Sunday, September 27, 2009

Does Asset Allocation Still Work?

Richard Bookstaber, author of A Demon of Our Own Design, recently wrote an excellent piece in Seeking Alpha, Why I'm Skeptical About Asset Allocation:

I appeared last Friday on a the PBS program WealthTrack, where the topic was asset allocation, in particular, as host Consuelo Mack put it, how to build an all weather portfolio. I was the skeptic of the group. I don’t think there is some magic asset allocation that protects you from the buffetings of financial storms without it also trimming your sails during fair weather. Here is an encapsulation of my views from the program.

Asset allocation and risk appetite

One of the participants, asset allocation guru David Darst of Morgan Stanley (MS), proposed various portfolios to protect against a 100-year flood, 30 to 70-year flood, a 25-year flood, etc. Those portfolios boiled down to putting less in risky assets and more in bonds; the more severe the flood you anticipate, the less risk you take. Of course, that will do the trick. If by asset allocation you mean determining where to set your risk tolerance dial, we’re all on board.

Asset allocation is like clapping with one hand

But the discussion of risk tolerance highlights that we can only go so far with asset allocation if we only look at assets. What matters is assets versus liabilities, because the liabilities determine our risk tolerance and, related to that, our demand for liquidity. It is impossible to formulate an ideal asset allocation strategy without knowing the liability stream those assets are intended to meet. There is no one-size-fits-all for asset allocation. This reminds me of an FAJ article I did back in the 1980s with pension actuary Jeremy Gold entitled “In Search of the Liability Asset”.

Diversification works well, except when it really matters

We all know the argument from Finance 101: If you hold 16 uncorrelated assets, your risk will drop by a factor of four. Well good luck with that.

During a crisis, when diversification really matters, correlations aren't near zero (as if they ever are). All that people care about is risk and liquidity. All assets that are highly risky drop, all assets that are less liquid drop. No one cares about the subtlety of earnings streams. It is like high energy physics. When the heat gets turned up high enough, matter is just matter, the distinctions between the elements is blurred away.

This is not to say that one should not try to diversify, but rather that one should not think diversification will work magic. It is a given that a portfolio should not be limited to U.S. Treasuries and S&P 500 stocks, because while it should not be oversold, diversification does have some benefit. And, on the other side, unless someone is still living in the 1970’s, it borders on the intellectually dishonest to trumpet a diversified portfolio by using the S&P 500 as the bogey.

A college kid can construct a portfolio that will beat the S&P 500 on a risk-adjusted basis, because there are so many more markets available now. A better approach is to look at a given asset allocation versus its nearby well-diversified neighbors, and try to understand why one is better than the other.

Commodities do not form an asset class

This sounds heretical given what we have seen oil and gold do recently, but a lot of the reason that has happened is precisely because people are treating them as an asset class when they are not.

Commodities are not assets. They are factors of production. They do not generate returns, they have no claim on production. They have supply that flows out at a nearly fixed rate short term, and they comprise very small markets compared to the financial markets.

If pension funds all decided to put two percent of their capital into commodities, two things would happen. First, that two percent would be a rounding error in their returns, no matter how commodities behaved. Second, they would swamp the supply of the commodities for economic purposes – i.e. for their true role as factors of production. I agree with Michael Masters’ view that oil prices were pushed up by this sort of financial activity. I might quibble with one chart or another, I might not couch it in the loaded terms of speculation.
But the subsequent behavior of the market demonstrated that he was right and Goldman and others who took the opposing view were wrong.

Inflation-Linked Bonds

Which brings me to inflation-linked bonds.
At the close of the program we all were asked for one investment recommendation. In one form or another we all focused on the same one: inflation-linked bonds. But I would not carve them out as a distinct asset class any more than I would commodities -- though unlike commodities, at least I think they are an asset. They are one of many assets that load on the inflation factor.

If you have a long-term view, equities are also decent inflation hedge. After all, over time prices adjust, and so do earnings.
And, as with commodities, the supply of inflation-linked bonds is low; there is a liquidity premium to pay.

I think what has elevated inflation-linked bonds from the category of “asset” to that of “asset class” is memories of the 1970s, a heyday for inflation-linked bonds. If you could have held them during the stagflation period, you would have looked golden; they would have given you a Sharpe Ratio of over 1.0 while many other assets was flat-lining. If I were building a simulation to beat the market on an historical basis, I would add in inflation linked bonds just for the pop they would give in that decade.
You can read at the transcript of that WealthTrack episode and watch it on YouTube below. I happen to believe that diversification is still important, but loses its power as huge inflows are going into all sorts of public and alternative asset classes.

Importantly, institutional fund managers have to start thinking how huge inflows into all asset classes are influencing the correlations between them, especially during a financial crisis when these correlations typically break down.

As the nature of markets evolve, you need to understand how collective inflows are influencing the trends in each asset class and changing the relationship between them. Rebalancing is crucial, but so is understanding what is going on in each asset class and how developments in one asset class will impact other asset classes.

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