60/40 versus hedge funds - the asset allocation battle

There is big fundamental battle raging for the hearts and minds of investors, stay traditional through a core 60% stock / 40% bond portfolio or go alternative. Go cheap with traditional indices and diversify by asset class or pay more for the opportunity to diversify across more asset classes choices and through differences in style or strategy. It is a difference in diversification through the beta found in an asset class or diversification with alpha through strategy and skill.

The numbers suggest that liquid alternatives and hedge funds are making significant in roads in this battle although the long history of simple diversification provides a bastion of support for classic asset allocation behavior. Nevertheless, this is not a popularity contest of gathering assets under management. Historical numbers can be marshaled for both sides, but a more important issue is the underlying assumptions for asset allocation.

Here is the real battle. Should you diversify under the assumption that managers do not have skill and markets are efficient or should you hold a portfolio that accounts for skill and exploits inefficiencies and changing risk premia. Just when most investors have learned to accept the value of passive investing, there is a switch within the industry to active management through alternatives.  There is more complexity and nuance to this issue than what we have outlined, but some stark choices help frame the issue of how to structure a portfolio.

Given low bond yields, holding fixed income as a safe asset class may not be a good assumption. Broadening the portfolio makes sense; however, we are more suspect of low correlation from other assets classes. The evidence tells us that when you need diversification most correlations increase significantly. The demand for diversification cannot be met. The alternative is to gain diversification not just from asset classes but from strategies. Strategy diversification may actually be more stable and unique than what we find across asset classes. However, for strategy diversification to work there needs to be a set of criteria met that includes skill, liquidity, uniqueness, and depth. The value of a strategy is by nature limited. Everyone cannot do it.

Framing the asset allocation decision as one between beta and alpha, class and strategy, or passive and active skill may not make choices easier but does focus the decision on what is important.

Deglobalization - the financial world is disconnecting

The world is getting more disconnected if you focus on global capital flows. Global capital flows outstrip movement in trade, so it is a strong signal of globalization. These flows are what moves savings around the world from creditors to debtors. The numbers are showing a sea change in financial behavior. Kristin Forbes of the BOE gave a good speech on "Financial Globalization" and the implications for global finance. It tells s tory of global financial world in transition.

Pre-financial crisis, the capital flow numbers were on track to represent almost half of GDP. The crisis changed the world with capital staying put or moving back to their  home countries. Banks especially retrenched their appetite for global lending. This change is really hitting emerging markets.

Some  of this flow slowdown is associated with slower global growth. The decline is also correlated with the fact that rates around the world are at similar levels. But, perhaps most important has been the anxiety about investment risks around the world. In spite of volatility in many markets being low, investor have returned to having a strong home bias. The retrenching for today may lead to more  global opportunities of tomorrow; however, right now, financial behavior is reflecting an inward focus and many global investment projects are suffering.

Chase hedge fund winners, but only so far

Momentum is everywhere and it is a strong foundation for any active management strategy, but there is an alternative view that chasing winners is a fool's game whereby buying of tops and bailing on losers will be a easy path to failure. The answer is somewhere between these extremes as presented by the Common Fund in their August 2014 white paper Chasing Winners: The Appeal and the Risk.

Their paper which evaluates hedge funds shows that chasing hedge fund winners, those with performance persistence, is a good thing except you do not want to chase too long. The longer you hold a winner, the more likely you will underperform.  Winners get stale. This is consistent with the research on momentum in stocks and in asset classes. In fact, you should do a quick evaluation, hold the winners for under a year and then move on. Active management of hedge fund winners makes a difference.  

Nevertheless, their work provides additional insight on skill based or alpha managers. Choosing those who are hot may make sense, but finding those with skill is even better. The winners or momentum strategy may be picking up trends in the underlying asset classes or beta while skills through alpha generation may transcend a trend. It is an interesting perspective which needs further exploration. Most likely, finding winners with skill is the best of both worlds but the rarest of managers.

Evolution of asset management - the march of indexing

A nice way to describe the evolution of the asset management industry is through the march of indexing. Returns can be broken into beta and alpha. The asset management industry has been able to form low cost indices for asset class beta. The replication of beta is not hard. 

It has now developed alternative beta approach to capture systematic risk premia.  This was creative but is now easy to replicate and produce for the masses. The next level of evolution has been to bundle multi-asset solutions which may be a cross between beta and alpha. Indices have been formed for these cross-ver products although this part of the industry is evolving. What has not been indexed has been manager skill which receives higher fees and should generate better return to risk. You cannot make generic products for manager skill.

The asset management industry is not that different than other industries where generic products are priced low and mass marketed, and customize products that require more skill to produce still receive premium pricing. If you cannot distinguish skill, you will be squeezed by the generic index products. The industry evolution now requires managers to better define and communicate their skills.