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.
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.
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