From a reader who is a dear friend of mine:
There are obvious many disparate approaches to asset allocation.? Similar to the disparate approaches of any style of investing, each asset allocation approach has its own particular pitfalls.? Some of these you can plan for and perhaps hedge against or at least mitigate the potential negative impact from those pitfalls, while some booby traps spring up out of nowhere.? Risk Parity issues revolve around leverage, negative skew, and potential negative returns from certain levered asset classes.? Long-term strategic asset allocation may suffer from the quality of initial assumptions and typically relies on stable volatility profiles and correlations between asset classes.? And so on.? Every professional investor ? let?s take an endowment for instance ? diversified its portfolio among several asset classes and styles of management.? But what is interesting to me is that I?m not sure I?ve ever seen an institutional (or even HNW) investor diversify its portfolio among multiple asset allocation approaches.? Theoretically, splitting up a portfolio between 3-5 different AA approaches (strategic, risk-based, tactical with an opportunistic value lens, tactical with a momentum/trend-riding lens, etc.) mitigates the pitfalls of each one.? What are your thoughts here? ?I have a few of my own, but I don?t want to muddy your own intellectual waters ahead of time.? 🙂
My personal approach to asset allocation is similar to Warren Buffett, or Value Line.? I invest mostly in stocks, and keep a bunch of safe assets for liquidity.? As the market rises, I add to my safe assets.? As the market falls, I buy stocks.? In October of 2002, things were so bad that I depleted my safe assets, an everything was in stocks.
In general, I think most complex asset allocation strategies are overly complex.? In general, there are safe and risky assets.? Asset allocation should first focus on the division between the two.? Typically the safe assets are high quality bonds and cash equivalents.? Sometimes there are more opportunities, sometimes fewer.? Safe asset levels should reflect that.
The second focus of asset allocation should be liquidity needs.? Even if there are a lot of promising opportunities to deploy cash, if the liability that funds the assets needs cash, have cash ready for it.? If you invest in limited partnerships or private companies where the assets are locked up for a period of time, have a sense of what your maximum level of illiquidity is (what will you with certainty never need to tap?), and ladder the investments so that like a laddered bond portfolio, you always have some illiquid investments maturing each year, providing fresh cash for deployment where current opportunities are most promising.? These top two ideas are very basic, but even experts neglect them at times.
The third focus of asset allocation is choice of risk assets, which is how I view your question.? There my view of asset allocation is like that of GMO.? Forecast future returns off of free cash flow yields; invest accordingly.
Don’t pay much attention to volatility, but aim for what is most likely, and bend a little in the direction of what can go wrong.? Most of the time, over longer periods of time, what is most likely happens on average; that’s why it is most likely.
Maybe “Too many cooks spoil the broth.”? I have enough trouble trying to work with momentum versus mean reversion.? I would lean toward having one AA strategy that fits with my broader asset management practices.? But on the other hand…
Suppose we did have five asset allocation models, and what their results were encouraging various investors to do.? If we thought that one of the models had been too hot of late, and was attracting too much money, and distorting ordinary market relationships, maybe that could give us a signal to make sure our asset allocation de-emphasized the results of that method.? Timing of course would be difficult, it always is, but seeing the results of the five methods could provide a fuller view of choices faced by our competitors.
I’m not sure that using the average of a number of asset allocation models will provide the best result, but I think that understanding what other players in the market are doing could lead to better decisions.
I’m open to your thoughts, and the thoughts of other readers here.? Anyone have a better idea?
Don’t have a better idea than this:
“Forecast future returns off of free cash flow yields; invest accordingly.”
If there truly are differences across asset allocation styles, then it seems like to more of them you use, the closer to a basic allocation model you’ll get.
Isn’t it the same as investing in 15 actively managed equity funds (all with ‘unique’ strategies) only to wind up with index performance?
David, doesn’t the ever-increasing level of intervention by governments/Fed in the market undercut your investment thesis to a considerable degree. For lack if a better term, I would call the FED’s intervention in the market at this point ‘political risk.’ I don’t understand how portfolio theory, which I think is what you are applying here in broad strokes, can help get you to better outcomes when the over-riding risk is no longer market risk, but de facto confiscation, or perhaps “financial repression” would be the more polite term. For example, in ordinary times, a rolling portfolio of 6 month T-Bills is a close substitute for 5 year TIPS. However, when you discover that the FED can control the short term bill rates, but not the inflation rate, the difference in potential outcomes becomes quite apparent. However, who would have rationally predicted that 5 years ago, when deciding how to hedge against inflation using bills vs TIPS. It seems to me that balancing and re-balancing a portfolio based mean reversion or more broadly, portfolio theory, no longer works when what you really need to be doing is a political calculation rather than an economic one.
Good point. That is why I am long liquidity, holding onto stocks that are long liquidity, and in general maintaining a flexible posture in an otherwise nutty world.
Also, I think value investing will have a resurgence in these abnormal times, FWIW.
Hello David,
The single most important book i ever read for my career was/is Market Wizards. The most valuable lesson i took away from the book is that there are many different ways to skin the cat. I’m always amused as I re-read the interviews in the book and two incredibly successful investors/traders/speculators express directly contradicting strategies. Ironically, other than Kovner they all went dead broke and busted at least once, which focused them on risk management.
So whether it was Michael Steinhardt, Paul Tudor Jones, Bruce Kovner or Jim Rogers, they all did/do things differently.
I’ve long advocated that it is wise for the average investor to diversify by strategy/manager and not by asset class. The entire financial advice industry is ass backwards, with silly risk tolerence tests driving capital allocation decisions made by the average retail advisor, who is mediocre at best in making such decisiosn. I say better to have people like those who manage funds like FPACX, PAUIX, IVWIX, BRUCX, WASYX, ARIVX,YACKX, etc make capital allocation decisions.
I tend to agree. I hope you are doing well, James, and if you ever get down to Charm City, look me up and we can do lunch.
This discussion of dividend factors in market returns from Wisdom Tree is better than the typical fund manager puff pieces:
http://www.wisdomtree.com/elqNow/elqRedir.htm?ref=http://www.wisdomtree.com/library/pdf/schwartzcommentary/WT_Research_Commentary_Feature.pdf
James Dailey, I loved Market Wizards also, but I firmly believe that the Market Wizards themselves are not able to comprehend exactly which non-stationary conditions favored their particular approach in a given period and whether that approach will outperform going forward. In that sense, the random market nihilists’ argument is more subtle. They don’t have to argue that trailing performance was really only due to chance factors unrelated to the manager. Rather they only need to argue that there isn’t an objective methodology for predicting outperformance going forward. It makes sense that current wide belief in an particular methodology going forward would largely eliminate its possibility of outperformance going forward. So the main hope is for good methodologies that the crowd doesn’t currently believe in, or at least isn’t currently acting on.
I’ll raise my hand as the original asker of the question. David, I appreciate you taking the time to respond.
Steve, your point is a fair one and is the biggest potential detriment to the suggestion that I outlined in my question. That has the potential of being true, particularly if each allocation approach is basically just using tilts around a core baseline sort of allocation. But I don’t think it’s true if each approach has significant flexibility to be truly unique. I don’t think hiring 5 really strong global macro hedge funds leads you to market-like performance. If they are all good, the overall portfolio alpha doesn’t get reduced, but the overall volatility obviously does. Same if you have 5 really good allocation strategies…at least that’s my hypothesis.
maynardGKeynes and James, you two have both hit on key themes that play into my thinking directly. I tend to agree with David that I think value investing and capital allocation will have a resurgence here, but what if it doesn’t anytime soon? And what about the sometimes prolonged periods when it doesn’t? In these “nutty” times, I don’t especially like being beholden to one particular approach that may get rocked by exogenous factors beyond anyone’s direct control.
James, I have come over the past few years to 100% agree with your point about average retail investors. Going with a cookie cutter 70/30 allocation, making sure you have constant exposure to all parts of the market, and rebalancing regularly MAY lead you to relatively decent results over the long-term as compared to the broad investing world. But history has shown that there are some great capital allocators out there, and why not outsource that job to them? (By the way, your own firm’s track record is tremendous…congrats!) I would add SGENX and BERIX to your list. My only additional point is that I’m not sure the average institutional investor is better than the average retail investor in this regard. They could either invest in the same sorts of flexible mulit-asset class mandates, or else they can use an approach similar to what I outlined in my original question and have the 5 asset allocation approaches be the five “strategies” that they allocate to, and then find best-in-class managers to actually execute the underlying investments.