In a span of less than 15 years, we have endured the Asian financial crisis, the Russian default and ruble crisis, the Long-Term Capital Management hedge fund debacle, the bursting of the tech stock bubble, the global financial crisis, the European debt crisis, and additional smaller-scale incidents. Financial crises seem to be the norm rather than isolated exceptions. Indeed, over the past two centuries, there were roughly 40 financial crises, with some lasting more than 20 years. Over the last 25 years, there has been one crisis every four years on average.
The traditional asset management approach may have worked in the 1990s, during what proved to be an exceptionally long period of stability. But clearly it has not worked in the past 15 years. Against this backdrop of instability, a paradigm shift is taking place in the industry, with the traditional approach giving way to a new approach that holds the promise of working better during periods of instability and crisis, as well as in an environment of low investment returns.
This shift in the asset management paradigm was the theme of a presentation by Vincent Duhamel, CFA, partner and head of Asia for Lombard Odier, at the Korea Investment Conference in June hosted by CFA Korea and CFA Institute. In South Korea, one of the key reasons for recent legal and regulatory changes to accommodate the development of a Korea-style hedge fund industry is to provide a new class of investment vehicles that delivers better portfolio diversification for Korean investors. Duhamel discussed how hedge funds and other alternative investment vehicles would fit into the asset allocation and portfolio management model under the new paradigm.
Duhamel began his talk by sharing some basic business principles that have enabled his firm, Lombard Odier (a Swiss private bank founded in 1796 with a private partnership management and ownership structure), to stand the test of time:
- Focus on doing what you know, and try your best to do it well.
- Do not be tempted and get carried away with fancy products.
- Avoid major drawdowns because what makes investment managers successful is the ability to minimize portfolio drawdowns during market crashes and crisis periods. This principle echoes the well-known contention of Charles Ellis, CFA, which he most recently outlined in a Financial Analysts Journal article entitled “The Loser’s Game,” that avoiding mistakes is the key to investment management success.
As Duhamel explained it, managing risks to minimize portfolio drawdown is a key element in the new paradigm. But to understand how asset management is evolving, it is helpful to describe the traditional asset allocation and portfolio management model, which is characterized by several key attributes:
- Categorization of assets into asset-class silos of stocks, bonds, cash, and alternative investments (which are investment vehicles, such as hedge funds, private equity, real estate, and commodities, that have been widely adopted in recent years).
- Regional demarcation of investment assets and markets (e.g., United States, Europe, Asia Pacific).
- Product-based asset management service providers, where implementation is based on demarcation of products.
This traditional model has produced relatively low returns over the past decade. Duhamel cited an example of a policy portfolio with the traditional asset mix of 50% in global equities, 35% in global bonds, 10% in hedge funds, and 5% in commodities returning less than 0.8% annually over the period from 2000 to the present with volatility of about 9% and maximum drawdown of 33%.
Nonetheless, the traditional asset allocation and portfolio management model is being questioned. For example, is the equity risk premium on the beta exposure to equity markets adequately compensating for the risk? Is the intra-horizon risk of major drawdowns properly managed with the traditional end-of-horizon risk measures (e.g., volatility, value at risk, Sharpe ratio, information ratio)?
Two recent developments are making the traditional asset management model ever more ineffective. First, the proliferation of financial engineering and investment technology has resulted in derivative instruments and securitized products that gray the boundaries between traditional asset classes. The traditional model does not allow managers to exploit opportunities between asset classes. Hedge funds have moved in to fill the void in exploiting these cross-asset-class opportunities.
Second, data communication and storage technology have improved to the extent that investors and market participants can access investment and market information globally at low cost, making cross-border investing convenient and less expensive. The regional or country demarcation in the traditional model is becoming irrelevant.
In addition, exploiting inefficiencies has become relatively cost-effective. Furthermore, “alpha” from traditional asset classes has increasingly become commoditized and readily replicated, or become much more difficult to generate as market inefficiencies have largely been arbitraged away.
In the new paradigm, the asset allocation and portfolio management model focuses on various sources of returns that are key performance drivers, instead of focusing on the traditional asset classes. One source is market risk factor exposures that provide market-directional returns. (This is parallel to “beta” in the traditional model.) Examples of market risk factor exposures include the following:
- liquidity risk
- sovereign risk
- interest rate risk
- credit risk
- equity market risk
- issuer-specific risk
Government bonds deliver the first three exposures; corporate bonds the first four; equity index futures or index funds the first five; and convertible bonds and common stocks all six. Under the new paradigm, the overall portfolio is managed in terms of the aggregate market risk factor exposures from these various investment instruments, rather than the beta of each of the asset classes.
Another source of return relates to the manager’s skill at exploiting arbitrage opportunities from market inefficiencies that are uncorrelated with market risk factor exposures. (This is parallel to “alpha” in the traditional model.) Skill-based arbitrage returns depend on the prowess of the manager, the size or capacity of the potential opportunity, and how long the inefficiency lasts.
A practical approach in the new paradigm is to focus on three buckets in managing the overall portfolio:
- Strategies to generate market-directional returns from risk premiums for exposures to market risk factors.
- Strategies to generate skill-based arbitrage returns.
- Strategies for illiquid instruments (e.g., private equity or direct real estate property investments).
In developing the policy allocation to the market risk factor exposures, the usual top-down macro scenario analysis would be performed. Managers and strategies that are most likely to be effective in providing the needed exposures are then selected. There are inadvertent exposures in the selected strategies that are not wanted (i.e., “unintended”), and these are hedged away on implementation. There are also inadvertent side effects that are not wanted but nevertheless anticipated (i.e., “intended”) and have to be retained. These will need to be monitored closely. In comparing the implementation result of the manager, the focus would be on the investment process. Did the investment process generate a high positive hit ratio indicating manager skill? If the hit ratio was low or negative, are there mitigating reasons and the prospect of an improved hit ratio going forward? Is the investment process still expected to generate the intended superior results?
The process of managing the overall asset portfolio would generally include six steps:
- Defining the risk budget in line with the asset owner’s risk tolerance (in terms of maximum drawdown, volatility, etc.).
- Defining the market risk factor exposures given market views and regulatory constraints.
- Selecting investment strategies and vehicles.
- Identifying market risk factor exposures embedded in each investment vehicle.
- Setting portfolio weights such that risks are diversified across various market risk factor exposures.
- Monitoring various risks and rebalancing as necessary.
In selecting managers and strategies, the focus would be on managers who are expected to have skills to exploit inefficiencies in the market, or generate “alpha” using the parlance of the traditional model. A prerequisite is that the manager’s vehicle must be transparent enough to allow a clear understanding and extraction of the magnitude of market risk factor exposures. In a practical implementation, about 20 to 25 managers are deployed, and risks are further diversified by allocating to multiple silos of asset types and strategy categories.
For risk management, the new approach uses additional risk measures, including intra-horizon downside risk, multi-moment parameters incorporating asymmetrical returns, manager compensation, and blow-up risk. The impact of leverage is also closely analyzed and monitored.
To conclude his talk, Duhamel highlighted several key tenets of the new approach:
- The new asset allocation and management model has no demarcation of the investment universe along asset class, product type, style, or geographic lines.
- There is also no demarcation between traditional and alternative strategies and asset management service providers — the key criterion is having the skills to identify and exploit market inefficiencies. Passive strategies and some commoditized alpha strategies are readily available at annual fees as low as 5 bps in many cases.
- All investments — active or passive, traditional or alternative — are simply return distributions that provide building blocks for portfolio construction to provide returns from market risk factor exposures or skill-based arbitrage returns.
- The policy portfolio and traditional market benchmark indices are no longer relevant. Most asset owners’ investment objectives involve absolute return requirements, and relative performance is becoming obsolete. The key risk is the shortfall in portfolio returns in meeting liability streams or other investment objectives that bear little relation to market indices.
The asset allocation and portfolio management model under the new paradigm is not simple, and only a stylized explanation is possible in a blog post. Nonetheless, the key tenets above can hopefully help capture the essence of where the industry is moving in an era of high volatility and low returns.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.