Asset allocation?
Asset allocation? The "endowment model" was seen as the solution to investing for the long term. But as some investors found out to their cost, the idea was badly flawed and overexposed to a weak economy. It was heavily long biased, poorly hedged and took significantly higher risk. Despite being asset diversified, it was insufficiently strategy diversified. The alternative assets weren't very alternative. Short term volatility cannot be ignored regardless of an investor's ultimate time horizon.
A dynamic investment opportunity set is not optimally captured with static or occasional rebalances to a strategic asset allocation. Overweight alpha, not beta and certainly not illiquid alternative betas. Skill is the essential driver of outstanding risk-adjusted returns but assets don't have skill. Good fund managers do. The opportunity cost from overallocating to illiquidity was very expensive. There is no long term; only a volatile series of short terms which each require competent navigation and robust risk management. Ride out market drawdowns? No.
Some long term investors didn't realise they would still need short term performance and income. Economic fluctuations ought not to have a deleterious effect on capital growth or the asset/liability match. Having so much tied up in illiquid assets makes it difficult to be agile enough to capture changing sources of return and adapt to market conditions. Flexibility, adaptability and liquidity are prerequisites for consistent performance. Hoping to be paid for holding risk assets is dubious. Expecting to also be compensated for illiquidity is dangerous. When liquid markets sneeze, illiquid assets catch pneumonia.
I don't believe in asset allocation. Why focus so much on beta decisions that fail to work in an alpha seeking world? Such a blunt tool is ineffective for dealing with the sharp complexities of today's markets. It is an anachronism and fails to emphasize RISK. The world has moved on in financial engineering and portfolio innovation. As a conservative long term investor I favor strategy diversification and hedging. It works if you know what you are doing and conduct proper strategy and manager due diligence.
The percentage in marketable alternatives, hedge funds, was too low while the allocation to long only non-marketable alternatives, mostly private equity, was too high. While asset allocation is about attempting to capture ASSUMED risk premia for a given risk tolerance, the endowment model increased the ASSUMPTION RISK by replacing the liquid with the illiquid. While you can generally hedge liquid securities, not so with illiquid assets. Non-marketable alternatives still have to be marked to market. Where was the scenario analysis and stress testing to construct a truly robust portfolio during a recession?
A long term investor still needs short term returns. Long term performance neither requires nor implies a long term holding period. Some of the best track records have been by managers with very short term strategies. Interesting how the same people who said you can't make money day trading now say too much money is being made in high frequency trading! Also the long term investor cannot ignore short term volatility or losses. University endowments might survive for centuries but in the short term, professors and other staff have to be paid, spending budgets met and capital projects funded at the same time as alumni contributions reduce due to the economy. Endowment spending policy necessitates retaining liquidity in down markets.
The endowment model was better than the 60/40 in stocks and bonds or "(100-age)% in equities" hubris that people sadly still get sold. But it had zero chance of achieving what endowments, foundations, pension plans, sovereign wealth funds and individual investors actually want. Reliable performance with capital preservation at minimal risk and maximal liquidity EVERY year. For that you need to hedge. And a proper strategy diversification NOT asset allocation. Assets alone do not have the necessary repertoire of return streams to derisk a portfolio. You also need access to skill and expertise for hedging, tactical trading and security selection.
CoRelations are more important than coRRelations. Many illiquid assets like private equity or real estate give the appearance of low volatility because they are valued infrequently. This creates the supposed low correlation to public markets. The disaster that was "Modern" Portfolio Theory favors such assets in a naive mean-variance optimization. But quantitative correlation measures do not give much insight into the coRelationships between risky assets and a risky economy.
While liquid security correlations infamously tend to 1 in down markets, the situation is exacerbated with illiquid assets that cannot be easily sold. Illiquid assets were often able to disguise their high coRelation because of delayed or overoptimistic valuations. However their dependence on a good economy was obvious ahead of time. The notion that liquid markets are efficient but illiquid ones aren't was always ludicrous. Some of the most widely traded and analyzed public securities are the MOST mispriced.
Real estate has been around a lot longer than stocks or bonds. It is not an alternative investment and relies on economic growth and availability of leverage. Real assets? Long only commodities is an even riskier concept than long only equity. Oil and gas partnerships fluctuate with the price of...oil and gas. Long/short commodities trading is safer. Many managed futures CTAs have demonstrated the ability to make money in up AND down markets. Gold and cocoa may be at highs as I write this but they are short term trading vehicles NOT long term investments. Inflation hedging? That's what TIPS and inflation derivatives are for.
Better portfolio optimization requires preparing for short term market tornados and long term economic ice ages. The endowment model carried almost no insurance against a bad financial climate. That is why substantial allocations to skill-based strategies that can make money in bad times are essential. Not enough short sales means not enough hedging. Derivatives are not to be avoided; they are MANDATORY for the risk averse. And the endowment model needed more attention to proper risk management, not basic VaR and CVaR stuff since much worse case scenarios than the assumed "worst" case have a habit of actually occurring. Most Monte-Carlo simulations and stochastic asset/liability models output too much optimism. That is not prudent for a fiduciary.
Despite all that alternative beta, there was still a large bet on a good economy of rising equity, easy credit and real estate. Replacing liquid assets with illiquid assets relied on the notion that there is such a thing as a liquidity premium. Many investors, even now, expect to be "paid" for taking higher risk. Despite what the economics journals claim, there is NO link between risk and return. Just because "stocks" are riskier than "bonds" does not guarantee outperformance over ANY time period. Replacing unleveraged long only public equity with leveraged long only private equity was asking for trouble but was widely popularized by the CIO at the Yale Endowment, David Swensen. Why overcommit to 10 year lockups and ongoing capital calls when there is so much alpha available in inefficient public markets? Private equity was a misnomer anyway; the correct term was private debt with a slice of equity.
Construct a portfolio that can adapt to market conditions and achieve a RELIABLE absolute return at the LOWEST necessary risk. Hedge funds are NOT an asset class and cannot be fitted into an asset allocation methodology. The only thing to overweight is SKILL, not assumed risk premia. Client wealth can and should be protected and increased regardless of economic volatility. A bear market is no excuse for a fund manager to lose money. Portfolio choice? Simple, choose alpha. Only alpha.
A dynamic investment opportunity set is not optimally captured with static or occasional rebalances to a strategic asset allocation. Overweight alpha, not beta and certainly not illiquid alternative betas. Skill is the essential driver of outstanding risk-adjusted returns but assets don't have skill. Good fund managers do. The opportunity cost from overallocating to illiquidity was very expensive. There is no long term; only a volatile series of short terms which each require competent navigation and robust risk management. Ride out market drawdowns? No.
Some long term investors didn't realise they would still need short term performance and income. Economic fluctuations ought not to have a deleterious effect on capital growth or the asset/liability match. Having so much tied up in illiquid assets makes it difficult to be agile enough to capture changing sources of return and adapt to market conditions. Flexibility, adaptability and liquidity are prerequisites for consistent performance. Hoping to be paid for holding risk assets is dubious. Expecting to also be compensated for illiquidity is dangerous. When liquid markets sneeze, illiquid assets catch pneumonia.
I don't believe in asset allocation. Why focus so much on beta decisions that fail to work in an alpha seeking world? Such a blunt tool is ineffective for dealing with the sharp complexities of today's markets. It is an anachronism and fails to emphasize RISK. The world has moved on in financial engineering and portfolio innovation. As a conservative long term investor I favor strategy diversification and hedging. It works if you know what you are doing and conduct proper strategy and manager due diligence.
The percentage in marketable alternatives, hedge funds, was too low while the allocation to long only non-marketable alternatives, mostly private equity, was too high. While asset allocation is about attempting to capture ASSUMED risk premia for a given risk tolerance, the endowment model increased the ASSUMPTION RISK by replacing the liquid with the illiquid. While you can generally hedge liquid securities, not so with illiquid assets. Non-marketable alternatives still have to be marked to market. Where was the scenario analysis and stress testing to construct a truly robust portfolio during a recession?
A long term investor still needs short term returns. Long term performance neither requires nor implies a long term holding period. Some of the best track records have been by managers with very short term strategies. Interesting how the same people who said you can't make money day trading now say too much money is being made in high frequency trading! Also the long term investor cannot ignore short term volatility or losses. University endowments might survive for centuries but in the short term, professors and other staff have to be paid, spending budgets met and capital projects funded at the same time as alumni contributions reduce due to the economy. Endowment spending policy necessitates retaining liquidity in down markets.
The endowment model was better than the 60/40 in stocks and bonds or "(100-age)% in equities" hubris that people sadly still get sold. But it had zero chance of achieving what endowments, foundations, pension plans, sovereign wealth funds and individual investors actually want. Reliable performance with capital preservation at minimal risk and maximal liquidity EVERY year. For that you need to hedge. And a proper strategy diversification NOT asset allocation. Assets alone do not have the necessary repertoire of return streams to derisk a portfolio. You also need access to skill and expertise for hedging, tactical trading and security selection.
CoRelations are more important than coRRelations. Many illiquid assets like private equity or real estate give the appearance of low volatility because they are valued infrequently. This creates the supposed low correlation to public markets. The disaster that was "Modern" Portfolio Theory favors such assets in a naive mean-variance optimization. But quantitative correlation measures do not give much insight into the coRelationships between risky assets and a risky economy.
While liquid security correlations infamously tend to 1 in down markets, the situation is exacerbated with illiquid assets that cannot be easily sold. Illiquid assets were often able to disguise their high coRelation because of delayed or overoptimistic valuations. However their dependence on a good economy was obvious ahead of time. The notion that liquid markets are efficient but illiquid ones aren't was always ludicrous. Some of the most widely traded and analyzed public securities are the MOST mispriced.
Real estate has been around a lot longer than stocks or bonds. It is not an alternative investment and relies on economic growth and availability of leverage. Real assets? Long only commodities is an even riskier concept than long only equity. Oil and gas partnerships fluctuate with the price of...oil and gas. Long/short commodities trading is safer. Many managed futures CTAs have demonstrated the ability to make money in up AND down markets. Gold and cocoa may be at highs as I write this but they are short term trading vehicles NOT long term investments. Inflation hedging? That's what TIPS and inflation derivatives are for.
Better portfolio optimization requires preparing for short term market tornados and long term economic ice ages. The endowment model carried almost no insurance against a bad financial climate. That is why substantial allocations to skill-based strategies that can make money in bad times are essential. Not enough short sales means not enough hedging. Derivatives are not to be avoided; they are MANDATORY for the risk averse. And the endowment model needed more attention to proper risk management, not basic VaR and CVaR stuff since much worse case scenarios than the assumed "worst" case have a habit of actually occurring. Most Monte-Carlo simulations and stochastic asset/liability models output too much optimism. That is not prudent for a fiduciary.
Despite all that alternative beta, there was still a large bet on a good economy of rising equity, easy credit and real estate. Replacing liquid assets with illiquid assets relied on the notion that there is such a thing as a liquidity premium. Many investors, even now, expect to be "paid" for taking higher risk. Despite what the economics journals claim, there is NO link between risk and return. Just because "stocks" are riskier than "bonds" does not guarantee outperformance over ANY time period. Replacing unleveraged long only public equity with leveraged long only private equity was asking for trouble but was widely popularized by the CIO at the Yale Endowment, David Swensen. Why overcommit to 10 year lockups and ongoing capital calls when there is so much alpha available in inefficient public markets? Private equity was a misnomer anyway; the correct term was private debt with a slice of equity.
Construct a portfolio that can adapt to market conditions and achieve a RELIABLE absolute return at the LOWEST necessary risk. Hedge funds are NOT an asset class and cannot be fitted into an asset allocation methodology. The only thing to overweight is SKILL, not assumed risk premia. Client wealth can and should be protected and increased regardless of economic volatility. A bear market is no excuse for a fund manager to lose money. Portfolio choice? Simple, choose alpha. Only alpha.
© posted by Veryan Allen on 9.10.09
by Veryan Allen 
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