I know many investment managers and they're universally competent, conscientious people. However, it's harder to claim that they add much value to the investment process, as they're hamstrung both by the failings of the intellectual framework that defines portfolio theory, as well as a career structure than offers perverse incentives to hug indices for the sake of job security. The way that most industry professionals look at markets is tantamount to doctors looking at disease without an understanding of pathogens. Much of the orthodoxy underpinning industry asset allocation principles is utterly misconceived. Take portfolio diversification; that derives from the CAPM approach that an asset's expected return premium is proportional to its market sensitivity, or beta. Beta is critical, because it decomposes the ratio of the asset standard deviation to the SD of the market, multiplied by the correlation coefficient between them.
The bedrock of conventional asset allocation for retail investors drilled into to every CFP is that they should seek 'uncorrelated returns' across a spectrum of non-equity assets to obtain superior risk-adjusted returns.If we've learned anything in 2008/9, it's that correlations are far higher than that theory ever assumed. For instance, on a 3 year rolling total return basis to end Q3 2009, US real estate correlated 81% with the S&P, hedge funds 66% (HFRI Composite Index), and private equity 84%. If anything those figures are an understatement, given stale pricing via NAV calculations for non-market traded assets, which would lag the return comparatives. We've seen cross-asset correlations hit 75-85% across equity indices (US and global), commodities and corporate bonds in 2008 on the downside and in 2009 on the upside.
The reason assets behave so differently to academic theory stems from a huge blindspot in the underlying economic models, and that is the crucial importance of liquidity and credit cycles in driving economic activity and markets, which until now only a handful of economists like Hyman Minsky have identified.Belatedly, leading industry experts (and indeed the Fed) are trying to incorporate broad credit conditions into forward looking models of inflation, growth and asset returns. It's something I've always focused on as a priority, and has helped me make timely contrary calls through 2008 and 2009, both bull and bear. This year, funds that track the benchmark S&P 500 rose 24% while commodities funds were up 20%, according to Lipper data. Over three years, funds tracking the S&P lost an average of 6.6% annualized; commodity funds were down 7.3% on average. Gold has been a rare effective diversifier, with gold funds gaining 10.6% on average over the three-year period, and that reflects the liquidity/credit issue, where the gold run reflects growing doubts about policy sustainability. More than half of the commodities mutual-funds and exchange-traded funds on the market have been introduced since the start of 2008, and investors have placed growing proportions of their assets into these products, but oil, gold etc are not an asset class but simply a trading strategy, which is fine, but never confuse the two. Or take a look at the 'average' return on US equities. Stripping out four bull market decades (two of which preceded the bear market that began in 2000) over the last century, the annual return is a paltry 3.3% including re-invested dividends. Timing matters.My motto is that risk is never where you see it, which is why a top-down macro perspective is crucial, as is a keen understanding of probability and asset correlations. It's astonishing how many investment professionals have only the vaguest understanding of either, which makes it incumbent on any savvy investor to ensure that he does. I'll keep doing what I can to help that understanding in 2010.
1920-1929: Average return 11.77% The U.S. was the China of its day, with the world's fastest growing consumer market and manufacturing base.
1950-1959: Average return 15.98% The U.S. dominated most goods markets; U.S. dollar became the world reserve currency as the decade began.
1980-1989: Average return 15.62% Historic fall in interest rates coupled with record levels of both fiscal expansion and tax cuts.
1990-1999: Average return 18.37% Cold War peace dividend, disinflation from China merchandise exports/ex Soviet commodities, loose Fed policy drives bubble.
The classic balanced portfolio of 70% equities invested primarily in the United States and 30% fixed income has proven, over time, to minimize risk while maximizing return. However, that was then and the investment environment has changed permanently over this last decade, a reality many are just waking up to.
