Does Asset Allocation Still Work?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Richard Bookstaber, author of A Demon of Our Own Design, recently wrote an excellent piece in Seeking Alpha, Why I'm Skeptical About Asset Allocation:

I appeared last Friday on a the PBS program WealthTrack,
where the topic was asset allocation, in particular, as host Consuelo
Mack put it, how to build an all weather portfolio. I was the skeptic
of the group. I don’t think there is some magic asset allocation that
protects you from the buffetings of financial storms without it also
trimming your sails during fair weather. Here is an encapsulation of my views from the program.

Asset allocation and risk appetite

One of the participants, asset allocation guru David Darst of Morgan Stanley (MS),
proposed various portfolios to protect against a 100-year flood, 30 to
70-year flood, a 25-year flood, etc. Those portfolios boiled down to
putting less in risky assets and more in bonds; the more severe the
flood you anticipate, the less risk you take. Of course, that will do
the trick. If by asset allocation you mean determining where to set
your risk tolerance dial, we’re all on board.

Asset allocation is like clapping with one hand

But
the discussion of risk tolerance highlights that we can only go so far
with asset allocation if we only look at assets. What matters is assets
versus liabilities, because the liabilities determine our risk
tolerance and, related to that, our demand for liquidity. It is
impossible to formulate an ideal asset allocation strategy without
knowing the liability stream those assets are intended to meet. There
is no one-size-fits-all for asset allocation. This
reminds me of an FAJ article I did back in the 1980s with pension
actuary Jeremy Gold entitled “In Search of the Liability Asset”.

Diversification works well, except when it really matters

We
all know the argument from Finance 101: If you hold 16 uncorrelated
assets, your risk will drop by a factor of four. Well good luck with
that.

During a crisis, when
diversification really matters, correlations aren't near zero (as if
they ever are). All that people care about is risk and liquidity. All
assets that are highly risky drop, all assets that are less liquid
drop. No one cares about the subtlety of earnings streams. It is like
high energy physics. When the heat gets turned up high enough, matter
is just matter, the distinctions between the elements is blurred away.

This
is not to say that one should not try to diversify, but rather that one
should not think diversification will work magic. It is a given that a
portfolio should not be limited to U.S. Treasuries and S&P 500
stocks, because while it should not be oversold, diversification does
have some benefit. And, on the other side, unless someone is still
living in the 1970’s, it borders on the intellectually dishonest to
trumpet a diversified portfolio by using the S&P 500 as the bogey.

A
college kid can construct a portfolio that will beat the S&P 500 on
a risk-adjusted basis, because there are so many more markets available
now. A better approach is to look at a given asset allocation versus
its nearby well-diversified neighbors, and try to understand why one is
better than the other.

Commodities do not form an asset class

This
sounds heretical given what we have seen oil and gold do recently, but
a lot of the reason that has happened is precisely because people are
treating them as an asset class when they are not.

Commodities
are not assets. They are factors of production. They do not generate
returns, they have no claim on production. They have supply that flows
out at a nearly fixed rate short term, and they comprise very small
markets compared to the financial markets.

If pension
funds all decided to put two percent of their capital into commodities,
two things would happen. First, that two percent would be a rounding
error in their returns, no matter how commodities behaved. Second, they
would swamp the supply of the commodities for economic purposes – i.e.
for their true role as factors of production. I agree with Michael Masters’ view
that oil prices were pushed up by this sort of financial activity. I
might quibble with one chart or another, I might not couch it in the
loaded terms of speculation. But the
subsequent behavior of the market demonstrated that he was right and
Goldman and others who took the opposing view were wrong.

Inflation-Linked Bonds

Which brings me to inflation-linked bonds. At
the close of the program we all were asked for one investment
recommendation. In one form or another we all focused on the same one:
inflation-linked bonds. But I would not carve them out as
a distinct asset class any more than I would commodities -- though
unlike commodities, at least I think they are an asset. They are one of many assets that load on the inflation factor.

If you have a long-term view, equities are also decent inflation hedge. After all, over time prices adjust, and so do earnings. And, as with commodities, the supply of inflation-linked bonds is low; there is a liquidity premium to pay.

I
think what has elevated inflation-linked bonds from the category of
“asset” to that of “asset class” is memories of the 1970s, a heyday for
inflation-linked bonds. If you could have held them during the
stagflation period, you would have looked golden; they would have given
you a Sharpe Ratio of over 1.0 while many other assets was flat-lining.
If I were building a simulation to beat the market on an historical
basis, I would add in inflation linked bonds just for the pop they
would give in that decade.

You can read at the transcript of that WealthTrack episode and watch
it on YouTube below. I happen to believe that diversification is still
important, but loses its power as huge inflows are going into all sorts
of public and alternative asset classes.

Importantly,
institutional fund managers have to start thinking how huge inflows
into all asset classes are influencing the correlations between them,
especially during a financial crisis when these correlations typically
break down.

As the nature of markets
evolve, you need to understand how collective inflows are influencing
the trends in each asset class and changing the relationship between
them. Rebalancing is crucial, but so is understanding what is going on
in each asset class and how developments in one asset class will impact
other asset classes.

Comments

[Anonymous]

A really broadly diversified portfolio is fighting the laws of thermodynamics. The 10%+/- efficiency of machines,human bodies, and the resulting societies. A positive yield has to skim off only the cream, the whole is clearly going to be a loss.

[eroc66]

Asset allocation is and was just a "sales track" perfect for the Bubble Years!

[crzyhun]

Asset allocation assumes reasonably efficient market....not like the one we have NOW. All points above well taken.

Asset allocation also assumes some amount of non co-relation. Not all like we have NOW.

Asset allocation also assumes a rational investor, professional and otherwise, not like we have NOW.

Asset allocation also assumes a process of rebalancing in a consistent manner, unlike we have NOW.

More fodder for the cannon.

However, this still allows for investment policy.

[Margin Call]

Leo,

Thanks for touching on this very important and timely topic. Asset allocation theory has fallen woefully behind in terms of accounting for both the ease and size of capital movement and the financialization of, well, every productive sector of society (commodities being the most glaring example). The boiler plate diversification approach sees the world as a collection of largely self-contained asset classes and markets ruled by their own internal logic which are ripe for low-correlation returns- which is funny, because the very financial and technological linkages that allow people to move their money around so effortlessly and make this sort of diversification possible is increasingly nullifying the supposed benefits.

If everyone diversifies at the same time and in the same instruments, is it still diversification?

[MinnesotaNice]

"Diversification works well, except when it really matters"

Exactly... IMO asset allocation only works when you generally have uptrending markets over a long timeline... each asset class alternating with the others at different speeds of appreciation...

And when you have markets that all decompensate at the same time... it doesn't work... at all.