Diversification Fails

Is your asset allocation strategy prepared for the bear market?

The Bear Is Coming

Given the instability of the capital markets, the subject of fiduciary investing is an opportune theme. A fiduciary relationship makes the most elevated obligation forced by law, causing that a trustee to put an investor’s interests first when making asset allocation decisions and act only on the investor’s behalf especially in the face of a bear market.

The financial advisor industry depends on Strategic Asset Allocation (SAA), aka Modern Portfolio Theory (MPT) and the Prudent Investor Rule (PIR) in giving financial advice. At the point when consultants are questioned concerning their advice, they summon SAA received by MPT and PIR as the support for their recommendations. Many advisors use SAA-based programming to build their asset allocation proposals.

While most advisors know about SAA. MPT and PIR, they are new to other essential precepts of MPT and PIR. Many advisors are ignorant that their SAA approach might conflict with the true MPT approach and the PIR, opening themselves and their clients to loss.

Modern Portfolio Theory (MPT)

What did Markowitz’s paper, Portfolio Selection, to impart with his momentous research? He led with: The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of the portfolio. This paper is concerned with the second stage.” 

It’s been many decades since the paper was first distributed. Many investors have repeated their “buy and- hold” mantra working together with Dr. Markowitz. But it isn’t what he proposed. Nor did he recommend SAA as the solution. Investors ought to be compensated for facing challenges that can’t be neutralized through negative or low correlation. Yes, stocks have more risks than bonds and, over time, have better returns. But consider the possibility that your holding period is not 80 to 100 years, which is what “buy and hold” and SAA s based on.

What if my holding period is 10 to 20 years? For that, reflect on historical 10 to 20-year horizons for your assumptions. This is stage one that Markowitz referred to, and it occurs before MPT is applied to the holdings.

Since 1900, there have been 85 twenty-year periods; the first was from 1900 to 1919, and there are eighty-four double decade time spans from that point. At the point when divided into two groups, those above the average and those below the average, the top group averages returns of 10.5% and the bottom group 5.1%. The average of each one of those scenarios shows the long term average return before exchange costs and taxes of 7.8%. Is there an approach to decide whether the following twenty years will probably be a top-half or bottom half period? This would empower us to improve our presumptions by using either 10.5% or 5.1%, as opposed to the default of 7.8%.

One trademark that is self-evident for the two groups is the beginning valuation in the market, as dictated by the price/earnings ratio (P/E). It’s the bellwether ratio of prices in the stock market. Almost throughout the previous century, when the P/E is above-average, ensuing returns are below average. Also, below-average P/E’s drive better than expected returns. So since the present, P/E is well above average, shouldn’t the assumption for Markowitz’s model be below average returns?

Markowitz gave us the answer to asset management; a tried-and-true way of thinking has been overlooked or disregarded the need to use suitable assumptions—the fundamental “first stage” of MPT. As Markowitz underscores, we must use “observation and experience” to create “beliefs about the future performances.” Although the future performance of the stock market can’t be anticipated with assurance or accuracy, through observation and experience, we have the option to, at any rate, refine the presumptions into better than expected or beneath average return expectations.

Considering current market valuations we’re in the “below -average” box and ought to incorporate a below-average return assumption for the following twenty years. At the point when we do, the allocation to stocks will be lower, and the expected average portfolio return will decrease.

But would it be a good idea for me to hold tight, to trust that this time will be unique? Or should I incorporate, or if nothing else consider, a situation that presents below average assumptions? Would it be a good idea for us to use below-average future stock market return assumptions?

Before MPT, portfolios were built dependent on the risk and return of the portfolio. With MPT, Markowitz proposed that covariance, or the correlation of portfolio holdings’ returns’ ought to be in the development of an SAA strategy.

While MPT has been censured for different reasons, correlations still are a significant input in the construction of the SAA strategy. Investments that have a low historical correlation can be combined to provide diversification benefits and protection from total portfolio loss.

Prudent Investor Rule (PIR)

PIR is a piece of the Restatement (Third) of Trusts. PIR sets up principles for the reasonable investment of trust assets. While PIR isn’t law, a majority of states have embraced the Uniform Prudent Investor Act. Even though PIR applies to a trustee’s guardian obligations, it has been used in defining standards for investment advisor fiduciaries.

Investment advisors are expected to offer ongoing advice consistent with how a prudent investor would manage investments. It requires an advisor use skill and prudence by taking all investment assets into consideration when rendering advice. Assets must be diversified with an exception if it’s not prudent. Advisors must be dedicated and impartial. Act with prudence when picking third-party money managers to manage the client’s assets. Advisor fees must be sensible and concerning the advisor’s responsibilities.

PIR concurs with this position, expressing that diversification requires risk management. Failure to diversify violates PIR.

Strategic Asset Allocation (SAA):

There are clear likenesses between SAA and PIR related to using correlation to construct a diversified portfolio. Correlation as a factor presents difficulties for the advice provided by investment advisor fiduciaries, just as it introduces potential liability.

In the paper, Post-crisis Perspective on Diversification for Risk Management, from the Edhec-Risk Institute, the findings reveal that since the financial crisis of 2008, improving risk management practices has been a hotly debated issue. The postmodern quantitative approaches recommended as augmentations of MPT by utilizing diversification. Even though diversification is a crucial segment of sound risk management, it is ill-suited for severe market downturns. They conclude that the solution can be found in active diversification approaches. They state, “dynamic asset allocation techniques deal efficiently with general loss constraints because they preserve access to the upside.”

SAA and the investment model that prompted a Nobel Prize should accompany an admonition name: Use with caution. It’s only as good as your presumptions.

The utilization of strategic asset allocation optimization software based on MPT is inescapable in the investment advisory industry. The reality remains that given SAA’s use of 80-100 year average returns, static risk, and correlations, the inability to perform a post-execution examination dependent on the client investor’s portfolio returns leaves the advisor exposed to potential liability. Contingent upon irregularity between the first projections and the post projections, perhaps the advisor’s activities are fraudulent.

Correlations among asset classes, similar to returns and risk estimations, are evolving. Besides, recent research has shown that correlations (and volatility/risk) increase and the diversification benefits of the SAA strategy fail during periods of market instability. In their paper, When Diversification Fails, authors and T. Rowe Price portfolio managers, Sébastien Page, CFA, and Robert A. Panariello, CFA state “One of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most. We surmise that many investors still do not fully appreciate the impact of extreme correlations on portfolio efficiency—in particular, on exposure to loss.” They recommend: “Prudent investors should not use them (correlations) in risk models, at least not without adding other tools, such as downside risk measures and scenario analyses. To enhance risk management beyond naive diversification, investors should re-optimize portfolios with a focus on downside risk, consider dynamic strategies, and depending on aversion to losses, evaluate  the value of downside protection as an alternative to asset class diversification.”

Markowitz’s guidelines and the general shakiness of the relationship of asset classes suggests that recommendations ought to respond to changes in the economy and the market.

Static asset allocation likewise negates the PIR model for a prudent investing approach, which expresses that “The role of proper asset allocation when diversifying the investment portfolio of a trust: Asset allocation decisions are a fundamental aspect of an investment strategy, and are a starting point in formulating a plan of diversification (as well as an expression of judgments concerning suitable risk‑return objectives). These decisions deal with the categories of investments to be included in a trust portfolio and the portions of the trust estate to be allocated to each. These decisions are subject to adjustment from time to time as changes occur in the portfolio, in economic conditions or expectations, or in the needs or investment objectives of the trust.”

Read more of PIR: http://www.nlrg.com/trusts-estates-wills-and-tax-law-legal-research-copy/bid/84067/the-duty-of-a-trustee-to-diversify-investments

All things considered, the industry has advanced the “buy and-hold” approach with the use of SAA and hung their hat on a mistaken understanding of an acclaimed investing study. In 1986, the Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower (BHB) study, “Determinants of Portfolio Performance,” was published in the Financial Analysts Journal.

The BHB study considered the variability of returns’ of 91 pension plans across stocks, bonds, and cash. The study found that the asset allocation policy represented around 93.6% of the fluctuation of the plans’ returns. The BHB study concentrated on the variability of returns, yet the industry over and over distorted the discoveries of the BHB study to intimate that the BHB study shows that asset allocation represents 93.6% of an investor’s returns. Advisors have used these distortions to promote and advance SAA.

To read the BHB paper: https://www.semanticscholar.org/paper/Determinants-of-Portfolio-Performance-Brinson-Hood/ef3a2d1bfbe55685903e538bcf329993eeb958d3

Nobel Laureate Dr William Sharpe described the circumstance as “financial planning in fantasyland.” To read what was meant: https://web.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm

Conclusion

The intentions of the MPT and PIR are clear that the modern prudent investment approach used by the investment advisor fiduciary must consider present market conditions. At a minimum, the investment strategy should not be based on asset class average returns, risk, and correlations over a historical 80-100 period.

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