Asset Allocation: Is Modern Portfolio Theory Dead? (2/2)


This is the second part of the summary of a session from the Money Management Institute’s 2012 Fall Solution Conference. You can read part 1 here.

Moderator:
  • Michael Jones, Chairman and Chief Investment Officer, Riverfront Investment Group
Panelists:
  • Colin Moore, Chief Investment Officer, Columbia Management, $339 billion AUM
  • Howard Present, President and Chief Executive Officer, F-Squared Investments
  • Steve Murray, Director of Asset Allocation Strategies, Russell Investment Group

How do fees affect your product decisions taking into consideration QE3 and a persistent low rate environment? Does paying 30-50 bps for bond allocations affect your product choices?

Murray said that fees do affect their product decisions, but that they always try to identify strong managers and the fees are a tradeoff versus the additional return that they’re expected to provide. Since Russell has a manager of managers structure allows them to move between managers with different fee levels as well as incorporate other products such as ETFs and mutual funds.

Fees have a higher impact when the product they’re attached to performs like Beta, Present ob served. Over the last decade, it was very difficult to extract value from equities as an asset class, while bonds appear that they will be difficult going forward. In 2008, the average target date fund was down 28%, so it didn’t matter if a manager was slightly above or slightly below that average. Relative performance in a down market is rarely appreciated by clients. You should be more aggressive with fees on beta products versus those that are designed to generate alpha, he said.

Does your philosophy of using low cost, transparent, liquid beta in the form of ETFs make it harder for your products to coexist on a sponsor platform alongside more traditional ones? — Randy Bullard

Jones proposed that their philosophy, which combines stocks, bonds and ETFs into dynamic allocation solutions is complementary to the more traditional solutions (like Russell). there is more than one way to create value besides picking stocks from a narrow slice of an asset allocation pie chart. They added another value dimension by adjusting the amounts allocated in each slice of the market based on the prices and momentum in each asset class. It’s not an either or decision to use their products or traditional. There’s a philosophical diversification that can be complimentary instead of competitive.

The free lunch of the past twenty years is over, Present announced, and bonds are no longer “set it and forget it” for exposure in a portfolio. You now have to manage those exposures, whether on the duration side or the credit side. Bond ETFs provide executional efficiency over trading individual issues, he noted.

However, while they do use a lot of ETFs, they they don’t use them to focus on narrow market slices, but to improve market efficiency and flexibility, Present pointed out. ETFs provide the ability to dynamically de-risk out of parts of their asset allocation, he said.

How you allocate across the available opportunity set is critical, Murray said. Whether you use ETFs or active management, the decision boils down to “what’s the best implementation?”. What you would do in narrow slices isn’t the same thing that you would do in the context of the total pie. You will be able to afford to have more aggressive slices if they are offset by other conservative slices, he advised.

The one good thing about using MPT was that you knew what you were getting, Jones explained. There was a fairly generic set of product solutions used across all firms, so everyone could be reasonable sure that their performance would be close to the industry average. However, the financial crisis created a new paradigm for asset allocation strategy. Many firms are now pursuing unique asset allocation strategies for clients with the same risk tolerance, he asserted.

Does this drive us to a different method of executing standard asset classes, Moore asked?  He explained how his firm put together a portfolio that was designed to achieved a certain level of volatility using derivatives. However, some of their trust clients were prohibited from holding derivatives, so they couldn’t use this strategy. We haven’t yet solved the problem of how to make complex strategies available to a broader audience, he observed.

Follow the Apple Example

Present added that a limiting factor for innovation in asset allocation is the availability of unique sub-components to drive new strategies. In the 80’s, asset allocation was based on an institutional model driven primarily by consultants and sponsors. Because of this, he believes, all of today’s products are still designed to fit into that framework and that limits the ability of firms to create innovative solutions.

The iPhone wouldn’t have been as successful if Apple had used only off the shelf parts, Present argued. They searched for cutting edge technology and even drove the development of new components in order to ensure that the iPhone would be revolutionary. Our industry must follow Apple’s example and develop new underlying components that can fit into broad risk tolerance categories in order to create innovative solutions for clients, he insisted.

Three Critical Innovation Lessons from Apple
1. Don’t just focus on building beautiful products. Build beautiful business models, new ways to create, deliver, and capture value. The iPod and iPhone would not have had nearly as much impact if they hadn’t been matched with iTunes and the AppExchange respectively.
2. Think in terms of platforms and pipelines. Competitors that chase Apple’s latest release find themselves behind when six months later Apple introduces its latest and greatest offering.
3. Take a portfolio approach. While Apple has been on a phenomenal run, not everything it has introduced has been a home run. For example, Apple TV hasn’t had the “revolutionary” impact that Jobs predicted upon its launch in 2007.
Source: Harvard Business Review

How do you explain complex strategies to HNW clients?

According to Moore, it should be a relatively simple discussion that avoids getting into the complexities of how the portfolio is constructed. Avoid technical terms like stripping out alpha or beta neutral and concentrate on what you’re trying to accomplish. He made the comparison to automobile advertising, which focuses almost exclusively on what the car does while avoid technical terms like engine compression ratio. Client communication should be kept at a very high level, staying away from the mechanics of what it is and focusing about what it does, he emphasized.

Moore posed two key questions that must be asked: Can the client handle downside risk?  If so, what is their tolerance for drawdowns?

Present said that his firm always talks with clients about returns versus expectations. They perform a lot of scenario modeling, which helps them explain to clients how their portfolio will perform under different market conditions. As part of this, they do a series of statistical runs over rolling time periods. This provides them with the data they need in order to manage client expectations based on historic, statistical evidence.

For example, their modeling might show that in a negative environment they expect their performance to be an A+, in a normal market they expect a gentleman’s B, while in a strong up market, like we have seen over the past six months, they would expect to be a C or C-. Scenario modeling is what they found to be the most effective when communicating with clients, he said.

Moore stated that you’ll be most successful if your clients buy into your strategy. It’s important to explain the chances of different outcomes occurring so that they’re prepared. That way, they won’t jump ship if things go wrong a year down the road, he advised.

Related Content
New Advice Strategies: Keeping Things Simple, MoneyMarketing.com
Why financial advisers are avoiding structured products, MoneyManagement.com
Why diversification is still the go-to risk killer, RIABiz.com

How much non-beta has to be added to the standard 60/40 model in order to manage the maximum drawdown?  Do you recommend getting into alternatives and other alpha strategies to deliver uncorrelated behavior and protect downside given that bonds are so over-priced?

Jones said he rejects the traditional 60/40 mix if you have to pay a high price for any of the assets.  This is because based on his firm’s methodology, you should adjust the asset mix based on the price you have to pay for the investments, since the higher the price, the greater the downside risk.

Riverfront’s investment model does recommends 60% stocks, but with much lower volatility, Jones explained.  The bond slice is split into 20% high yield and 20% very short corporate bonds, although this will probably change due to the collapse in the high yield market since they set this strategy, he commented.   Corporates should be included because when you roll down the yield curve you get just enough incremental price appreciation to offset inflation so they don’t hurt the portfolio returns.  They also had a small slice of long bonds that acted as the ultimate call option on disaster, but they got out of them when long yields hit historic lows, he said.

Murray believes in layering long-term and tactical views as part of more active management.  From the longer term perspective, you should start adding in components of real assets (i.e. real estate, commodities, infrastructure), while the standard components of the 60/40 model need to shift.  Fixed income should shift away from sovereigns and Treasuries and into high yield and emerging market debt, he advised.

According to Present, the F-Squared approach focuses on managing downside risk.  When they create a custom asset allocation for a client, they pre-define how much latitude they  have to de-risk the portfolio.  In an ideal solution, if their analysis predicts a bear market, they would like to be able to totally shift out of equities into all cash. However, some clients won’t let them, do this, so they might instead shift into a lower volatility portfolio.  If they have more latitude, then they would expand the number of asset classes by adding non-correlated ones and also could dynamically adjust the weighting between equity and fixed income.  Their approach is less mean variance optimization and more about how much they are able to de-risk the portfolio, he emphasized.

One option is to start with 60% equities and then hedge it, Moore proposed, since moving a small percentage (since the IPS often restricts the amount in each pie slice) between existing asset classes will have almost no impact.  They often start 30/70 and use 20% non-correlated beta (i.e. forestry) or alpha, he said.

Survey: Advisers ditching 60/40 portfolio allocation
According to a recent survey, only 1 in 5 advisors believe that the 60/40 model is the best for most clients. New asset allocation models and portfolio construction methods are needed according to 40% of the advisers, while just over 20% are sticking with the status quo.  Source: Investment News
Will The Real 60/40 Please Stand Up?, SeekingAlpha.com

This was part 2 of 2. You can read part 1 of this session summery by clicking here.

Check Out Our Summaries from the MMI Spring 2012 Conference:
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