One of the tenets of modern portfolio management most damaged due to the financial crisis has been asset allocation. We have discussed how during a bear market correlations tend to one, the myth of the all-weather portfolio and how investors may need a more dynamic approach to asset allocation. It seems we are not alone in our opinion(s).
Noted finance professor Andrew Lo of MIT has a piece in the Financial Times discussing how the practice of portfolio management has been upturned in part due to the financial crisis – asset allocation included. While we recommend you read the entire piece, the bottom line is that the investment world is now much more complicated post-crisis. Lo writes:
Diversification is still a good idea, but it has become much harder to achieve. Thanks to the increasing competition for additional yield, every type of investment vehicle and strategy has experienced substantial growth in assets under management.
The asset classes (and dynamic) strategies that have been touted as portfolio diversifiers have seen an influx of capital and managers. Lo cites the case of the “carry trade” that has become popular enough to have spawned an ETF that follows the strategy. In yesterday’s linkfest we cited a couple of articles (Morningstar also SSRN) that question whether timber is still a worthwhile portfolio diversifier.
Therefore adding strategic allocations to certain asset classes is no longer sufficient to achieve true diversification. One could argue that the end of the benign economic period described as the Great Moderation may have something to do with this. As Lo writes:
To achieve true diversification, investors must now have a broader set of asset classes and risk exposures, long and short, in their portfolios…In this environment, managing risk can no longer be easily accomplished via simple buy-and-hold portfolios as before, but requires more frequent rebalancing or “tactical risk management”.
What that leaves us with is a much more complex world. As Lo notes the financial industry is not standing still. The continued introduction of investment products and strategies will help round out the tools an individual needs in building a diversified portfolio. For example, some are making the case that equity market neutral has become a more attractive space post-crisis. This is due in part to the reduction in capital employed in the strategy.
Unfortunately for investors there is no simple asset allocation story to tell in this new world. As Lo notes it will sometimes look “normal” where all our old rules apply. Other times it will look far more chaotic which is when this adaptive approach will pay dividends. Which begs the question: what market environment are we now facing?