Friday

Asset allocation

Asset allocation does NOT drive portfolio returns. Static percentages also fail to consider changing opportunities and factors. Stock markets are either too cheap or euphorically overvalued. Valuation or potential decides whether to be overweight an equity or not. Does putting x% in "fixed income" make sense regardless of inflation or whether a bonds real yield is -2% or +5%. Asset class silos have no place in this dynamic, volatile, high frequency world. SKILL is what you need.

Optimal asset allocation? It's easy to rigorously prove that for all forward looking scenarios, investors should never asset allocate. Performance and volatility are entirely decided by manager mix, security selection and competent (or not!) factor hedging. Was nothing learnt from 2008? Asset allocation dominated conventional "wisdom" and wrecked those portfolios. Trillions are mis-invested due to asset allocation nonsense.

Focus on talent. Investors don't have the time or risk appetite to gamble on indices. Time slows for no-one so don't grow old riding out drawdowns and gambling on the idiotic ideas of the asset allocation crowd. Markets may rise - eventually - but that time CANNOT be recovered. 100% needs to be invested in skill so I invest with the world's best managers. Why put a cent with anyone not good enough to run a hedge fund?

If everyone was required to invest all their savings in one stock of their choice, Gary Brinson would conclude that ONLY security selection drove returns! If you flip a coin to be all stocks or all bonds or all real estate then market timing becomes the sole factor. The ridiculous risks and ludicrous losses of traditional portfolios show "bet on beta" asset allocation fails. Genius salesman and Wall Street darling Jack Bogle offers "cheap" beta but his speculative products devastated retirement plans. Prudent investors don't bet on unskilled toxic waste.

Bad science: decide on conclusion then find a data set you know IN ADVANCE will "confirm" it. If Brinson BHB had confined study to high frequency strategies they would "discover" that skill at high frequency trading drove performance! Long term asset allocation would have had no influence. Is it valuable to find that asset allocators' depend on asset allocation? Top performers focus on alpha so why waste time and money in beta. How did such "research" ever get through "peer" review? Would not happen in the hard sciences where rigor is required.

Asset allocation has cost millions their retirement. It has also destroyed the spending budgets of university endowments and foundations. Liquid long only is bad but leveraged illiquid long only is crazy. David Swensen is still being allowed to gamble alumnae money at casino Yale, for now. Many pensions keep doing what they have always done and get what they always get: lower funded status. Why waste millions on consultants to do an asset/liability study when asset allocation is useless?

Skill is necessary if you want consistent capital growth. Short positions are required; longs are optional. α yes, β no. Those landmark studies reached BIASED conclusions because asset allocation is what the CHOSEN investors already focused on. In contrast smart investors pay no attention to asset class labels and focus on security selection and tactical timing. Good fund managers analyze securities using skill. I have no interest in unskilled asset classes. Beta does not compensate for risk even in strong bull markets. Don't breach fiduciary duty to yourself or others you represent.

A stock and bond asset mix determines variation of returns only if you focus on beta. It's easy to debunk the asset allocation "axiom". If you encounter any "consultant" claiming that asset allocation accounts for over 90% of returns, don't walk away, run. Risk averse people invest in alpha. The true determinant of superior risk-adjusted returns is investment SKILL not percentages in UNSKILLED asset classes. It's the manager mix NOT the asset allocation. Check out the dire funded status of DB and DC pensions that gambled on betas due to incompetent advisors and conventional "wisdom".

It was a GREAT decade for the S&P. No beta for "passive" index funds but every day offered an opportunity set of fluctuating securities to capture alpha. It was an even better quarter century for the Nikkei. No beta since 1984 but vast alpha was generated from security selection and market timing by those with talent. Some "experts" say investors ought to have more in risky assets due to higher "expected" returns. Instead people would be wise to focus on 100% in skill. For those with liabilities to fund, intolerance of volatility or dislike of deep drawdowns, alpha is the prudent investment. Can't beat beta? Forget about beta.

In aggregate, stocks can underperform bonds for decades. 60/40 sounds prudent until rephrased as 90/10 risk. Why have a high risk appetite when unhedged equity indices NEVER compensate with sufficiently high reward even in bull markets. Last century's 8% return on 16% volatility was an insult but a last decade's negative total return with even more risk is absurd. Most bonds also don't reward enough for their risk. Do not go near index fund garbage. It is for speculators NOT fiduciaries.

Choose specific securities or hire other people with rare skill to do it for you. If your portfolio lost money in 2008 or you spend less than 100 hours a week dedicated to manager due diligence, portfolio construction and security selection you need to re-evaluate WHO is making investment decisions for you and HOW to upgrade. The Greeks got it right: alpha is before beta. If a manager is unable to make money or preserve capital in DOWN markets they aren't suitable for ANY portfolio.

Alpha beta separation is trendy but beta tends to swamp alpha as we saw in the downs and ups of 2008/2009. That led to the mistake inherent in the crazy concept called portable alpha. It was a beta-centric way of getting some investors into hedge funds but failed because it kept asset allocation front and center. It diluted the absolute return attribute and changed it into just another relative return index based product. The alpha beta separation idea still has too much risk budget in beta. But why bother with beta at all? "Cheap" beta is expensive considering its risk. Cost and risk conscious investors favor alpha. It's a cheaper source of return.

The more vituperative commentary on hedge funds, the more one should invest in alpha vendors. Why tie up precious capital in riskier beta when lower risk alpha is available? Better to identify mispricings and arbitrages than invest in "the market" itself. It is safer to minimize market exposure and analyze specific securities to buy and short sell that just gambling on benchmarks. Most portfolios are very beta biased while some investors implement a beta plus alpha model. The natural progression is to alpha only which has a much better efficient frontier. I do not understand why investors must surrender their wealth to the hazards of beta when superior alternatives exist.

Selecting the RIGHT betas at the RIGHT time is a form of alpha anyway. Choosing the WHICH and WHEN of asset classes takes as much talent and expertise as at the security level. I have no idea where "the markets" are going in the long term but will not take the chance of finding out. Asset and security selection, timing and hedging skill, though rare, are the only properties a conservative investor can rely on if they need adequate and consistent absolute returns. Beta is passive but do we really live in a world that rewards passivity in any activity? I don't think so which is why they are called ACTIVITIES. Alpha comes from acumen driven ACTION.

Successful investing is about leveraging informational, structural and analytical advantages or hiring those that have them. Let's look at portfolios that did well over long periods but didn't asset allocate, instead focusing on security selection or timing. A low frequency trading firm like Warren Buffett's Berkshire Hathaway identifies specific multiyear opportunities in currencies, commodities, stock and bond markets, derivatives and event driven special situations. In contrast the high frequency trading of Jim Simons' Medallion Fund times thousands of liquid securities over shorter holding periods down to microseconds. Producing alpha depends on your knowledge and technology edge applied to appropriate time horizons.

Beta bets drive many portfolios because that is what most investors do. It is like those who assume carbon is necessary for life because the science they know and only lifeforms they have analyzed are carbon-based. The anthropic principle applied to finance. It is false logic similar to the "all swans are white because every swan I've seen is white" phenomenon. Asset allocation fit nicely into the established body of theory which is why it remains popular despite its woeful weaknesses. Efficient, unbeatable markets imply the non-existence of skill! Choose beta because alpha is just "random" luck in a zero sum game? The much cited Brinson Hood Beebower paper has cost too many investors too much money. Beta people advocate index funds since they want you to invest in "the market". But the optimal way to achieve absolute returns at the total portfolio level is to be alpha-centric.

Beta vendors don't manage risk, don't market time and outsource ACTIVE security selection to benchmark construction firms. They even stay fully invested long only in bear markets! A beta-centric portfolio is where investors decide policy asset allocation and then hire managers to basically deliver the return from asset classes and hopefully a bit of alpha on top from tracking error constrained active mandates. Most long only funds have an R-squared with their benchmark over 70% - ie beta explains most of their returns. Alpha strategies and manager selection shouldn't be secondary but that is the result when beta bets dominate the allocation of investment capital.

Alpha vendors see a market of securities offering long/short opportunities in many time horizons within and between asset classes. An alpha-centric portfolio is where investors hire managers to analyze, trade and hedge for absolute returns. Of course you have to be good and work extremely hard to find alpha. Any manager that depends on beta is NOT running a hedge fund. A truly efficient portfolio does not pollute itself with beta. Dismissing all hedge funds is like avoiding all stocks because Enron, General Motors and Nortel fell to zero. Don't invest in bonds because some default and there is no such thing as a risk free rate? Nortel stock lost -100% while a Nortel bond is up +700% but most missed it.

Pure alpha sources do not fit well into the beta allocation process that some find so compelling. Since they are not assets, treating hedge funds as an asset class is wrong. The dispersion of returns across the industry is very high. So variable that AVERAGE performance has little meaning. 10,000 hedge funds, 10,000 strategies. People like to know if "hedge funds" were up or down each month. But what does that mean? Some made money and some lost money. Likewise I am often asked where I think "the market" is going. That is a beta question. Some stocks go up and others go down. Seek alpha.

Do I want "hedge funds" that outperform? No. I look for hedge funds that make money which is a very different target. I know that good hedge funds will have high risk-adjusted returns and bad ones will not. Alternative beta is just another beta and is therefore to be avoided. Most betas are becoming more correlated whether by geography or the equity, credit and real estate correlation to the economy. I am not concerned whether a hedge fund is "market neutral" or not. But it must be able to deliver absolute returns that are "economy neutral".

Alpha is the REAL diversifier because there are so MANY different ways of generating it. Focus on alpha if you want good returns regardless of the economy. Why pay attention to asset classes when investing in SKILL-BASED STRATEGIES makes more sense? Others are welcome to unhedged beta bets but for conservative investors like me beta with a bit of alpha is inferior to an ALPHA ONLY portfolio. Making money is simple: do the opposite of "Nobel" Prize economists.

By Veryan Allen Creative Commons License

This work is licensed under the Creative Commons Full Attribution, Non-Commercial, No Derivative Works 3.0 License

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