Let s take a look at the two distinct philosophies, or models that lie behind virtually all investment strategies:

Transcription

1 The Myth of Asset Allocation, or would you rather beat the market or make money? Intro: Let s take a look at the two distinct philosophies, or models that lie behind virtually all investment strategies: SLIDE 2 The first is the historically traditional Absolute Return Investment Philosophy which sets consistent profitability as its key objective. The second is the more recent, and now widespread, Relative Return Investment Philosophy which seeks its profits by participating in the long term growth of the economy. These two philosophies are clearly different, and each has its strengths and weaknesses which are brought out in different stages of the market s cycles. Relative return investing has been used almost exclusively by the large brokerage houses over the past few decades, for reasons we will explore later, as the traditional approach so it likely is the most familiar to you. Whereas Relative Return investors and managers take a passive approach- participating in general market trends through diversification across different asset classes by buying a wide range of stocks, bonds, and/or mutual funds, Absolute Return

2 investing relies on the active skill of the investment manager for its returns. Let s drill down on these differences a little more by looking how each of these philosophies defines and views the risks associated with any investment strategy. SLIDE 3 Although there is a myriad of risks pertaining to investing, there are two fundamental risks that we need to look at: Systematic Risk and Non-Systematic Risk, or sometimes Systemic and Non- Systemic Risk. Systematic risk can be defined as The risk inherent in the entire market or an entire market segment. Also known as undiversifiable risk or market risk. Examples of systematic risk are: changes in interest rates; war; consumer prices; employment/unemployment factors; political/regulatory changes, etc. Systematic risk is also known as Market Risk, and is often denoted by beta - a measurement of an assets correlation to the overall market, which is a concept we will look at a little later. Non-Systematic risk can be defined as: Risk that is unique to a certain asset or company. Examples of Non-Systematic risk are: labor strikes and other problems; natural disaster/weather problems; result of unfavorable litigation; management,

3 corporate fraud/malfeasance, etc. Non-Systematic risk is also known as unsystematic risk or Diversifiable risk. Now that we can identify these two fundamental risks, let s take a look at how they impact investment decisions. SLIDE 4 For that we need to review Modern Portfolio Theory [MPT], a subject that has been drilled into finance students over the past 5 decades or so since its inception. Modern Portfolio Theory was developed by Harry Markowitz in the early 1950s and has changed modern investment practices dramatically. At its core, MPT is a mathematical equation. The fundamental concept embedded in MPT is that, when constructing an investment portfolio, assets should not be selected based upon their individual merits, but rather in consideration of how their price fluctuations (volatility) relate to the price fluctuations of other assets in the portfolio. Markowitz stipulates that it is this volatility which defines risk, and posits that an investor is not compensated for individual company risk since that risk can be mitigated or removed through diversification -- that the broader market(s) comprise an Efficient Frontier. SLIDE 5 In other words, a broadly diversified portfolio eliminates, or at least dramatically reduces, the risk associated with the poor performance of a single issue. As the old sales pitch

4 goes, if one asset always pays when it is sunny, and another always pays when it is rainy, own both and your portfolio will always pay. SLIDE 6 That s the Efficient Frontier. The concept of efficient markets is embodied in a theory known as The Efficient Market Hypothesis [EMH]. Building on Markowitz s work with the Efficient Frontier, Eugene Fama wrote his Ph.D. thesis for the University Of Chicago Booth School Of Business in the 1960s. Fama s theory quickly gained prominence, and in 1970 he published a review of both the theory and evidence for the hypothesis. He also refined and extended it by adding the definitions for three forms of financial market efficiency: weak, semi-strong and strongwhich you can see on the slide. EMH stipulates that stock prices always reflect all known information. As a result, stock prices are always perfectly priced, and no investor can have an edge in finding undervalued or overvalued securities. So here s a little anecdote I like to tell that may help to illustrate the dangers of buying in to this (or any) theory whole hog : A young student and a scholar on efficient markets are walking across campus. The student notices the scholar s glance toward a dollar bill lying on the sidewalk. As the

5 scholar looks away, and walks by the dollar, the curious student asks why he did not pick it up. The scholar continues with a lesson on efficient markets: The bill must have been an illusion, unworthy of the effort to pick it up. If there ever was a dollar bill lying on the sidewalk, someone else would have already found it. More recent versions of the theory allow for some shortterm inefficiencies or market fluctuations, but a version of the EMH is a key assumption for many of the other theories on which relative return investing is based. One such idea is the now widely known Capital Asset Pricing Model [CAPM]. SLIDE 7 CAPM was largely explained by Bill Sharpe building directly on the work of both Markowitz and Fama. In a nutshell-sharpe s work created a subsequent mathematical formula for the pricing of assets relative to the assumed inherent risk. This formula codified volatility (= to risk according to Markowitz) as beta, and suggests that the market pays a premium for the assumption of this additional risk. Stated another way, the individual risk premium equals the market premium multiplied by β. Ultimately Sharpe concludes that if a risk could be mitigated by diversification, then efficient markets would not provide a return for that investment. Sharpe s tight synthesis of the two prevailing ideas of his day became

6 the bedrock for institutional portfolio construction that has transformed both the professional and layperson s understanding of the forces (risks) at work in modern financial markets by focusing investors attention on the expected rate of return. Relative Return investors, therefore, seek to eliminate Non-Systematic Risk the risk of poor performance by an individual company or companies by diversifying across a broad range of stocks or bonds (or mutual funds). The natural outgrowth of this type of thinking is seen in the idea of benchmarking or indexing ones investments. This makes the impact on the portfolio of an individual company s poor performance very small. In effect, Relative Return investors accept, even embrace Systematic Risk. Their belief is that returns occur over the long term, by staying invested throughout the cycles of the market. Future returns are anticipated based on backward looking benchmarks which show the average long-term risks and returns of the market. It can be said, then, that Relative Return investing is Risk Based investing investors returns are the compensation for taking the risks of the market. Absolute Return investors, on the other hand seek to eliminate market risk and accept, instead, non-systematic risk, or individual stock risk. Avoiding the volatility and vagaries of the market, the Absolute Return manager

7 seeks consistent profitability through skillfully identifying mis-valued or undervalued securities. SLIDE 8 It can be said, then, that each investment philosophy attempts to isolate risk in such a way as to make it more palatable. It is impossible to entirely eliminate either of the major risk characteristics, so a modicum of each is present in nearly every portfolio whether as the Dominant Risk or the Secondary Risk. This is where the 2 philosophies different views on diversification become the most obvious. The relative return manager uses diversification to minimize his Secondary Risk (in this case Non- Systematic, or Securities Risk) and to concentrate on his Dominant Risk (Market Risk) because in his philosophy returns are the rewards for assuming risk. In this way, relative return investing magnifies, or increases its Dominant Risk. The absolute return manager uses portfolio construction to minimize his Secondary Risk (in this case Systematic, or Market Risk) and to concentrate on his Dominant Risk (Securities Risk) because in this philosophy returns are the rewards for skillful investment selection. Diversification is used to mitigate, or spread out the potential negative consequences of any single investment

8 decision. In this way, absolute return investing decreases the Dominant Risk. At this point, let me make something clear both Markowitz and Sharpe received a Nobel Prize in Economics for their individual work. I would be a fool to argue with their brilliance. My beef, if you will, is with the legions of pseudo-intellectuals who have misappropriated their mathematical models in pursuit of a conclusion (staying fully invested) in which they already have a vested interest. Why is it that the financial meritocracy is so consistent in its exhortations that we need to have patience -an insinuation that we do not understand what is at stake? When pressed, most Wall Street representatives are unable to define exactly what the long term is. I do not claim to know the answer(s), but there are a few possibilities worth considering. SLIDE 9 Wall Street Sales Machine Training Research/punditry Regulatory Environment Secular Bull Market

9 Quoting Ed Easterling from his book Unexpected Returns The Wall Street sales engine is fueled by commissions and asset management fees. As a result, the long-term, buy and hold philosophy was easy to adapt to their sales model. The pitch encouraged investors to remain invested in stocks at all times and allowed for sector rotations and portfolio adjustments to allow for some turnover in the portfolio. The scholarly research, which generally includes theories based on the long term, has been used to train the young professionals entering the investment industry. As they matriculated into roles advising and assisting investors, MPT, EMH, and CAPM became useful, simple tools for working with their clients. As investment philosophies evolved, the press looked to the experts Wall Street executives and scholarly researchers for insights to include in articles about the markets and investing. At the same time, securities laws and regulations were developed that encouraged the average investor to use traditional Wall Street products and prevented many from accessing the skill-based partnerships. The traditional approach was further reinforced by its success during the great secular bull market of the 1980s and 1990s. In a secular bull market, the demand for skill-based investing is quite low, since the market s winds blow so strongly into investors sails. As a result, an entire generation has

10 come to see the notion of market-dependent returns as being traditional, while skill-dependent and risk-controlled returns are seen as non-traditional. (end quote) Easterling goes on to make another superbly salient point: As market share collapsed for many of the small, independent brokerage firms, assets became concentrated in the hands of fewer and fewer firms. This meant that each of the Wall Street big boys were now responsible for overseeing asset pools in the trillions of dollars, across huge client bases. The stay the course buy and hold strategy became a matter of survival for the big firms even if headwinds were seen gathering for particular securities or market segments, how can one unwind positions in the 10s of millions of shares without it becoming a self-fulfilling prophesy? Easterling uses the classic example of IBM in the 1980s. Computers were proliferating faster than most procurement officers could keep up with the differences. The common wisdom became-buy an IBM, you can t go wrong. Even if the machine did not work well, or fulfill its intended purpose, you bought the best it s not your fault! How many remember the E.F. Hutton commercials? My broker is EF Hutton, and he says SLIDE 10

11 So Easterling made the point about the great secular bull market of the 1980s and 1990s. Secular market cycles are alternating longer term trends (usually lasting years). Here s an interesting point-whereas a secular bull market ends with the market as a whole at a considerably higher valuation depicting an upward slope, a secular bear market ends with the market as a whole at essentially the same valuation as when it began, depicting a flat or horizontal market defining a trading range. There is a lot of pain along the way, though, particularly for those investors who are tied to the market. Let s look at this chart a little more closely. This graph plots the annual closing numbers of the S&P Index and gives us a good horizontal view of market trends. What jumps off the page at you? 20 th century What amounts to only 3 complete secular markets: o (bear)/ (bull) o (bear)/ (bull) o (bear)/ (bull) It is worth noting that the incubation period, if you will, of Relative Return investing ( ) falls directly within the secular bull market of SLIDE 11

12 Secular market cycles include several cyclical markets. So, a secular bull market will begin with a larger cyclical bull alternating with a smaller cyclical bear. The opposite is true for a secular bear market. This next chart provides us a visualization of these alternating cyclical markets within the longer term secular markets. Although this graph actually covers more time ( ), it uses monthly averages for the S&P for its data points which gives us a better vertical view. Note that there are (with the short secular bull of the 1920s being the notable exception) at least three bull/bear or bear/bull cycles within each secular market. SLIDE 12 Here we have really shortened the time horizon to include just the secular bear market of Black Friday-a killer day-sets off this 20 year secular bear market with a larger cyclical bear market lasting 33 months and a drop in market valuation of 83.22%. A cyclical bull market rally lasting 13 months follows offering a dramatic % jump in market valuation from the extremely depressed low point of June, Another sell off, another rally, another sell off, another rally, another sell off, another rally, and another (final) sell off marks the end of the secular bear on or about June 30, SLIDE 13

13 Put this all together and it gives us a picture like this. me Frame Duration Number of Recessions Starting P/E Finishing P/E Decline (Inf Adjusted) Yrs 6 Mos % Yrs 9 Mos % Yrs 6 Mos % ERAGE 18 Yrs 7 Mos % 00- esent s of July 9, 12) 11 Yrs 5 Mos % So if history is any guide at all, I think it is reasonable to say that we are: A) in a secular bear market (and have been since 2000); and B) the next secular bull market is AT LEAST 4-6 years away, and likely longer.

14 So let s wrap this up by getting back to the difference between Absolute Return investing and Relative return investing, and then I ll make the case for the importance of the Investment Policy Statement. We have covered a lot of information, and I know many of us are more visually oriented, so let s use some pictures and chart the results of a classic Relative Return investment manager and an Absolute Return manager during a recent bull cycle within our current secular bear. These next two slides are Easterling s charts, so I will quote his descriptions of them, but I want to point out that the points in BLUE represent the overall market returns, whereas the points in RED are the returns of the investment manager(s). SLIDE 14 This slide reflects the graph for the relative return mutual fund for As you can see, the return pattern closely tracks the market returns. The slight variances represent a measure known as tracking error, a risk measure for relative return investments. The key observation is that the relative return mutual fund very closely tracks the return pattern of the stock market.

15 During the down days on the left of the graph, the mutual fund is down; during up days, it is up. SLIDE 15 This slide reflects the graph for the absolute return hedge fund for As you can see, the return pattern distinctly diverges from the market returns. The pattern during down days is substantially similar to the pattern during up days in the market. The hedge fund has significantly neutralized its relationship to the market and has focused on generating returns from the superior skills of stock selection. The key observation is that the performance of the absolute return hedge fund is unrelated to the returns of the market. SLIDE 16 The return patterns or style profile for relative return investments are the opposite of the returns from absolute return investments. They reflect the difference between the respective approaches to return generation and risk management. Neither profile should be considered superior; each represents a different style of investment and has different roles in an investment portfolio. Note that the red points/pattern on these graphs are the DAILY returns of each manager. It is important to remember that TOTAL return is a COMPOSITE of all DAILY returns. I think Easterling is being kind, in a sort of

16 Ben Franklin way when he suggests that neither profile should be considered superior, at least in theory. It is hard, though, to argue with the numbers. Over the period in question, where the SP 500 returned a negative 4%, the Relative Return Mutual fund returned a negative 5%, and the Absolute Return Hedge Fund returned positive 45%. SLIDE 17 So how does the Investment Policy Statement impact our investment performance? Are they even related? Well, the answer is both straight forward, and a little tricky. More often than not, an organization s IPS only has a direct impact on performance in a negative way. That is, when the IPS bites off more than it can chew it has a tendency to become unintentionally restrictive to the actual management of the assets. Let s take, as a starting point, what BoardSource says an Investment Policy Statement ought to be: Any organization that has assets to invest should also have appropriate policies to guide these investments. One set of policies does not fit every organization but each organization needs to define its own goals and understand its own fiduciary responsibilities. Here is a list of the basic points to cover. Any investment policies should be developed with the advice of a financial professional or be reviewed by legal counsel

17 define general objectives (preserve and protect the assets; achieve aggressive growth) delegate day-to-day asset management to an independent finance committee or a professional manager set asset allocation parameters (include diversification) describe asset quality (itemize quality ratings for stocks, bonds, or short-term reserves based on your risk tolerance) define the investment manager's accountability (include risk in transactions, social responsibility, reporting requirements, and coverage of cash flow needs) establish a system for regular review of the policies This is our first encounter with the term asset allocation since the title page, so maybe some of you are now wondering, What is the Myth of Asset Allocation that I referred to at the opening of this presentation? The myth, if you will and this is my own term is centered on what I believe is a misunderstanding of what asset allocation really is. Asset allocation, as correctly identified by BoardSource, is a (lower case) set of parameters. It is not, as it is systematically misrepresented by much of the financial services industry, an (upper case) strategy. Slide 18

18 Here are two examples of actual asset allocation models taken from actual Investment Policy Statements. They are similar, yet they are from very different organizations. Besides that there sizes are worlds apart, there is another critical distinction you may notice. The first is from the University of California Retirement Plan, which, as you can imagine, is significant pool of money. It is specific, very specific in fact, about diversifying across a broad range of asset classes. It is important to note that, given the size of the whole portfolio, even the 1% and 2% current allocations represent 7 figure sums, allowing for professional, skill-based management of each tranche within the portfolio. The second is from an RFP I recently received from a relatively small 501(c)3 organization. Their reserve account, for which they were soliciting asset management proposals, is approximately $2.6mm. This makes all of their desired allocations which are less than 10% of the whole categorically unavailable for professional, skillbased management. And here is the critical distinction: Whereas UCRP s asset allocation is across a broad range of asset classes (US Equity, Non-US Equity (developing, and emerging), Core Fixed Income, High Yield bonds, etc.), theirs runs the gamut of investment styles (Large Cap Growth, Small Cap Value, etc.). Based on this imperative, written in to the Investment Policy Statement,

19 their reserve account will be relegated to relative return mutual funds, likely even passive index funds. And for the privilege, they will likely also pay a consultant an additional asset based fee for the selection of the funds. So, if you are wondering which of the two investment philosophies may be embedded in your asset allocation, it can be useful to see whether you are allocated across Asset Classes, or across Investment Styles. I d be happy to help point out some other markers as well, if you would like. SLIDE 19 I have taken enough of your time, and I am grateful for your attention. We ll open it up for questions in just a minute, but first let me make a final statement on the importance of the Investment Policy Statement. The IPS has PRIMACY. It is the foundational document for the long term financial health of your organization. Therefor it should be considered FIRST, and not as a result of backing in to a course of action, or investment strategy, that may seem like the right thing at the time. For this reason, it needs to be SELF-AUTHORED. Although we agree with BoardSource that gathering advice from a financial professional or professionals is extremely valuable, it should be YOUR document, and not theirs.

20 The IPS needs to be a visionary statement. This vision must come from the organization itself--and this is a piece that is often overlooked in an effort to simply get consensus and move on to other business. The future is always difficult discern, and so the CLARITY needed is often better expressed in terms of what your organization does NOT want to see, or CANNOT tolerate. Understanding what OUGHT NOT happen is about setting guidelines, whereas asserting what MUST BE is about strictures which rob your IPS of the FLEXIBILTY it should have to be a document that can and should stand the test of time. It should be REVISITED often and reviewed regularly, not because it should be altered with impunity, but rather because it needs to be protected against whimsy and capriciousness. Thank you. Are there any questions?