There’s nothing like a crisis to make an industry question its fundamental beliefs, and poor old Harry Markowitz has certainly been in the firing line since everybody’s asset-allocated, ‘diversified’ portfolios all crashed together in 2008/9. Does his modern portfolio theory still stack up? What role will alternative assets play in any, ahem, alternative to it? These questions are sure to be fiercely debated at September 8’s third annual Absolute Returns Conference, produced by Conexus Financial (publisher of this magazine). Diversification ain’t diversification when everybody’s doing it, it seems, and as KRISTEN PAECH reports overleaf, some stakeholders are now calling for a more ‘back to basics’ approach, even dragging the old ‘balanced vs specialist’ debate out of the mothballs. Elsewhere in this Absolute Returns Conference primer, SIMON MUMME reports on the managers who try and make beta better – the activist hedge funds – and finds out why they’ve struggled for a toe-hold in Australia. Meanwhile, GREG BRIGHT investigates a hybrid between private equity and credit which promises the best of both worlds – mezzanine debt. Let the alternative ideas flow…
Death knell for asset allocation, or a new dawn?
When most correlations went to ‘one’ during the financial crisis, investors were left questioning whether the established principles of asset allocation and diversification still held up. KRISTEN PAECH investigates whether we’re witnessing the end of ‘asset allocation’ – with the multiple managers and ‘buckets’ the term implies – or a return to the simpler days of portfolio construction, and the role that absolute return-seeking alternatives will play in either scenario. Warren Buffet once described diversification as a protection against ignorance. “Wide diversification is only required when investors do not understand what they are doing,” he said. But during the financial crisis, asset class diversification failed to protect even the savviest of investors, with many of the world’s most sophisticated investors suffering the wrath of the global financial market meltdown. Brinson’s landmark 1986 paper “Determinants of Portfolio Performance”, famously argued that asset allocation drives more than 90 per cent of return variation, with stock selection accounting for less than 10 per cent.
However the high correlation displayed between most asset classes during the crisis has led many funds to question whether the “policy portfolio” or long-term strategic asset allocation is dead. As the argument goes, you can’t set your investment strategy based on longterm assumptions; you have to be more tuned in to current market conditions. In a recent paper by Citi Global Markets titled “Multi-Asset Strategy for Australian Investors”, Citi says globalisation has increased the interrelation between asset markets, products and regions. “At the same time, the accessibility of all investors to new regions and asset classes has increased markedly,” the paper notes. The classic GFC case of how diversificiation strategies can break down was outlined recently by Pimco’s head of analytics, Vineer Bhansali, and relayed by Felix Salmon’s ‘Market Movers’ blog. In a note, Bhansali reminded investors of how commodity prices enjoyed an historic rally in early 2008, as stocks and bonds struggled.
The rally was fuelled by a plethora of research from Wall Street firms, purporting to show the lack of historical correlation between stocks and commodities. What Wall Street forgot was that prior to this decade, investment in commodities was out of reach for most people, due to the complexity of the futures markets and difficulty in gaining the over-the-counter access required. Then, exchange-traded funds came along, and suddenly investors could buy and sell commodities with the click of a mouse. By mid-2008, ETF investors had poured billions into commodities in just a few months. As the financial crisis worsened and stock and bond prices collapsed, ETF investors with margin calls to cover found it as easy to get out of commodities as anything else.
As a result, the Dow Jones AIG Commodities Index plummeted 37 per cent in 2008. “When people start buying an asset, the act of them diversifying ultimately makes the asset less of a diversifier,” summarises Pimco’s Bhansali. What happened to commodities also happened to tactical asset allocation, the Citi paper points out. “Through [the 1990s], tactical asset allocation was marginalised into futures overlay products, which were difficult to sell, given the inevitable episodes of underperformance elicited a cash call. Strategic asset allocation (SAA) in that period was left to the asset consultants, plan sponsors and product specialists. In recent years, the pendulum has shifted again, with multi-sector strategies enjoying a renaissance.” In a client note earlier this year, Watson Wyatt warned funds to review the suitability of their existing SAA before rebalancing, following severely negative returns which left many funds substantially underweight to risky assets.
“We think that it’s true that you should be focused on current conditions but we don’t think that means you abandon your long-term strategic asset allocation process,” says Ross Barry, head of portfolio construction at Watson Wyatt. “As far as diversification goes, we don’t think that’s dead either, in fact we think the crisis serves to underscore the importance of genuine diversification. More specifically, the problem going into the crisis was that people didn’t appreciate how connected many of the markets are or can become in stressed conditions.” In many cases, the crux of the problem lay in the lack of transparency within many of the so-called alternative structures being invested in. Without this transparency, funds were unable to understand the underlying sources of risk and return of their investments. “Three or four years ago we started to see, particularly within fund of hedge funds, that there were increasing exposures to leveraged credit and also to equity beta (equity market risk) in those portfolios,” Ross says.
“While a lot of the fund of hedge funds were diversifying in terms of the number of managers – some had as many as 70 or 80 managers – they were actually becoming increasingly concentrated in terms of some of these key risk exposures.” Hang the cost, give me control With all eyes back on the risks inherent within alternative investments and particularly private market investments, Barry says super funds have become much more focused on the structures that they’re investing in and the degree of ownership and control afforded to them as an investor. As a result, Watson Wyatt is working towards developing “more customised programs” for hedge fund investing that are tailored to individual clients’ specific objectives and liquidity needs. “It’s not going into an off-the-shelf pooled or commingled fund of hedge funds, but rather something that has been very carefully configured to target the specific objectives of the client,” Barry says. “Generally these configurations are much more focused, and have fewer managers, but do target a broader range of strategies. There’s not a lot of benefit of just having a lot of managers doing the same thing; what we’re looking for is some niche strategies, genuinely differentiated sources of return. Catastrophe reinsurance is a good example.”
Multi-asset class managers claim that rather than mark the end of asset allocation, the crisis has served to emphasise its merits, as well as the poor decisions some investors made when building portfolios. Simon Doyle, head of multi-asset at Schroder Investment Management says a major problem with portfolio construction is that most investment strategies adopt a rigid 60/40 or 70/30 type asset allocation structure, with the biggest component in equities. “If you move through an environment where equity markets don’t perform, the overall portfolio is not going to perform because equity risk dominates,” Doyle says. Super funds must really understand the underlying economic risk that they’re taking when they invest in something that falls into the “alternatives” bucket, he adds. “Generally what you’re buying is a liquidity premium, but often you buy the same risks you’re getting in the more transparent parts of your portfolios such as private equity or debt markets,” he says. Guy Stern, head of multi-asset management at Standard Life Investments in the UK, agrees asset allocation is far from dead. Rather, he says, its value is becoming increasingly apparent.
“The rules haven’t changed. In fact, the best performance has been achieved by those who remember the rules,” Stern says. “One of the basic rules is if you’re going to diversify yourself, you have to find things that don’t react to the same basic macro-economic environment. Over the past couple of years there have been a number of funds and fund concepts that have gone generically under the name ‘diversified growth’ where you’re combining several different types of growth assets in order to reduce the volatility of the portfolio somewhat and still participate in upwards movements. “The problem is the name reveals itself – it’s diversified growth, these separate asset classes are all responding effectively to the same macro-economic characteristic of economic growth. It’s kind of like buying several different flavours of icecream.” Stern says there is a growing interest in asset allocation as “a reversion to searching for better risk-return characteristics” from assets. Investing on a multi-asset basis is one way of improving the risk-return environment within portfolios.
Multi-asset portfolios attempt to invest for a positive outcome in lots of different environments, not just an environment where economic growth prevails. They also utilise the full capitalisation structure of organisations. “One of the issues for Australian investors has been, given a lot of risk is in the Australian equity component of the portfolio, that a lot of that risk is related directly and indirectly to commodities via the resource exposure, and even the indirect effects of that back through into the domestic economy,” Doyle says. “Adding commodity exposure is doubling up on that risk. Even if you argue that because commodity prices have an impact on inflation, they’re a good inflation hedge, if you pay too much for them, it doesn’t matter how good an inflation hedge they are, you’re going to lose money.” Inflationary future press es alternatives case Matthias Gaertner, managing director of managed futures funds provider SuperAlphaFund, is a strong advocate of diversification through alternatives, particularly in light of government spending which he says will create pressure on bond markets and push up gold prices as investors look for a non-debt backed hedge.
He says a well diversified portfolio should have up to 20 per cent of assets invested in alternative investments, including managed futures, which have a low correlation to traditional asset classes. “Diversification only makes sense if there’s a low correlation between the different asset classes,” he says. “Governments around the world have spent $3 trillion on stimulus packages and we believe this will cause inflation or hyperinflation in the future. We really believe in gold, because gold is the oldest currency in the world and it’s not affected by any debt. It’s a real currency, not a paper currency.” While the more complex alternatives may still have a role to play in a more risk-conscious environment, Doyle says simplicity, in his view, wins out.
He predicts a shift back towards simpler, more transparent strategies and single manager balanced funds. “Effort in the industry has gone into looking at alternatives, understanding alternatives managers, hedge funds, style diversification which… have a role at the margin,” he says. “The big decisions trustees should make are: what are the broad risks I should be taking in my portfolio, how much risk should I be allocating to equities versus bonds versus credit versus alternatives and making sure that risk is allocated in a way that’s aligned with the funds’ objectives, not some arbitrary historic convention that says 60 or 70 per cent of my portfolio should be sitting in equities.” Stern does not see alternatives as a viable asset class in and of themselves, but instead believes they will become either subcategories of traditional asset classes or investment strategies, rather than asset classes.
While no one can anticipate the next generation of truly diversifying assets, he says there are some global themes that should shape the construction of portfolios. “You’re going to get better risk/ return characteristics out of incomeseeking and carry-type strategies than you are out of purely directional strategies,” he says. “We’re back to a phase where a larger proportion of the return is going to come from the underlying income stream, so you have to think about: ‘have I diversified not just the asset class but my source of income within the portfolio as well?’.”