Topic: Public Equities

Executive Summary

• Investors considering timing equities should proceed with caution
• Forecasting returns, particularly over short-time horizons, is very difficult
• Underweighting equities often results in unattractive opportunity costs
• Successfully timing the decision to return to a normal long-term allocation requires extreme fortitude

The past few months have been a period of very high volatility in equities due to several factors. Items weighing on investors likely include a combination of President Trump’s decision to increase tariffs on imports, continued tensions between the US and China, unclear resolutions to the armed conflicts in Gaza and Ukraine, and uncertainty from the DOGE initiative, which could either help balance the budget resulting in a more efficient US government or weaken a variety of strategically important social services and government programs. We have started to receive some questions from clients about the merits of underweighting equities relative to their long-term strategic targets. In general, we do not recommend that course of action for several reasons:

1. Forecasting Challenges

It would add material value if we could avoid the very worst months or quarters in equities. Unfortunately, forecasting in investments is unlike forecasting in most other fields. Predicting outcomes over the next month or year is not that difficult in most industries. Most owners and operators of businesses have a good idea of how their company will perform over the next month or quarter. However, forecasting business outcomes over the next ten years is much more difficult, if not impossible, for most sectors. For example, many publicly traded companies provide guidance for the next year but very few provide detailed guidance beyond that. Forecasting in investments is exactly the opposite. The range of annualized returns for monthly or quarterly data points is very wide. If we instead looked at rolling five-year outcomes and annualized those results, the range of IRRs would be considerably tighter. In investments, the longer the time horizon becomes, the easier it is to accurately predict the rate of return. The table below illustrates that shorter periods show a wider range of outcomes, with a 72% spread between the best and worst months. In contrast, longer periods, like five years, have a much narrower range, with approximately a 10% spread.

Range of Annualized Returns at Different Measurement Intervals, 1945-20241

We observe the challenges in short-term forecasting when evaluating managers. One of the methods we use to evaluate equity long/short hedge funds is to decompose the sources of excess returns into three categories: longs, shorts, and value-added from variance in net exposure. Across a growing library of several hundred different managers, we have seen very little evidence of statistically significant value-added from short-term variance in the net by equity-oriented hedge fund managers. We utilize a similar strategy for long-only managers who prefer to hold cash. It is very rare for the managers’ actual realized results to outperform a pro forma portfolio that grosses up their holdings such that they would have been at least 95% fully invested at all times. Even among trend-following managers, who are much more focused on market timing, we have seen mixed results. Short-term forecasting is very difficult.

2. Opportunity Costs

If we instead rely on longer-term forecasts, which are typically more accurate, we encounter a different problem. For an institutional portfolio, the meter is always running. We do not get to call capital when interesting opportunities arise and give it back when there are less attractive options. When we reduce equities, the capital must go somewhere else. The most obvious alternative to stocks when people are concerned about the risk of losing money is bonds or cash. The problem we face as investors is there are not many periods when bonds or cash outperform stocks over reasonable forecast horizons. We have used the S&P 500 and the benchmark 10-year Treasury bond for our analysis below.

Average Relative Results: Stocks vs. Bonds2

Even if the next five or ten years will in fact turn out to be one of these unusual periods when the return on equity is disappointing, it is important to evaluate the alternative use of capital. Revisiting the first chart and assuming the next five years will generally be a bottom-quartile return period for stocks, we can roughly estimate a 5% annualized return. The problem is that the yield to maturity on the 10-year Treasury bond is only 4.2%3. Selling something with an estimated return of roughly 5% to buy something that we should reasonably expect to return 4% is still a long-term expected performance concession. As outlined in Jay Willoughby’s Q4 2024 CIO Commentary and given some of the fiscal challenges the US faces, we think a much higher starting yield to maturity on bonds would be required for investors to consider materially underweighting equities in favor of bonds.

3. Psychology and the Pattern of Returns

For an equity market timing strategy to be successful, investors need to get two calls correct, not one. Those who underweight their long-term strategic targets will eventually need to decide when to return the equity allocation to its normal level. This second decision is key because, in equities, the big days are very important. Since 1945, the annualized return on the S&P 500 is roughly 7.9%4. If we exclude the top 1% return days, the annualized return would be a loss of -1.8%. Market prices tend to overshoot the changes to long-term fundamentals. As a result, equities are often undervalued at the bottoms of drawdowns. Also, markets discount anticipated economic conditions. When sentiment finally improves at the bottom of a drawdown, prices can move back up very quickly. The tables below show the best single day returns for the S&P 500 since 1945. All of them occurred during points in the cycle when uncertainty and volatility were very high. Because the absolute best days and worst days tend to cluster together, mistiming one of the two decisions, even by a day, can be very damaging. The best time to add to equities will often be at the point in the cycle in which doing so feels the most uncomfortable. The average investor who tries to time the market is highly likely to miss at least the first part of the recovery. Missing these big days often locks in long-term underperformance.

Highest Single Day Returns for the S&P 500, 1945 – 20245

Conclusion

While equity market volatility can be unsettling, maintaining a long-term perspective on equities is crucial for achieving optimal investment outcomes. Predicting short-term market movements is highly challenging, and the costs of missing key recovery days can be significant. By sticking to a long-term strategy around equities, investors can avoid market-timing pitfalls and benefit from the growth potential of owning stocks. Our tactical adjustments to equity exposure tend to be small because we understand how difficult it is to do this well. We tend to be biased to overweights because that improves our odds of generating good returns.

The materials are being provided for informational purposes only and constitute neither an offer to sell nor a solicitation of an offer to buy securities. These materials also do not constitute an offer or advertisement of TIFF’s investment advisory services or investment, legal or tax advice. Opinions expressed herein are those of TIFF and are not a recommendation to buy or sell any securities.

These materials may contain forward-looking statements relating to future events. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” the negative of such terms or other comparable terminology. Although TIFF believes the expectations reflected in the forward-looking statements are reasonable, future results cannot be guaranteed.

Trevor Graham, TIFF’s Head of Equities, Deputy CIO and Managing Director, provides insights into the efficiency, benefits, and risks of small-cap equities, along with their potential future trajectory of this market segment. Additionally, Graham discusses TIFF’s investment approach and the ongoing debate between value and growth strategies in the small-cap space.

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The materials are being provided for informational purposes only and constitute neither an offer to sell nor a solicitation of an offer to buy securities. These materials also do not constitute an offer or advertisement of TIFF’s investment advisory services or investment, legal or tax advice. Opinions expressed herein are those of TIFF and are not a recommendation to buy or sell any securities.

TIFF aims to serve the private equity investment needs of our nonprofit members.  We recently developed a Private Equity Primer as a guide to understanding the basics of private equity.  You can access the primer by clicking on the Download PDF link above.

Evolution of TIFF’s Chinese Equities Investments
Fall 2021

Background
As many of our investors know, TIFF has had a material investment in Chinese equities for over five years.  While our exposure has never been more than 15% of our equity portfolios, it has represented a larger percentage of our tracking error and overall risk over the past few years.  As a result, we receive many questions about this part of our portfolio.  Therefore, we thought it would be timely to provide a brief update on our positioning and thoughts on the market.

First, Principles: why did we invest in China in the first place?
China became a research priority for us in mid-2015 due to our observations that 1) its economy was growing quickly, and 2) the stock market (represented by the CSI 300 Index) declined over 40% in the two months ending in August 2015 and might represent good value.  We spent almost two months in the country doing on-the-ground research, and we ultimately made multiple investments throughout 2016.  We found the Chinese equity opportunity attractive for several reasons, including:

1. Investing in China presented an unusual combination of many inefficiently priced businesses and very high liquidity. Usually, we find inefficiently priced securities in niche parts of the markets that are not liquid and do not support large investments.  This situation was an exception.
2. We perceived that institutional capital could do well in light of heavy retail participation – with roughly 75% of the trading volume being generated by retail investors. Institutional investors often have research advantages versus individuals.
3. China was (and still is) underrepresented in the various global benchmarks compared to the percentage of global GDP. We felt that eventually, index vendors like MSCI and FTSE would adjust, and the subsequent inflow of passive capital would provide a tailwind.  Additionally, not only was China underrepresented in various benchmarks but also many investors were underweight by even that modest index percent.  We thought this dynamic could represent an ongoing bid as investors potentially added to their exposures and as China grew in terms of index representation.
4. The onshore China stock market, partly because it can be complicated to access, exhibits a relatively low correlation to the US and other major markets. We believed that within the realm of equity opportunities, this investment would provide some valuable diversification for our portfolios.
5. We found three outstanding partners who we felt had a high probability of outperforming their benchmarks. We debated whether it would be possible for the identified managers to outperform by 2-3% per year.  Our most optimistic case was they might generate up to 6% alpha annually.  To date, they have outperformed their benchmark since inception by 6.8% per year as of August 31, 2021.

2020 Adjustment
Between 2016 and 2020, our China investments exceeded our expectations.  Over that period, the market nearly doubled, and our active investments there almost tripled.  TIFF’s China investments handily outperformed the S&P 500, one of the best performing major market indexes in this period.  Despite this good outcome and our continued confidence in our manager partners, we decided to reduce the position at the end of 2020 from 12-13% of equity portfolios to roughly 8% at year-end.  Our decision to reduce our position was the result of several key observations:

• China was the first country to experience COVID and the first large economy to gain control over the spread of the virus. We have described this dynamic as “COVID FIFO” (first in, first out) in several meetings and letters.  We felt that China’s outperformance in 2020 reflected this development and other countries that were a bit further behind in the process were better places to deploy capital in 2021.
• We also worried that China’s “zero tolerance” policy towards COVID outbreaks could, absent other material offsetting policy decisions, negatively impact the Chinese economy and stock market in the event of future outbreaks.

In addition to our macro-observations, many of the basic pillars of our original thesis have weakened slightly. MSCI has increased the onshore China weights in their various benchmarks, although we expect more to come.  The China stock market has become more efficient in our view.  Foreign investors’ percentage ownership of Chinese equities has increased, and many of the various peers that we talk with seem more comfortable deploying capital there.

2021 Observations
Reducing our China position at the end of 2020 has been beneficial to our 2021 performance as the Chinese markets have underperformed ACWI by roughly 20% through August.  However, this outcome is part skill and part luck.  The skill we think was making the various observations discussed above and acting.  The luck portion was reducing the position in advance of regulatory adjustments that have hurt the profitability of a variety of Chinese businesses and caused increased uncertainty.  Examples include converting multiple education-focused businesses into nonprofits, applying banking regulations to non-traditional finance companies, cracking down on anti-competitive behaviors of several large tech businesses, forcing delivery businesses to guarantee minimum wage and offer social security to their workers, and implementing a three hour per week max on playing video games for minors.  It is not clear whether these adjustments are good or bad over the long run.  While maintaining a more equitable society could create a stronger, more durable economic expansion, many of these adjustments either limit revenue growth or increase expenses for some of China’s largest companies.

Given the power that the Communist Party has in China, periods of regulatory adjustments are not new or surprising.  We identified this issue as one of the major risk factors associated with investing in China in our original memos from 2016.  However, the extent and speed of the reform in 2021 was a negative surprise that we did not expect.  With the benefit of hindsight, we would have been better off reducing our position even more – at least in the short term.

Current Thinking
We continue to be overweight relative to our equity benchmark, the MSCI ACWI, but just not as much as in the past.  China continues to experience higher growth and more attractive valuations than much of the rest of the world.  We continue to expect our managers to be able to outperform their benchmarks.  For example, while the Chinese markets have underperformed thus far in 2021, our managers on average have outperformed their benchmarks by over 450 bps through August – essentially right on track with the annual alpha we’ve experienced over time.  While the correlations to other markets have increased as we expected they would, they are still low in absolute terms.  The trailing three-year correlation to the S&P 500 is only 0.60 versus 0.90 and 0.83 for Europe and Japan, respectively.  China’s path to becoming a major market and major player in the global economy has become clearer.  We believe that we are heading toward a bipolar world with China as the major economy in the East and the US as the major economy in the West.  We wouldn’t have a global, forward-looking portfolio without material exposure to both markets.  While the recent reforms have caused some mark-to-market losses, it is hard to argue that the new regulations are unreasonable public policy decisions.  The Communist Party has a track record of making mostly good economic decisions.  According to their statistics, they have not had a recession in over 40 years.

Finally, the recent bout of volatility and uncertainty may just be another case of conditions that play to the strengths of active management.  For example, a potential default by Evergrande, a large Chinese property developer, has caught the market’s attention over the past few days.  While this is a fluid situation, based on discussions with some of our manager partners we think the Chinese government has the resources and the incentive to prevent an Evergrande restructuring from becoming a broader systemic problem.  If our assumption is correct, we may look back on this period as an attractive entry point.  Some of the businesses that we still find attractive are cheaper than they used to be.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance. The specific types of assets that each manager holds will vary over time. The managers discussed above invest capital for one or more TIFF portfolios and do not invest on behalf of all TIFF portfolios. Both the aggregated manager return (which is net of fees) discussed above and the aggregated benchmark return discussed above are based on an equal weighting of returns by manager. The benchmark return is a blend of each manager’s benchmark (in certain cases, the manager benchmark is itself a blended return). The relevant indices are the MSCI China Index (large and mid cap offshore Chinese stocks and large cap domestic Chinese stocks), the Shanghai Shenzhen CSI 300 Index (tracks the 300 largest and most liquid domestic Chinese stocks, or A-shares). ACWI is the MSCI All Country World Index (large cap stocks worldwide).

All investments involve risk, including possible loss of principal. Not all strategies are appropriate for all investors.  There is no guarantee that any particular asset allocation or mix of strategies will meet your investment objectives.

Diversification does not ensure a profit or protect against a loss.

The materials are being provided for informational purposes only and constitute neither an offer to sell nor a solicitation of an offer to buy securities. Opinions expressed herein are those of TIFF and are not a recommendation to buy or sell any securities.

The enclosed materials may contain forward-looking statements relating to future events. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” the negative of such terms or other comparable terminology. Although TIFF believes the expectations reflected in the forward-looking statements are reasonable, future results cannot be guaranteed.