Asset allocation?

V. Allen -

Asset allocation? The "endowment model" was once seen as the "solution" for how to invest for the long term. Sadly as some universities have found out to their cost, the model was flawed and overexposed to a bad economy. It was heavily long biased, higher risk and not hedged. Despite being asset diversified, it was insufficiently strategy diversified. The ONLY thing to overweight in a portfolio is alpha; not beta and certainly not illiquid alternative betas. A dynamic investment universe cannot be optimally navigated with a static or occasionally rebalanced asset allocation. A bad economy needs a good portfolio.

Economic fluctuations ought not have a deleterious effect on portfolio growth or asset/liability matching whether you have $1,000 or $1 trillion to invest. Many long term investors forgot that they still need SHORT TERM cash and income. Having so much tied up in illiquid assets makes it difficult to be agile enough to capture and adapt to the changing inefficiencies that the market ALWAYS makes available. Why commit so much to 10 year lockups and ongoing capital calls when there is vast alpha available in liquid markets? The OPPORTUNITY cost from overweighting illiquidity was very expensive. And where was the scenario analysis and stress testing to construct a TRULY robust portfolio? When liquid assets sneeze, illiquid assets catch pneumonia.

The percentage in marketable alternatives (hedge funds) was too low while the allocation to long only non-marketable alternatives (private equity, real estate, real assets) was too high. While asset allocation is about attempting to capture ASSUMED risk premia for a given risk tolerance, the endowment model increased the ASSUMPTION RISK by replacing the liquid with the illiquid. The alternative assets weren't very alternative. While you can generally short sell liquid securities, not so with illiquid assets. Non-marketable alternatives still have to be marked to market. The bid-offer spreads on private equity secondaries are wide.

A bear market is no excuse for a fund manager to lose money. Hoping to be compensated for risk is dubious. Expecting to also be compensated for illiquidity is doubly dangerous. Of course the endowment model was better than the obsolete 60/40 stocks/bonds or the "(100-age)% in stocks" pabulum that many people still get sold. But it had no chance of achieving what most endowments, foundations, pension plans, sovereign wealth funds or individual investors actually want. Consistent returns with capital preservation at minimal risk and maximal liquidity EVERY year. For that you need to hedge. And a proper strategy diversification NOT asset allocation.

A long term investor still needs short term returns. Long term performance neither requires nor implies a long term holding period. Some of the best track records have been by managers with very short term strategies. Odd how the same people who said you can't make money day trading now say too much money is being made in high frequency trading! The long term investor also cannot ignore short term volatility. Universities using the endowment model might survive for centuries but in the short term, professors and other staff have to be paid, spending budgets met, capital projects funded at the same time as alumni contributions reduce due to the economy.

Many illiquid assets like private equity or real estate give the "appearance" of low volatility because they are valued less frequently. This also leads to a supposedly low correlation to public markets. But quantitative correlation measures do not give much insight into the coRelationships between risky assets and a risky economy. While liquid security correlations infamously tend to 1 in down markets, that situation is exacerbated with illiquid assets as they can't be easily sold. Illiquid assets were often able to disguise their high coRelation because of delayed or overoptimistic valuations. But their dependence on a good economy was obvious ahead of time.

Real estate has been around a lot longer than stocks and bonds. It is not an alternative investment and relies on economic growth and lots of leverage. Real assets? Long only commodities is an even stranger idea than long only equity. Oil and gas partnerships fluctuate with the price of...oil and gas. Long/short commodities trading makes more sense. Many managed futures CTAs have demonstrated the ability to make money in up AND down markets over the long term. Gold and cocoa may be at highs while I am writing this but they are trading vehicles NOT long term investments. Inflation? That's what TIPS and inflation derivatives to hedge are for.

Constructing the true All Weather Portfolio requires preparing AND hedging for short term tornados or long term economic ice ages. The endowment model carried almost no insurance against a bad market climate. That is why substantial allocations to skill-based strategies that can make money in bad times are essential. Not enough short sales means not enough hedging. Derivatives are not to be avoided; they are MANDATORY for the risk averse. And more attention to proper risk management, not basic VaR and cVaR stuff since much worse case scenarios than the assumed "worst" case have a habit of actually occurring.

Despite all the exotic beta, there was still a large implied bet on a good economy of rising stocks, easy credit and real estate. Replacing liquid assets with illiquid assets relied on the notion that there is such a thing as a liquidity premium. Many investors, even now, expect to be compensated for taking higher risk. But despite what the economics journals claim, there is NO link between risk and return. Just because "stocks" are riskier than "bonds" does not guarantee outperformance over ANY time horizon. Replacing long only public equity with long only private equity was asking for trouble. Private equity is a misnomer anyway; the correct term is private debt with a little equity.

I don't believe in asset allocation. The world has moved on in financial engineering and innovation. As a conservative long term investor I favor strategy diversification and hedging. It works if you know what you are doing. Adapting to market conditions and achieving a RELIABLE absolute return at the LOWEST necessary risk. Hedge funds are NOT an asset class and therefore cannot be fitted into an asset allocation methodology. The only thing to overweight is SKILL not assumed risk premia. Investor wealth should be protected AND increased regardless of the economy.