Across all major strategies, hedge fund returns were dire, with the obvious exception of Short-Bias and the less obvious Managed Futures.
Private Equity, Venture Capital, all manner of mortgage obligations in the alphabet soup of CMO, CMBS, etc - pretty much every risk asset went down when the good ship Leverage sank.
This year will hardly be the year to judge whether a model that failed in 2008 has ‘righted’ itself. Most probably, the circumstances ante-bellum of 2007 have changed for good and there is no going back to those established practices. One wonders what will be salvaged and why.
Modern portfolio theory proved flawed in this environment, particularly because it measures risk through variance of returns instead of the probability of capital loss, let alone extreme loss.
“Traditional” asset allocation depends upon the modern financial orthodoxy which was developed principally at the University of Chicago in the post-war decades. Efficient market hypothesis, efficient frontiers, modern portfolio theory, Sharpe ratios and much of the intellectual approach now taken for granted all date from the 50s and 60s.The hypotheses remain sound; the problem is that the modern investment manager allocates between a range of asset classes barely imagined by the fathers of this science. Furthermore, the narrowly-defined asset classes which suggested over several years pre-2008 that they did not correlate with each other turned out to do just that during a financial crisis.
Some have suggested asset allocation itself has become subject to the efficient market hypothesis, whereby the volume of money being allocated, in herd mentality, to the same asset classes for the same reasons, had the effect of increasing correlation. Asset allocation models became established in circumstances referred to as the Great Moderation of the past 20 years. American and British macro economic policy, which delivered great inflation problems, was correctly reversed, resulting in the reduction of volatility. Models were tweaked, fluffed and polished over a period of generally very benign economic conditions. They were, in effect, fitted with low-profile tyres for the smooth ride that had become commonplace.
Off-road tyres were thought unnecessary as collective wisdom had it that any fool would be able to tell when economic policy makers were getting it so wrong as to cause a fully-correlated market crash. Yet the evidence is that most asset managers did not spot the failure of economic policy to curb the supply of cheap money which inflated the asset boom.
It is also worth pondering whether the ‘Swiss Model’ of private banking and asset management has proved to be flawed. To look at the humiliation of the biggest of the Swiss banks, one is tempted to say that it is. Then again, the older, truly ‘private’ banks have largely performed both as institutions and in terms of investment returns, in such a way as to suggest not.
For the big banks the villain was the hybrid business model which required stuffing their clients’ portfolios with questionable products created by their sister investment banking divisions. The private bankers sacrificed their independence of judgement in order to complete an alliance of two previously separate business practices. It was obvious the vested interests of the bankers were at odds with the best interests of their clients.
However, identification of the problem has been straightforward and the solving of the problem and the purging of the architects of the disaster is being gradually achieved. The Swiss Model will survive, by reverting to a form that frees it from the conflicts of interest the investment banking activities imposed upon it.
Another concern within allocation models concerns liquidity. This is chiefly, but not solely, a hedge fund characteristic. It is axiomatic that the better the reputation and returns of a manager, the less liquidity on offer to clients. This rule has been tested to destruction over the past 18 months and might see significant change going forward.
Not only will investors quite rightly demand better liquidity, they will expect greater transparency from managers, so as to demonstrate liquidity.
The fee structures that hitherto invited sophisticated investors to part with 2% and 20%, yet be kept in the dark surely have little chance of survival. Sub-optimal performance does not merit super-normal fees. Despite high water marks on incentive fees, this seems an area ripe for evolution in the investors’ favour. Greater regulatory oversight is likely to be imposed but it will doubtless prove less effective than peer group reform.
The death of so many non-correlation certainties at the end of the last investment cycle signals an end to the past two decades’ settled orthodoxy of asset allocation. Many investment theorists will suggest interim measures before a new consensus is formed and my bet is that it will take some time before such consensus is reached. In the meantime, a return to nimbler strategies is anticipated. ‘Active’ management of a greater percentage of a balanced portfolio, with the ability to put very liquid hedges or directional speculation in place at short notice, might become more prevalent.
Maybe we shouldn’t bother with diversification at all: “Wide diversification is only required when investors do not understand what they are doing.” So says Warren Buffett; Berkshire Hathaway Inc B shares fell by 32% in the 12 months to 31 December 2008.
