By Richard Bernard
Walk into any financial institution to meet a financial advisor and you will likely end up spending time answering a questionnaire to determine your expected return, risk tolerance and liquidity needs. This questionnaire will end up determining your portfolio’s asset allocation, which will likely be derived from a standard 60% equity and a 40% fixed income allocation. While there are many variants of this asset allocation model, this is the framework that has been used for the last 50 years or so to mitigate risk and achieve the optimal rate of return. In recent years, adjustments were made to this model with an allocation to alternatives such as Hedge Funds, and a focus on the correlation of different global or emerging markets and the emphasis on geographic diversification also became key. This 60/40 allocation has been around since the 1950s and still exists today as the Modern Portfolio Theory (MPT).
It is widely accepted that holding a diversified portfolio would perform better and protect the investors from a downward turn. Based on the investor’s risk tolerance, an ‘efficient’ or ‘optimal portfolio’ is created to yield the greatest possible return. The portfolio’s metrics are based on the following criteria:
1. Market volatility is most commonly measured by the VIX (Volatility index) or the ‘fear index.’ This index is a very good tool to understand the current view of investors but due to its lagging features, it is an ‘after the fact’ measurement.
2. BETA: measures the volatility of an investment compared to its sector or the market as a whole. This is the type of risk that cannot be eliminated by diversifying and is commonly referred to as Systemic Risk. Therefore, it is assumed that a high beta stock (with a value greater than 1) is riskier than a low Beta stock (equal to or less than 1). While Beta may show the future uncertainty of the stock, it does not mean it is riskier, it could be a company growing very rapidly and investors are having a hard time to determine the future cash flows. The distinction between good and very good is not a measure of risk…think Google in their first 5 years.
So why are so many of today’s portfolio managers turning against MPT? A theory, which has stood the test of time for managing portfolio volatility. The answer is quite simple: expected returns. Before discussing expected returns, let us recap MPT.
In 1952, a young economist from Chicago named Harry Markowitz published a paper on ‘Portfolio Selection’ that would forever change the way portfolio managers would mathematically manage risk. This theory is based on the simple premise that in most cases, the higher the return the more risk is involved. Asset classes such as private equity were therefore classified as high risk while government T-bills were considered low risk. Risk of course, being defined as the standard deviation of returns, or how much the actual returns varied over time from the expected returns. This is the framework of MPT.
Today’s investors are no different from previous investors. Investors were and are always looking for the following combination of these 5 main needs in their portfolios:
· Income generation
· Capital preservation
· Protection against inflation
· Retirement planning
· Succession planning
Therefore, if portfolio needs have not changed, what has caused a change in questioning MPT?
Since the great depression, bond yields have fluctuate on average anywhere between 5%-7%. Today, we are looking at 2% returns.
Modern medicine and science has increased life expectancy therefore making the retirement time horizon much longer than previous generations.
You can obviously predict the impact of a 60/40 portfolio’s expected return based on current bond yields combined with people living longer… a cash shortfall. So what impact does this have moving forward? Portfolio managers are moving away from the 60/40 portfolio and simply using it as a rule of thumb now. By shying away from this traditional portfolio, portfolio managers are seeking new avenues to reduce volatility and maintain diversification, therefore explaining the boom in alternative investments, other than typical hedge funds. Alternative investments provide great diversification benefits to an overall portfolio due to the fact that they have a low correlation to public markets.
So the question is how to position portfolios moving forward. There is a common belief in the industry that asset allocation historically explains over 90% of a portfolios return and the more positions are added inside an asset class will create increase diversification. Both beliefs are actually not entirely correct. Asset allocation explains about 90 percent of the variability of a fund’s returns over time but it explains only about 40 percent of the variation of returns among funds. For the longest time, people have had the belief that asset allocation decisions will justify over 90% of a portfolio’s returns, but the reality it will explain 90% of variations from expected return.
For the case of diversification, Warren Buffet once said, “Diversification is protection against ignorance, it makes little sense for those who know what they’re doing.” The prevailing view is that the more positions you hold in a portfolio, the lower your overall unsystematic risk. While we believe having a diversified portfolio in terms of different asset classes, diversification within the same asset class does not help much. For example, holding the stocks of 2 banks or 6 banks will produce very similar returns and correlation between them is almost perfect. Furthermore, over-diversification will dilute expected returns and do little to protect a portfolio on the downside. The more positions you hold will increase the likelihood that some positions will be bad apples, and therefore increases the probability that the overall portfolio returns will be lower.
To summarize, expect to hear more and more about the death of the 60/40 portfolio as a strategic asset allocation, which will be a decrease in fixed income asset allocation, alternative investments becoming more mainstream and active management to yield better returns than historically what traditional portfolios could provide.
Richard is the the CIO and portfolio manager at WhiteHaven Securities. He is responsible for all investment strategies at WhiteHaven Securities and has over 20 years experience in portfolio management. He has also earned the right to use the CFA designation. WhiteHaven Securities is a dynamic fully integrated financial services firm currently expanding across Canada. WhiteHaven Securities’ multi-license platform is anchored on discretionary portfolio management, exempt products, insurance and mutual funds. Clients and representatives alike, benefit from WhiteHaven’s unique in-house approach to financial management.