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Wednesday, October 7, 2009

An Interesting Example of A Different Way of Looking at Risk....and A Sign Hope Still Springs Eternal

The Financial Times (FT) has been running a great series on investing with one theme being the need for a new model. One theme in the articles is the idea which now (finally) seems to be widely accepted, that MPT (modern portfolio) and its partner the efficient markets theory, while elegant in academia have shown little correlation (pun intended) to what goes on in the real world of financial markets. As John Authers the excellent writer for the FT points out in one of the articles:(my italics and bolds)

In the past 10 years, these models have become much more sophisticated, as investors add new asset classes that appear to have a low correlation with equities or bonds. Most prominently, this has involved diving into commodities and currency trading. But it has also been popular to try out esoteric strategies used by hedge funds, that were designed not to correlate with the market, as well as highly illiquid investments in forestry or energy.
Last year this approach came catastrophically unstuck, as virtually all of these asset classes fell in unison. This was a disaster for institutional fund managers.
“The correlation between supposedly uncorrelated assets was higher in the up market and much higher during the down market than they had been led to believe,” says Amin Rajan, of CREATE Research of in Kent, southern England, who said that many institutions wanted to follow the trail blazed successfully by big endowments such as that of Yale University. “These models hadn’t been stress-tested. They went into it on the principle that these opportunities existed, and there was a first-mover advantage. But they had no governance structures and no skill sets to manage those risky assets.” Asset allocation previously proceeded on the assumption that correlations between different asset classes were relatively stable over time. One implication of the crash is, therefore, likely to be that the alternative asset classes, such as commodities, that gained favour because they appeared to have a low correlation with stocks and bonds could now lose popularity....

The article cites an interesting different way of risk proposed by Wells Fargo Asset Management I couldn't agree more:

.... of “alternative risk budgeting”, comes from Wells Fargo, a company that was in the forefront of developing modern portfolio theory a generation ago.
All look at the risk of outright loss, rather than the volatility of returns.
This requires asset allocators to look at nine different kinds of risk: concentration risk (the risk that many investors have crowded into the same strategy, making it more prone to sudden busts); leverage risk (which multiplies both gains and losses); liquidity risk (the chance that an asset cannot be sold quickly at the prevailing price); transparency risk (if the investment structure is too complex to understand, Wells Fargo suggests, it is too risky); sensitivity to the overall equity market, and bond market; event risk (the danger an unforeseen event could pose); volatility risk (the extent to which returns vary); and operational risk, which includes various risks of businesses failing to perform.

The article mentions as "similar" the following approach from Pimco. I find far less substance to the Pimco approach but more on that in a future post.

Mohamed El-Erian, head of the large bond management group Pimco, suggests that asset allocation should be about the “risk factors” of different investments, rather than about asset classes. “The same risk factor can apply in different asset classes,” he says. For example, there is an equity risk factor in corporate bonds. “What makes this interesting is that it’s not just about the classic factors like equity, or default, or interest rates, or inflation or liquidity. There’s also a risk factor, which is public policy. Whether we like it or not, government has become an integral part of markets

I'm not quite sure what the above means...more later.

Mr. Authers is a very bright man yet even he falls into the camp of "looking for alpha" arguing that most of a portfolio should be indexed but that a small % should be allocated to "genius managers" Needless to say I agree with the former and strongly disagree with the latter.

Auther writes

Other changes are afoot. The steady shift towards passive investing (merely attempting to replicate a benchmark, rather than to beat it, and saving on expenses) is likely to stay intact. ....
There will also be a change in the way brokers analyse retail mutual funds, and the way pension consultants analyse institutions. Over the past 10 years the “style box” approach has predominated..... managers have skill, and then to give the truly gifted managers greater autonomy. Rather than “closet indexing” – staying close to a benchmark – the idea is that assets should be truly passive, or entrusted to managers with skill. ...
““You’ll see a move away from the practice of constraining managers and towards absolute returns, as opposed to relative nonsense.”
Ill have more to say in a future post about "absolute returns" funds which to me is a fad. Firstly few of these "absolute return" managers fared will in the recent crash, they proved to be heavy in leverage and illiquid assets. In fact they were high in virtually all of the risk categories listed by Wells (above).

So in my view the search for extremely talented go anywhere investors will prove no more successful than those within categories. There is likely to be little consistency in returns and in fact rather than having skill in a narrow niche of the market these absolute return investors must have even broader skills. As Naseem Taleeb writes in Followed By Randomness manager luck is often misinterpreted as skill.

Finally as the head of one of the largest absolute return managers writes, these managers will likely be more conservative going forward eliminating one of their major tools for outperformance :
Investors will also be more conservative, particularly when it comes to leverage. Clifford Asness, founder of AQR, says: “For the foreseeable future, I think people will be much more sensitive about getting into a leveraged trade. While leverage will still be a useful tool, all-else-equal, the smarter investor will always prefer the less leveraged trade, and more so going forward.”

I still feel that while MPT is oversold, a prudently diversified portfolio with passive vehicles is the best approach. Importantly it guarantees avoiding all of the key risk factors cited by Wells...somethin absolute return managers cannot assure/ Searching for "absolute returns" is just another word for the elusive quest of "searching for alpha". In my view absolute return funds are simply a fancy way of saying "we have a genius manager, trust us and give us your money to manage" thanks.

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