PIMCO founder Bill Gross, the famed fixed-income investor who manages the $268 billion PIMCO Total Return Fund (PTTRX), has made his prediction about the tightening of US monetary policy abundantly clear:
Gross: So bonds come out of their coffin & it’s not even Halloween. #Bernanke says follow policy rate & we agree. 2016 tightening @ earliest
— PIMCO (@PIMCO) July 21, 2013
Gross’s view that the U.S. Federal Reserve will not tighten rates until 2016 at the earliest raises some fundamental questions for investors: Should asset allocation be adjusted in response to such (newly formed) expectations, or should investors continue to use models based solely on past data and fixed time horizons?
To contextualize this question, we turn to Bill Gross’s own colleague and an executive vice president at PIMCO, Sébastien Page, CFA. Presenting at the CFA UK Annual Conference 2013 in London in June, Page argued that asset allocation is evolving in the aftermath of the global financial crisis — and he explained four differences between traditional, pre-crisis asset class approaches and the relatively newer approaches being used in today’s so-called “new normal” environment. Here are the key differences, as explained by Page, that help illuminate the asset allocation decision:
First, traditional asset allocation approaches are backward-looking and statistically driven, whereas newer approaches are forward-looking and driven by macroeconomics. We have been in a declining-interest-rate environment for nearly twenty years, and the asset class return data we have for this period may not be as relevant if interest rates rise. Current conditions matter, and in today’s conditions, debt of some emerging market countries may well be of lower risk than that of developed countries. The quantitative techniques used in investment decision making need to take into account what is expected to be different in the future. “Data and models are useful but only to the extent they help formulate a forward-looking view,” Page said.
Second, traditional asset allocation approaches focus on asset class diversification whereas newer approaches focus on risk factor diversification. There is a growing realization that the same risk factors cut across asset classes, reducing the benefit of diversification. Asset classes are better seen as containers of risk factors. Just like food can be broken down into fat, carbohydrates, and proteins, asset classes can also be broken down into risk factors. The constituents of a portfolio — whether they be high-yield bonds or private equity — can be broken down by such risk factors as interest-rate risk and currency risk. Page shared data showing that average cross correlation for risk factors is much lower than that of asset classes. “Diversifying across risk factors is more effective than diversifying across asset classes,” Page contended.
Third, traditional asset allocation approaches underestimate the dynamic nature of the market whereas newer approaches focus on the secular and cyclical horizon. Traditionally, investors will have a fixed time horizon, say three years, and they will commit to a certain asset allocation for this horizon, changing things only after the period has expired. But now investors know that what happens in between these three years — say, the default by Lehman Brothers — can change expectations about the future, even for the long term. Whether or not investors have a governance process, asset allocation needs to be divorced from fixed time horizons. “The world changing is different from time passing,” and recognizing this difference, “asset allocation is becoming more dynamic,” Page observed.
Fourth, traditional asset allocation approaches use volatility as the sole measure of risk whereas newer asset allocation approaches seek to explicitly address “fat tail” risk — the risk of rare, unexpected, extreme losses. Investors are realizing that volatility and exposure to large losses can be two very different things. Two portfolios with the same volatility can have very different exposure to large losses. Page referred to a research paper written by Andre Lo, professor of finance at MIT’s Sloan School of Business, which was published in the Financial Analyst Journal in 2001. The paper showed that “traditional risk management tools such as mean-variance analysis, beta, and value-at-risk do not capture many of the risk exposures.” Lo suggested that volatility based on the symmetrical normal distribution is a poor measure of risk. “We have to deal with these asymmetries and refocus risk management on tail risk,” Page argued.
So what’s your view? When do you expect the Fed to tighten rates? Are you reconsidering your asset allocation strategy based on your expectations? Please use the comments section below to share your views.
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