower than in the past, investors have to expect much less from various risky asset classes than they earned historically.”
But expectations for a number of strategies and hence fund flows – including emerging market debt or low volatility equities – have climbed in recent years as short-term interest rates have plummeted.
“If those strategies are a smart thing to do, who are the dummies on the other side of the trade?” Sharpe asks. “Active managers need to show me the image of the people they are trading with”, he told InvestmentEurope at the annual conference of the WU Gutmann Center in Vienna.
Indeed, only a few strategies in Sharpe’s eyes might “make sense in a macro way. Value managers, for instance, will tell you they are trading with individuals who are buying a company because it is a good company and forget about the price.”
But overblown expectations are not just a shortcoming of private investors. Sharpe criticises the incentive for pension funds in the US to overstate their return expectations.
He says: “More thoughtful people in the industry say that you cannot expect even 5% from a 60/40 stock and bond mixed fund in this environment. Lower real rates on riskless bonds also lower the expected returns for other asset classes.”
A key irritant to Sharpe lately has to do with inflation-adjusted real yields.
He says that the finance profession and academia need to do more to ensure the message of lower expectations is understood by retail and institutional investors. After all, “inflation-adjusted yields are abysmal and negative for long horizons”.
As a former teacher at Stanford University, he is puzzled to find basic concepts of financial theory thrown upside-down: “Friends of mine that still teach finance have difficulty explaining negative real interest rates over long periods of time. People require more real goods tomorrow, if they sacrifice consumption today and save.”
This basic principle – the time value of money – has been violated in the past as lower long-term yields have been met with more stable inflation expectations.
For Sharpe, it is “remarkable” that central banks were able to push real yields, adjusted for inflation, into negative territory. For retirees, this spells bad news.
“The fact that we have had negative real rates for so long is surprising, almost shocking and very disturbing. If you are a retired person, you will have to live at a much lower standard of living.”
However, Sharpe is not sure that equities are an escape route for retired people amid low interest rates. “Investors get much more conservative as they grow older.”
He has been involved with studying the “de-cumulation phase” of investors in recent years, in which questions such as how investors should deal with money after retiring, and how much money they should take out of their savings annually are key.
“Unfortunately, many scholars and the financial industry have spent time and resources understanding how to accumulate capital, but very little on how to de-cumulate it efficiently,” Sharpe says.
Vital to understanding those decisions is to study the approach towards risk. For Sharpe, the “stocks for the long run” thesis is a risky bet for many private investors. “Stocks in the long run are riskier than many think.” Even though an individual portfolio might be less volatile when stocks are held over longer time horizons, the risk to an investor’s financial health are much more serious.
“There is no magic involved. You might be richer, but there is also the possibility that you might be a lot poorer, and this tail risk should be avoided.”