The Ulysses Contract

An espionage thriller for summer reading? No. A pre-commitment contract for investors and others? Yes!

According to legend, Ulysses, the hero of Homer’s epic tale, the Odyssey, encounters the Sirens on his return from the Trojan war. The Sirens lured sailors to their doom through their enchanting music and singing. To thwart the Sirens, but curious to hear their enchanting voices, Ulysses instructed his sailors to tie him tightly to the mast and to plug their own ears with beeswax. Should he try to free himself, Ulysses instructed the sailors to bind him ever tighter. Ulysses and his crew avoided the beguiling call of the Sirens and safely headed home.

Ulysses contracts are used in medicine for treatment of psychotic patients who wish to pre-commit themselves to undergo treatment should they have an episode where their judgement is impaired. More generally, they are the foundation for motivating behavioural change through commitment contracts. An example would be to identify your least favourite cause, write a cheque for a painful amount and have a third-party hand it over unless a task is completed by a specified deadline. Two Yale professors have developed a website to encourage the use of Ulysses’ contracts for motivational purposes.

The Ulysses contract for investors is the Investment Policy Statement (IPS). The IPS pre-commits the investor to a fixed asset allocation (e.g. 30% bonds and 70% stocks). This might not seem particularly onerous, but a commitment to a fixed asset allocation requires periodic rebalancing as stock returns outpace bonds over the long term. Rebalancing is countercyclical meaning buying low and selling high. In contrast, a buy and hold approach would allow the higher performing asset to grow unchecked, increasing portfolio risk.

While a buy and hold strategy can be pursued by all market participants a rebalancing strategy cannot. This becomes clear if we consider a market with only two participants: if one investor wishes to sell stocks to re-balance then the other participant must be willing to be a buyer of stocks – they cannot both rebalance. In this sense, rebalancing is an active strategy and does not work in every circumstance (just most of the ones that matters, as we shall see).

If the value of one your investment assets trends to zero, then successive rebalancing will underperform a buy and hold strategy. Conversely a rebalancing strategy will do better when asset returns tend wander around a mean value (in other words, exhibit mean reversion). As discussed elsewhere, when current asset prices fall, future returns rise so the process of selling high and buying low continually sells assets with low expected returns in favour of assets with higher expected returns. This works best for broad diverse asset classes as the risk of these going to zero is lower than with a specific sector or an individual stock.

The siren call is usually a variation of “this time is different” and an asset that was once a sound investment is in serious decline : stocks (or bonds) are in a bubble, inflation (or deflation) will wipe out investors, value investing is dead, tech stocks are overvalued. Abandon ship! The sirens become more insistent whenever there is market volatility. The financial crisis of 2007 and 2008 was certainly a period of volatility and many commentators warned that the monetary response would lead to run away inflation which would be detrimental to bond investors. By 2015 the U.S. Federal Reserve had quadrupled the size of its balance sheet and interest rates were at historic lows, yet U.S inflation was only 0.12% and bond returns over the past decade have been comparable with equity returns. Regime changes exist (e.g. Weimar Germany) but for broad based asset classes they are much less frequent than even large swings in capital markets.

If there an advantage to re-balancing what is it? We consider the simple case of a portfolio with only two assets: a risk-free asset (e.g. a short-term government bond) and a risky asset (e.g. a broad index of Canadian stocks). Let’s be pessimistic and assume that the risky asset price fluctuates around some value but doesn’t appreciate over the long term. Without rebalancing the portfolio wealth may fluctuate but does not increase over the long term. With rebalancing, the portfolio grows exponentially!

This sounds like magic – taking two assets that do not grow and creating wealth from mixing them together, yet this is precisely the consequence of the countercyclical rebalancing¹. A rebalanced portfolio will always beat a buy and hold portfolio over a long enough time, but rebalancing requires persistence to pay off. For the situation described above the additional annual return from rebalancing is approximately 0.5% annually. With an expected annual return from a balanced portfolio of 5%, a 0.5% contribution from rebalancing is significant.

The gain from re-balancing is a function of the volatility of the assets, their allocation in the portfolio and their correlation with each other. Other things being equal, the gain is higher when market volatility is higher, which usually coincides with the siren voices being at their loudest.

There are some circumstances when investors have concerns other than portfolio volatility. One example would be a retiree concerned with running out of money who might focus more on downside risks to their terminal wealth rather than volatility during retirement. Even in those circumstance studies indicate that a rebalancing strategy is appropriate, even when the overall asset allocation changes with time.

Who re-balances? Studies of individual investors in Sweden indicates that investors do re-balance but not completely and sluggishly. Institutional investors, even when they have an Investment Policy Statement can fail to follow it. An example is the actions of the California Public Employees’ Retirement System (CalPERS) as explained by Ang and Kjaer, which we summarise below.

At June 30, 2007, before the financial crisis, CalPERS’ equity weight was 60%. This shrank to 52% by June 30, 2008 as stock markets declined. Instead of re-balancing and buying equities CalPERS sold equities so the equity weight fell to 44% by June 30, 2009, missing the rebound in public market returns in 2009. CalPERS had a statement of investment policy (IPS) but at the critical juncture when it could have helped them the most, they chose to ignore it.

One of the difficulties encountered by CalPERS was their investments in leveraged real estate holdings meant that they faced repayment obligations just when they should have been buying rather selling equities. Individual investors can encounter similar liquidity problems if invested in alternative assets such as private equity, hedge funds and real estate which require a cash injection or are difficult to liquidate to fund rebalancing needs.

The sirens’ voices will always persist. In Greek legend they were given names such as Parthenope, Ligeia, and Leucosia. In a more modern rendering, they might be called: Panic, Fear and Hubris. Reach for the beeswax.