This post summarizes the findings from a 3.5 year old CFA Institute monograph titled Investment Management After the Global Financial Crisis.
Although this research is old, I believe that its findings will be useful in the post 2008 world. The title of this blog post is a bit ostentatious and will unsettle stock pickers (myself included) who believe that they can beat the benchmark by exploiting the inefficiencies inherent in capital markets.
Mr Jeremy Grantham also agrees with this conclusion in the Forbes article titled Don`t try to be Warren Buffet
The monograph points out that asset allocation is the new trend in investment management and not stock picking, at least in the efficient markets of the developed world. Indian markets, I believe, will take another 70-90 years to reach the level of efficiency achieved by first world markets.
DB to DC Pension Plans
The other big change effected by the crisis has to do with pension funds. The monograph claims that a big shift from defined benefit to defined contribution plans is to take place. While I am no expert in pension fund investing, I can safely point out that this change is going to have an adverse impact on retirees.
As the monograph points out ” The dilemma of those entering retirement in March 2009 is an example of how a lifetime investment can be compromised by the retirement date “ It further points out that the asset manager handling such pension funds will see a reduction in fund size and will have a new mandate. A mandate that will emphasize on downside protection of plan funds and objectives that will be set by the beneficiary (retirees) rather than by plan sponsors (companies).
ASSET ALLOCATION – IT`S THE TIMING, STUPID
Timing seems to be the most crucial and the most disconcerting aspect of asset allocation. The longer time horizon assets that are worth owning seem obvious.
As Mr Grantham points out, we could buy farmland (maybe in rural India) or Phosporous. http://online.wsj.com/news/articles/SB10001424127887323665504579032934293143524
I would like to add Helium to this list. http://www.bbc.com/news/magazine-24903034
The short term is the real issue. With the Fed distorting markets, asset allocation becomes all the more harder. Stock picking using fundamental analysis seems substantially simpler. Plus, as the monograph points out, with fewer number of asset classes to work with, compared to the number of stocks, getting your timing wrong with asset allocation could end up as a big mistake.
The monograph uses some jargon and differentiates between Global Tactical and Global Dynamic Asset Allocation (GTAA and GDAA). While GTAA refers to a short and medium time horizon, GDAA refers to a longer time horizon.
WHEN THE TIDE GOES DOWN, ALL ASSET CLASSES SINK
During the 2008 crash, all assets correlated to 1, except for high quality bonds. This is seen as a major shortcoming of diversification. Another interesting aspect of correlation that has been mentioned by multiple asset managers in the monograph, is the clubbing of domestic and international equities as a single asset class. This is surprising considering the differences in political, economic and social systems of different countries.
RISK MANAGEMENT
VaR (Value at Risk) comes in for severe criticism from the monograph for being able to predict only the frequency of losses and not the magnitude. Also, since VAR is not sub-additive (the whole maybe greater than the sum of parts), it did not allow the system to be analyzed as a whole. The authors and some asset managers have proposed using conditional VaR to overcome the shortcomings of VaR.
SPECIAL MENTION
The business model of the Dutch consultancy Cardano has received special mention in the wake of financial consultancies being heavily criticized for their role in the crisis. Cardano has been able to bring all expertise in-house except for the actual asset management part.
CalPERS (California Public Employees Retirement System) has been mentioned for being at the forefront of Socially Responsible Investing (SRI) in the USA. It is also clear that European funds take SRI more seriously than American and British ones.
Carmignac Gestion, France`s answer to Fidelity, has grown from 797 Euros in 2002 to more than 55 billion Euros in 2013. The monograph has mentioned Carmignac as a sample success story that has been able to break into retail distribution in a short time.
http://www.next-finance.net/Edouard-Carmignac-the-art-of
http://www.ft.com/intl/cms/s/0/a00ede4e-2691-11e3-9dc000144feab7de.html#axzz361mXGXYj
ASSET MANAGER REMUNERATION
While pre-2008 asset manager salaries formed a tight bell curve grouped around the median, post 2008, a clear polarization between weak and strong performers has flattened the bell curve. Also, since asset allocation is the new ubercool, companies have begun looking for people with multi-asset experience.
PARETO DISTRIBUTION, POWER LAW and EXTREME VALUE THEORY
While the first 2 terms refer to the 80/20 rule (20% of listed firms constitute 80% of market capitalization), extreme value theory is being used to study whether stock market crashes are fat tailed (probability of occurrence of large events is more than expected) or are simply outliers.
http://wiki.fool.com/The_Power-Law_Distribution_of_Market_Capitalization
ECONOMIC EXPLANATION OF FAT TAILS
This paragraph explains the reasons why financial market crashes (or fat tails) occur. The author refers to Aggregation phenomena, which refers to the interconnected nature of financial markets, Self reinforcing principle, which is very similar to Mr George Soros`s famous theory of reflexivity and to the coupling of financial models in which the parameters of one model are dependent on another.
All in all, the monograph is a good read. It would be even better if the same is updated to understand the present day reality. How much have things changed? Is Asset allocation still the king? How much do market participants worry about the activities of the Federal reserve?
thepokaranmoneymanager 