Asset allocation?
Asset allocation doesn't work. It does not drive portfolio returns. Whether mathematically or empirically, it is easy to show for all forward-looking goals, market scenarios and risk tolerances, investors big and small should NEVER asset allocate. Experts were wrong: take a look at the disastrous state of pensions and retirement savings. They are in that situation due to asset allocation.
Let's destroy asset allocation with a simple proof. If investors were required to put their entire portfolio in one stock of their choice, "experts" would conclude ONLY stock picking drives returns. Or if you flip a coin each month to be "100% stocks" or "100% cash" then market timing becomes the SOLE determining factor. Asset allocation is based on bad science. If you are already doing "asset allocation" then of course, "asset allocation" will decide the results, just as much as stock picking or market timing will.
Decide on conclusion you want; then search for a data set you know in advance will "confirm" the delusion. Brinson, Ibbotson etc studied investors that were already doing "asset allocation". If the superstars had confined themselves to market timers they would amazingly "discover" that market timing drove performance! Asset allocation would have no influence. Is it valuable to discover that asset allocators' returns and variances are driven by "asset allocation"? No.
Warren Buffett's returns are entirely driven by stock picking. He, like me, does not asset allocate. We money allocate. VERY different. I've read the academic papers, heard all the gurus speak, met with the geniuses marketing to me. Safe in mediocrity and groupthink but empirical garbage and dangerously mistaken. Sadly most investors obey such conventional "wisdom". As a data scientist I follow facts and evidence not flawed fallacies.
Naive asset percentages in various market betas is a breach of the fiduciary standard. Truly "prudent" people do NOT invest like that. Some urge low fee, high cost, high risk beta based funds but such speculative products have vicious volatility and devastating drawdowns. The prudent way to achieve investment goals for ALL long term scenarios is skilled strategy selection NOT academic asset allocation.
Was nothing learnt from 2008 crash? The ludicrous losses of pension portfolios in major drawdowns show "bet on betas" asset allocation fails. Portfolio returns are actually decided by level of manager talent, security selection and competent (or not) factor hedging. Asset allocation dominated conventional "wisdom" and wrecked too many portfolios. Meanwhile the skilled thrived in those wonderful market conditions. Trillions are mis-invested due to asset allocation.
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 asset allocation crowd. Markets might 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 risk a cent with anyone not good enough to run a hedge fund?
Asset allocation has cost retirements. It has also destroyed the spending budgets of university endowments and foundations. Liquid long only is bad but leveraged illiquid long only is crazy. Many pensions keep doing what they have always done and get what they always get: lower funded status. Why do an asset/liability study when asset allocation is useless? Liabilities need an absolute return. Best match to achieve that are skilled absolute return strategies.
Skill is necessary if you want consistent capital growth. Short positions are required; longs are optional. 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 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.
Let's destroy asset allocation with a simple proof. If investors were required to put their entire portfolio in one stock of their choice, "experts" would conclude ONLY stock picking drives returns. Or if you flip a coin each month to be "100% stocks" or "100% cash" then market timing becomes the SOLE determining factor. Asset allocation is based on bad science. If you are already doing "asset allocation" then of course, "asset allocation" will decide the results, just as much as stock picking or market timing will.
Decide on conclusion you want; then search for a data set you know in advance will "confirm" the delusion. Brinson, Ibbotson etc studied investors that were already doing "asset allocation". If the superstars had confined themselves to market timers they would amazingly "discover" that market timing drove performance! Asset allocation would have no influence. Is it valuable to discover that asset allocators' returns and variances are driven by "asset allocation"? No.
Warren Buffett's returns are entirely driven by stock picking. He, like me, does not asset allocate. We money allocate. VERY different. I've read the academic papers, heard all the gurus speak, met with the geniuses marketing to me. Safe in mediocrity and groupthink but empirical garbage and dangerously mistaken. Sadly most investors obey such conventional "wisdom". As a data scientist I follow facts and evidence not flawed fallacies.
Naive asset percentages in various market betas is a breach of the fiduciary standard. Truly "prudent" people do NOT invest like that. Some urge low fee, high cost, high risk beta based funds but such speculative products have vicious volatility and devastating drawdowns. The prudent way to achieve investment goals for ALL long term scenarios is skilled strategy selection NOT academic asset allocation.
Was nothing learnt from 2008 crash? The ludicrous losses of pension portfolios in major drawdowns show "bet on betas" asset allocation fails. Portfolio returns are actually decided by level of manager talent, security selection and competent (or not) factor hedging. Asset allocation dominated conventional "wisdom" and wrecked too many portfolios. Meanwhile the skilled thrived in those wonderful market conditions. Trillions are mis-invested due to asset allocation.
60/40? Does x% in fixed income when bonds yielded 10% make sense even if they now yield 2% or less? Still x%? Of course not. Since client long term goals require the SAME absolute return no matter what, fixed income attractiveness varies as a function of interest rates. As for "high" yield, many junk bonds were yielding +15 to 20% when Michael Milken made his name. Today under 5%? "High" is absolute, not relative. Need a lot more coupons to absorb the defaults. And inflation.
Check out "risk free" government bonds during inflation. The "lower for longer" crowd urge loading up on duration at these rates! Risk reward? Equity markets are usually either too cheap or overpriced. Asset class silos have no place in this dynamic, volatile world. 100% in SKILL is what you need. Diversification is no free lunch and adds value only if it REALLY diversifies. Mostly it diworsifies.
Check out "risk free" government bonds during inflation. The "lower for longer" crowd urge loading up on duration at these rates! Risk reward? Equity markets are usually either too cheap or overpriced. Asset class silos have no place in this dynamic, volatile world. 100% in SKILL is what you need. Diversification is no free lunch and adds value only if it REALLY diversifies. Mostly it diworsifies.
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 asset allocation crowd. Markets might 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 risk a cent with anyone not good enough to run a hedge fund?
Asset allocation has cost retirements. It has also destroyed the spending budgets of university endowments and foundations. Liquid long only is bad but leveraged illiquid long only is crazy. Many pensions keep doing what they have always done and get what they always get: lower funded status. Why do an asset/liability study when asset allocation is useless? Liabilities need an absolute return. Best match to achieve that are skilled absolute return strategies.
Skill is necessary if you want consistent capital growth. Short positions are required; longs are optional. 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 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.
© posted by Hedge Fund on 8:08 PM
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