I first learned about asset allocation back in the late 70s. The person that introduced asset allocation to me was a wholesaler for a large asset management firm and he spent more time telling me that he played football at the University of Michigan than explaining the finer points of asset allocation. I had to endure ninety minutes of such unlikely-Oscar Wilde bon mots as, 'In sixty-eight I had two sacks against Ohio State.' Eventually the big guy lumbered away leaving me with a stack of papers to study, and I remembered thinking as I was self-educating myself that this was how investment planning should be. By using asset allocation I did not have to guess if fund manager A was going to blow up or if fund manager B was going to stick with his investment philosophy. I need not worry that in case the domestic economy imploded I'd have foreign holdings propping me up on the other side. I was giddy with excitement. I could build safe guards into client's portfolios that if something bad happened I ad another asset class to partially support the portfolios from doom.
Doom is what brokers fear most of all. Since 'most' brokers get paid the same if they buy a great investment or a piece of junk it behooves the broker to find what they believe is the best investment for their clients. What brokers don't want at any time in their career is a catastrophic meltdown of any investment for any client. Asset allocation wasn't meant to get investors rich but to reduce risk and increase total return over simply buying one asset, one stock or one fund.
Pension plan managers were probably the first to latch onto asset allocation because they had to provide income for retirees for a significant length of time and could not foresee what particular investment would so well and which would do poorly. Pension plan managers knew that they would need x dollars to provide x income for x years for each of their retirees. In defined benefit plans if the pool of money did poorly the company would have to contribute more money and if the investments did extremely well the company did not have to contribute as much, or in certain cases anything at all for a particular year.
Just to give you an idea how sectors differ in performance in 1998 an investment in Large Cap Growth sector was up 38.7% while small value lost 6.5%. But knowing this ahead of time was impossible. Managers would hedge their bets and create portfolio models like recipes and put a percentage into each investment class.
Then came the moment no one thought could ever happen in modern investment history. In 2008 Small Cap Value lost the least of the equity classes or a -29.8% while Mid-Cap Growth was the biggest loser with a negative 44.3%. Did I write that the best performing sector in 2008 lost almost 30%? Yes, I did. In fact 2008 showed that in a global meltdown asset allocation did not work at all.
Very smart money managers in 2008 were caught losing significant amounts of money for their clients including the venerated fund manager Bill Miller. Miller was so far off base that he kept on looking for a market and sector reversal and buying investments that, in retrospect, had as much of a chance of turning into winners as the Kingston Trio had of another hit record.
Other money managers while not seeing the crisis coming either, just happened to be making some very wrong investment bets that turned out brilliant. When the dust cleared those fortunate's who made, in ordinary times, extraordinary stupid bets, were billionaires. Particularly well rewarded was Nassim Nicololas and his hedge fund partner. Part teacher, manager and philosopher when asked how they did it Nassim simply shrugged and said they were lucky. No one, he insisted, knows anything about how markets work.
Economists, slipping in their comfy smartest- people in the room suits, explained to the rest of us dimwitted ones that the markets were deleveraging. They pointed out that debt and leverage were what got us into the mess and the entire kit and caboodle had to unwind. Not only business, they pontificated, but also consumers who had used debt to fuel their lifestyle. I had to wonder why my 90 year old mother who didn't owe a drachma to anyone had to have her portfolio unwind 50%? But the wise people in the Ivory Towers were adamant that they knew what of they spoke.
The simple fact is that panic and wholesale selling by investors, hedge funds, investment banks and brokerage firms caused stocks and, yes, dear reader, even bonds of good companies to plummet in value. There were more sellers than buyers. We saw a bit of it in 1987 but nothing like 2008-2009. When the panic hit people they needed to get liquid and get liquid quick. Big Mouth Jim Cramer showed up on the morning Today Show with a can of gasoline (he didn't but you get my point) in one hand and a BIC lighter in the other stating that if any investor needed money over the next five years they better sell their stocks, funds and bonds. And an hour later sell they did as the panic turned into a stampede for the exits. (Less than a year later he shows up on the same program spouting Mea Culpa's and that it was now a great time to buy.) Why, I keep asking myself, isn't this person locked up where there is a lot of padding on the walls and he can't hurt himself or others?
Bottom line- traditional asset allocation failed us.
It just didn't work when it was supposed to. Actually, when panic sets in and people are selling everything they own asset allocation cannot work. This has resulted in some of today's investors seeking the magic of Absolute Return Management.
Mathematicians and investment gurus have been fiddling with portfolio mixes that replicate a positive return but using investments that have no correlation with equities. It's something like betting on meatball futures or shorting the VIX or some esoteric concept that needs a football stadium filled with super computers trying to eliminate risk from an investment while getting significant returns over a specific index. Today there are funds and managed accounts that state their mission is to provide a return of X with zero beta. Beta is a measurement of volatility and every investment has some volatility. The trick has always been to reduce beta while getting better than market or sector returns.
What these 'mad' managers of today have done is redesigned asset allocation to create something called 'market neutral'. And as giddy as I was about asset allocation some 30 years ago today's twice bit investors are all gaga over Absolute-Return Funds. There are lots of these engineered products coming out, designed to provide positive returns over a set period of time no matter what the overall market does. These funds utilize shorts, hedges, options and commodities to give their clients a positive return, or so it is said.
The problem, that investors, and sideline critics have observed, is that these funds have failed to deliver. In the first eights months of last year a few of the touted Absolute Return Funds provided shareholders with a measly 2% while the overall market returned 14%, In addition these funds are expensive to manage. One fund charges an upfront fee in excess of 3% plus an annual expense load of 1.25%. All that for a 2% return. It's like the Gene Wilder Frankenstein firm where he installs an Abby Normal brain into the monster and mulls that the concept initially looked good on paper.
The other problem with Absolute Return Funds is that the investors want equity returns with none of the equity risk. That won't happen now or ever. Absolute Return Funds at best will provide one or two points above Treasury.
The best thing that investors can do is forget ARFs and be proactive with their investments, buy a diversified commodity ETF and add short-term domestic and foreign bonds along with their equity holdings.
Sometimes the cure is worse than the disease. Investors buying ARFs may well find themselves earning very little indeed to get zero risk while the broader markets may well shrug off the malaise of the prior decade and possibly motor along in double digits for the next 10-years.
If you want additional information on anything in this blog or more information on designing your asset allocation write to Paul Stanley at pstanley@westminsterfinancial.com or call 877 783 7080. Get on the e mail notification list. Call or send your e mail address to be contacted when new blogs and info is posted.
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