Tag Archive for: asset allocation

Roger Ibbotson attacks asset allocation "folklore"

“The time has come for folklore to be replaced with reality” says Roger Ibbotson in “The Importance of Asset Allocation” in CFA Institute’s Financial Analysts Journal (March/April).

Folklore means “the idea that asset allocation policy explains more than 90 percent of performance,” which is a misinterpretation of the classic 1986 article, “Determinants of Portfolio Performance” by Gary Brinson, Randolph Hood, and Gilbert Beebower, says Ibbotson. 

“Asset allocation is very important, but nowhere near the 90 percent of the variation in return is caused by the specific asset allocation mix,” writes Ibbotson. Rather, active management plays a role equal to that of asset allocation, as shown by “The Equal Importance of Asset Allocation and Active Management,” an article co-authored by Ibbotson with James Xiong, Thomas Idzorek, and Peng Chen in the same issue of the Financial Analysts Journal.

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Copyright 2010 by Susan B. Weiner All rights reserved

JP Morgan’s Eigen: Put your clients in non-traditional, long-short fixed income

Too many of your clients are over-invested in traditional fixed income, in the opinion of William Eigen, JPMorgan Asset Management’s director of absolute return strategies and portfolio manager of the JPM Strategic Income Opportunities Fund. He made a case for using fixed income funds that can go short and use synthetic financial instruments during his presentation to the Boston Security Analysts Society on March 15. 

Why bond funds haven’t changed
Fixed income funds really haven’t changed in 30 years, said Eigen. Their managers still basically rely on changes on interest rates to make money. In contrast, he said, managers of equities have driven the development of hedge funds.

Fixed income hasn’t evolved because interest rates have been falling for 30 years, said Eigen. In other words, with falling rates driving capital appreciation, there was no need for new techniques.

Can you imagine, Eigen asked, what would have happened to stock funds if the Standard & Poor’s 500 had gone straight up for thirty years? Clearly he believes this would have stifled innovation in the management of stocks. Instead, the stock market’s ups and downs spurred creativity. 

The need to protect your clients’ capital 
Traditional fixed income performed more or less okay for thirty years, with some rocky years here and there. But the interest-rate decline that drove bonds’ long-term positive performance will end. “I’m nervous with short rates at zero,” said Eigen, “yet investors are still piling in.”

Indeed, Eigen managed traditional bond funds during his 12-year career at Fidelity Investments. He left because he felt he couldn’t protect his investors’ capital adequately under the limitations of traditional bond investing. “I won’t be held prisoner to duration,” said Eigen. He wanted to be able to short-sell and put on relative value trades using synthetic instruments.

It’s important to earn positive returns in fixed income by taking advantages of factors other than falling interest rates. If not, asked Eigen, what happens when a long-term trend of rising interest rates takes hold? If you’re familiar with concept of duration, you know that bond prices fall when interest rates rise. Another negative: With interest rates at historic lows, there’s no “coupon cushion” of attractive interest rates to ease the pain of bond investors.

It’s easy to see the appeal of short-selling bonds in a rising interest-rate scenario. Investors would profit by essentially betting on bond prices’ decline.

Now Eigen can take advantage of short-selling as manager of the JPM Strategic Income Opportunities Fund, a long-short relative value fund that does not use leverage. The fund can use synthetic instruments. It can also hold cash because Eigen’s top priority is not to lose money. That’s a challenge for which cash is sometimes the only solution.

The fund is managed as an absolute-return fund with a target of t-bills plus 2%-8%. “You don’t need duration to generate solid fixed income returns,” Eigen said. Another potential benefit of his approach: it has “zero correlation to traditional fixed income,” Eigen said. 

Outlook: Rising rates, risky sovereign debt, relative value
Eigen thinks interest rates could rise faster than most pundits expect. Investors might get scared once rates start rising. Then they might quickly bail out of bonds to cut their losses.

Eigen is also scared about sovereign risk. Look at what’s happened in Europe and Dubai, he said. His fund is taking advantage of that on the short side.

Synthetic instruments such as credit default swaps are a good way to take advantage of the relative value opportunities that arise in times of low volatility in bond markets. For example, investors seem to perceive a solid company such as Berkshire Hathaway as on a par with lesser insurance companies. Synthetic instruments are sometimes the only economical way to invest in this disparity.

What do you think? Is the end near for traditionally managed fixed income funds–or have they still got some life left in them?

Related posts
Fund using alternative strategies gain steam
* I LOVE this fixed income presentation
* Strong words from editor of Financial Analysts Journal

Institutional plan sponsors make lousy decisions

Institutional plan sponsors don’t know what the heck they’re doing when they make asset allocation decisions.

At least that’s the conclusion I’m tempted to draw after reading “Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors,”(subscription or membership may be required to access article) Financial Analysts Journal (Nov./Dec. 2009) by Scott D. Stewart, John J. Neumann, Christopher Kittel, and Jeffrey Heisler.

Plan sponsors’ poor product selection was responsible for most of the underperformance in the author’s study. As their abstract states, 

Results show that plan sponsors may not be acting in their stakeholders’ best interests when they make rebalancing or reallocation decisions. Investment products that receive contributions subsequently underperform products experiencing withdrawals over one, three, and five years. For investment decisions among equity, fixed-income, and balanced products, most of the underperformance can be attributed to product selection.

These poor decisions may be due to investment officers finding “comfort in extrapolating past performance when, in fact, excess performance is random or cyclical,” suggest the authors.

Should this research impact how plan sponsors manage their assets? I’d like to hear what you think.
Susan B. Weiner, CFA
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Copyright 2010 by Susan B. Weiner All rights reserved

Poll about overweight, but not the stuff of New Year’s resolutions

I grapple with “overweight” at the end of every year and every quarter. 

It’s the kind of overweight measured in percentage points, not pounds. That’s because I’m writing performance reports for institutional mutual funds that may overweight or underweight sectors relative to the funds’ benchmarks.

I haven’t found any guidelines about how to write about these statistics, so I’d like to find out which wording you prefer for talking about a fund that has above-benchmark holdings in a sector.

  1. Our overweight in
  2. Our overweight position in
  3. Our overweight to
  4. Our overweighting in
  5. Our overweighting to

Please answer the poll that will appear in the right-hand column of this blog until some time in February. I’ll report the results in my March newsletter.

If you can give a compelling reason why you favor specific wording, I’d also like to hear about that.

Strong words from editor of Financial Analysts Journal

“…I hereby consign the shibboleth of ‘uncorrelated return’ to the scrap heap of asset allocation lingo, where it shall be available only to unscrupulous sellers, credulous buyers, and unschooled investment analysts.”

— Richard M. Ennis, executive editor, Financial Analysts Journal

These strong words from Ennis appeared in in his “Editor’s Corner” entitled “The Uncorrelated Return Myth,Financial Analysts Journal (Nov./Dec. 2009). 

Ennis asserts that “The notion of the existence of ‘uncorrelated return’ assets with handsome risk premiums flies in the face of financial theory and conflicts with empirical evidence.” 

When he says “financial theory,” Ennis is referring to the capital asset pricing model, which accords positive risk premiums to market-correlated assets. He also says that evidence shows that so-called uncorrelated assets such as real estate, hedge funds, and private equity are actually highly correlated with the stock market.

What do YOU think about this topic?

The best private equity opportunity in generations

“Our database tells us we’re in a multigenerational opportunity to be a private equity investor,” said Martin Grasso, CEO of Pearl Street Capital Group, a private equity fund-of-funds manager. He believes that investors with longer time horizons can get above-benchmark returns without significant volatility. Grasso made his comments as a panelist on “The State of Private Equity: Opportunity Through Crisis,” presented to the Boston Security Analysts Society on November 5.

Data suggests that capital growth and buyout private equity get the highest returns in years with the lowest levels of EBITDA leverage, said Grasso. That’s the situation we’re in now.

It also pays to invest with the best, according to Grasso. Top quartile and top decile private equity fund managers show much higher levels of persistence than long-only public securities managers. In other words, top performers in private equity have a greater tendency to remain top performers. The difference in performance between top and bottom quartile managers is much greater in private equity than among public equity managers.

Implications for advisors:
* Access to top firms is still difficult, so go with a fund-of-funds to gain that access.
* Invest in 10 vintage years and consider some secondary offerings, which are available now that some investors can’t meet their funding obligations as limited partners.
* Best private equity opportunities now are in small-medium companies where there’s less competition and where private equity managers are more inclined to partner with management to “accrete value” and make minority investments.
* Diversify across geography and sectors.

The last two paragraphs of this post were revised on Dec. 7, thanks to some clarifications by Martin Grasso of Pearl Street Capital Group.

Fixed income viewpoints from CFA Institute conference

Here are opinions on currency and CDOs that grabbed my attention at the CFA Institute’s Fixed Income conference last week.

If YOU were at the conference, I’d be interested to learn what surprised or intrigued you. 

“The New Currency World Order”
Ron Liesching of Mountain Pacific Group, LLC

The U.S. dollar cannot be replaced as the world’s reserve currency, but its role will be profoundly altered.

It’s time for investors to consider
*  Hedging their U.S. dollar risk
*  Active currency management
*  Active long commodity allocation
*  Long commodity currencies
*  Strategically long emerging market currencies
*  Global is the new core

“The Pricing of Investment-Grade Credit Risk during the Financial Crisis” 
Joshua Coval, Harvard Business School

There’s evidence that ratings agencies bent their standards to bestow too many AAA ratings.  They rated 75.5% of CDOs’ capital structure as AAA, when the rating agency model allowed 63.4%, according to “Did Subjectivity Play a Role in CDO Credit Ratings?” by John Griffin and Dragon Tang. Thanks, Prof. Coval, for sending me the link to Griffin and Tang’s article!

The collapse of structured products will impact the economic recovery to the extent that cheap credit is less available. The U.S. consumer had been the engine of U.S. GDP growth thanks to cheap credit.

Related posts:
* Dan Fuss: Bond investors have learned from experience…not

Harvard Management’s Mendillo grapples with challenging environment

Even Jane Mendillo admits she had awful timing in becoming president and CEO of Harvard Management Company (HMC) on July 1, 2008. As she said in her presentation on “Endowment Management in a Changing World” to the Boston Security Analysts Society on March 25, she assumed her post
* Two days before commodity prices peaked
* Six weeks before the beginning of a massive rescue of financial institutions
* Just before six to nine months of the most challenging markets that most investment professionals have seen
Nonetheless, Mendillo showed a cheerful face to the friendly audience containing many fellow CFA charterholders.

Mendillo is cautious about investments because “At this point, uncertainty is a big factor in markets and economies. The short-mid term may be challenging,” she said. It could take many years, she acknowledged, for the size of the Harvard endowment to return to its $37 billion level of June 30, 2008. Still, she noted, the endowment has posted excellent gains since its beginnings, including its growth from only $19 billion five years earlier.

Mendillo’s caution is reflected in the endowment’s actions. “We’re not rushing for the exits. Nor are we rushing to get back into the markets,” she said. Mendillo took pains to correct what she called misperceptions that HMC has sold private equity holdings for “pennies on the dollar.” The firm has made some transactions in secondary markets, but hasn’t taken major chunks out of its private equity holdings, she said.

HMC is taking a more conservative tack under Mendillo. It has cut back its -5% cash weighting to -3% for the first time in decades. Moreover, the portfolio is “seriously in cash,” she said, because she wanted to create more flexibility in the portfolio and make room for new investments.

Where is HMC heading? Mendillo gave some clues, saying
* We continue to be cautious about deploying cash.”
* “If we don’t think we have an edge in a market, we stay out or we index.”
* External management is significantly more expensive than internal management, so if external management doesn’t pay off, HMC will hire a team that can deliver
* The failure of the illiquid portion of the portfolio to be self-funding has “impacted our appetite for further illiquid assets”
* She expects to see very attractive opportunities in real estate, but they may lie a couple years ahead.
* She is very excited about what the firm’s natural resources team has uncovered.

Funds using alternative investment strategies gain steam

Alternative investments that are less correlated to major market indexes are gathering momentum in the advisor community. Two trends are fueling the movement. First, the sharp market declines since September 2008 have boosted the attraction of strategies that don’t dive along with stock market. “This year, people are looking to dial down risk in their portfolios,” says Bill Harding, director of research at Morningstar Investment Services in Chicago. Second, these strategies are increasingly available to those who don’t qualify as accredited investors (with investable assets of $1 million or more).

Continue reading “Against the Grain,” my article in the March 2009 issue of Financial Planning magazine (free registration may be required for access).

Also, here’s some information that didn’t make it into the article. It’s the list of funds used by the advisors whom I interviewed.

Absolute Opportunities
Absolute Strategies
Diamond Hill Long-Short
Direxion Commodity Trends
Highbridge Statistical Market Neutral
Hussman Strategic Growth
Nakoma Absolute Return
PIMCO CommodityRealReturn Strategy
Robeco Boston Partners Long/Short Equity
Rydex Managed Futures Strategy

Prof. Andre Perold on "Stable Risk Portfolios: A Timely Alternative to Static Asset Allocations?"

Risk matters. October’s wild stock market swings have reminded investors that volatility can be painful. They simply can’t stomach as much risk as they thought they could.

In this environment, it’s no surprise that Professor André F. Perold’s October 21 talk on “Risk Stabilization and Asset Allocation” attracted a bigger than usual crowd to the monthly meeting of the Boston chapter of the Quantitative Work Alliance for Applied Finance, Education, and Wisdom, affectionately known as QWAFAFEW.

Perold’s premise: A stable-risk portfolio that keeps risk constant is a viable alternative to investors’ classic static policy portfolio, such as 60% stocks and 40% bonds, and it may offer superior risk-adjusted returns.

Continue reading about stable risk portfolios in my Advisor Perspectives article.