Perspective :

A zebra in lion country

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In 1999, famed investor Ralph Wanger penned “A Zebra in Lion Country.” The premise of this little book is that incentives for clients, advisors, and investment managers promote a run-with-the-herd mentality, encouraging conformity by owning similar assets and adhering to ride the market. Straying from the pack and being different is viewed as risky or labeled as “tracking error.”  In the herd, you can hide like a zebra and run with the trends of the day. The market goes up, all good. The market falls off a cliff; well, at least you were in the herd.

However, a few times in your career, it might be advantageous, or even safer, to step away from the herd. The herd could be heading for the cliff, or there might be great opportunities at a different watering hole. The risk of stepping away from the herd, regardless of your reasons, is the lion. Standing all alone, munching on the long grass, and sipping the clean water exposes the opportunistic zebra to getting eaten by the lion. The lion is getting fired by the client, the advisor, or even your boss. Said another way, the apparent risk is not losing money; it is losing clients or your job.

Interestingly, Ralph Wanger wrote this simple book in 1999, when the herd ran fast towards the then unforeseen tech wreck cliff. Many of you may remember that the year 2000 set off one of the worst decades ever for the S&P 500® Index. Maybe Ralph was guessing, or perhaps he knew that 1999 would be a landmark time to step away from the herd.

At that time, the Internet was going to change the world, and any stock associated with the Internet was skyrocketing. Further, indexes were extremely concentrated; 28% of the S&P 500 was in the top 10 stocks. Indexes became the only vehicle to invest in these internet-related companies in a meaningful manner, as active managers with any experience only saw risk in those names.  Investors seeking to keep up indexed more and more until they just started buying the stocks themselves on the new eTrade website. Those who bought value stocks, international stocks, emerging (sub-merging) market stocks, or worse, cash or alternatives, were quickly fired. Risk management became tracking to benchmarks as opposed to exposure to potential loss. And then, as if out of the blue in March of 2000, it all stopped for no apparent reason. The NASDAQ proceeded to lose about 70% of its value.

Many who stepped away from the herd in 1999 or even 1998 went from worst to first. The trend is your friend until it is not, and change is inevitable.

Today, the herd appears to gather around three driving forces in the marketplace:

  • First, there is the obvious focus on what has performed best in the past: large-cap U.S. stocks and, by de facto, the mega-cap growth stocks that are currently driving the S&P 500. Thematically, AI is going to change the world, which it likely will. But, just as in 1999, the Internet lived up to the hype, but not all of the companies of the day did.
  • Secondly, the herd appears to have come to a consensus that interest rates will fall, and many investors have extended their duration in an effort to capitalize on that outcome.
  • Finally, and most importantly, today’s herd seems to be giving little consideration to risk. After an extended bull market, the goal moves from managing return for risk outcomes to “I just want to keep up with the market.”

For strategic indexers following asset allocation theory, large-cap stocks and longer duration high-quality bonds are the foundation of their portfolios. These types of portfolios have simply been standing in the right place and thus have risen in popularity. Many quasi-strategic indexers, those that benchmark their proprietary funds to indexes, also appear to be standing in the right place. Collectively, I guess, I am calling them the herd. There are a lot of them; they all look and sound the same and are experiencing highly similar performance patterns.

Frontier’s risk-managed strategies have, at this point in time, effectively stepped away from the herd. Frontier strategies hold less large cap, less duration, less indexes, and potentially less risk than the strategic index or quasi-strategic portfolios by which we are compared (whether that be competitors or benchmarks).

It is important to note that Frontier’s strategies have not wavered or deviated in any way from our process, philosophy, or historical norms. Frontier strategies are performing well relative to the risks that we take. The herd, benchmarks, and thus, frame of reference have drifted with the current trends of the day. The reason that I must write this article is that the drift appears to be a consensus, the opinions unanimous, and the popular strategies of the day ubiquitous. Similar to 1999, we find ourselves having to explain what we have always done.

We have stepped away from the herd for the following reasons and in the following ways.

Large-cap U.S. stocks: Underweight relative to the herd

By most measures, the S&P 500 Index is nearing its most overvalued point in history, second only to 1999. Frontier’s expected return for large-cap stocks is significantly lower than that of other competing assets, such as small-cap stocks and international stocks. Thus, we view moving away from the S&P 500 Index as opportunistic. We are seeking higher expected returns.

Furthermore, the S&P 500 Index today looks messed up (technical term). The concentration in the S&P 500 is higher than in 1999, with the top 10 stocks representing 34% of the index. With that much concentration, a few underperformers can cause the entire index to underperform. This coincidentally happened in 1973, prior to the Nifty Fifty collapse, and in 1999, prior to the Tech Wreck. But I digress; insignificant details.

Duration: Underweight relative to the herd

We did not extend duration; quite the opposite. Frontier’s strategies hold less duration and higher yields than benchmark bond indexes. With an inverted yield curve, shorter-term bonds yield more than longer term. Secondly, corporate bonds have higher yields than treasury bonds. It would seem obvious in this environment that the sweet spot in the bond market would be short-term higher yielding corporate bonds.

We are well aware that the consensus opinion of the herd is that interest rates are going to fall, and thus, many have extended duration by overweighting high-quality, longer-term bonds. Without dragging this point out into a dissertation on the current dynamics in the bond market, I will postulate that – so far – this “bet” has not panned out.

Alternative investments: Overweight relative to the herd

The herd may dogmatically hold duration-based bonds due to their overall inverse correlation to stocks. Stocks like a good economy, and duration bonds like a poor economy. It seems natural to combine them. Asset allocation theory is based on this relationship to manage portfolio risk. However, correlations are derived by averaging performance patterns over long periods of history. In any given year, though, the correlation between stocks and high-quality duration bonds is almost random. Further to this point, when inflation is the problem, the correlation between stocks and high-quality bonds is often positive in the downside window. In other words, they both go down together (think 2022).

To combat positive correlations in the downside window, a risk manager may seek to hold assets that are not correlated to either stocks or duration bonds. The assets we hold today are managed futures and a specific market-neutral strategy. It also happens that the expected return of both of these assets rises with the Fed Funds Rate. Holding alternative assets in this manner is a logical approach to help alleviate the risks of inflation, higher for longer, and positive stock-bond correlations.

Risk: Less risk than the herd

Frontier’s strategies, as far as we can tell, are designed to take less risk than the popular competitors of the day. Why is that? The economy appears strong, unemployment is low, the housing market is reaching the stratosphere, AI is going to change the world, and asset prices are rising. Why not be on trend?

I could lift the hood of our process and point to the specific details of our risk modeling that are leading to a lower risk posture overall, but I think it would be more understandable if I put it into words. Are you ready?

Higher for longer is the risk. It’s not the higher; it’s the longer. Interest rates may not stay elevated, let alone actually rise from here, but the risk is that they do. Higher for longer is the unpriced risk that the herd is not even considering, and the longer it hangs around, the worse it usually gets.  Higher interest rates will eventually bite us all: consumers, businesses, and even governments (talk about an unpriced risk!). Maybe not this year, but if they stay high, the burden compounds.

Almost every time in history, when the Fed raised the Fed Funds Rate and left it high, it has not ended well. Throughout history, the S&P 500 Index has corrected, over and over again, for what appears to be the same reason – higher for longer.

When these corrections occurred, asset prices were rising, investors were all in on keeping up, and many owned the same few investments; the economy was strong, and there was no indication that the trends would end. Few saw it coming; fewer did anything about it.

It would be a “bet” to hope that the Fed will save you. Maybe they will. But the risk is they can’t. I do not know of a time in history when the Fed significantly cut the Fed Funds Rate without an economic disaster to deal with. Maybe this time will be different. I sure hope so.

By now, hopefully, you don’t feel sufficiently beat up. I know that this is a long read for the Internet age, and I can assure you that ChatGPT did not write this. I believe, though, that all that I have said would appear to be common sense given the circumstances of the marketplace. When I speak with investors, there seems to be complete agreement that our positioning is appropriate or even obvious. I think the issue, again, is that investors wish we would have performed better recently relative to the herd, benchmarks, or other comparisons. To that, I say we have been managing money for 25 years, and nobody beats their benchmark all the time unless, of course, you are Bernie Madoff. Not to make light of performance or the arbitrary short-term nature of benchmarks, but we can’t go back in time. We always want the best outcome for our strategies, and we do not take this issue lightly. Nevertheless, we must always position for the future, not the past.

When there is a consensus of opinion amongst the herd, when the name of the game is to keep up, and when the herd is moving fast, I believe there should be an inordinate value placed on those few managers that are willing to remain on process or appear to step away from the herd. Maybe they know something? Clients still need risk management, all the time.

It is also not as if Frontier has made extreme positioning moves; it is that the herd has drifted with the current trends of the market. We are doing what we have always done – and that’s seeking to manage risk in the current environment, grow the portfolios for the long term, and provide as much added value as we can derive. We manage money this way because we believe it to be the most consistent and reliable method to endure the multiple market environments that we will have to navigate, not just the current market environment that we find ourselves in.

Our position remains, less risk and more broadly diversified. I thoroughly thank you for thoughtfully considering what now appears to be our contrary position.

Past performance is no guarantee of future returns. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any type of securities, to invest in any particular asset class or strategy or as a promise of future performance, and no investment decision should be made based solely on the information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees, and expenses. Frontier may modify its process, opinions, and assumptions at any time without notice as data is analyzed.

Information provided herein reflects Frontier’s views and opinions as of the date of this newsletter and can change at any time without notice. Frontier obtained some of the information provided herein from third-party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information.

Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. The estimates, including expected returns and downside risk, throughout are calculated monthly by Frontier and will change from month to month depending upon factors, including market movements, over which Frontier has no control. They are only one factor among many considered in Frontier’s investment process and are provided solely to offer insight into Frontier’s current views on long-term future asset class returns. They are not intended as guarantees of future returns and should not be relied upon in making investment decisions.

Frontier Provides model strategies to various investment advisory firms and does not manage those models on a discretionary basis. The performance and holdings of model strategies may vary from strategies managed by Frontier.

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U.S. Large Cap Equity S&P 500 / Nasdaq Composite Index Represents US large company stocks.



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