Thursday, January 21, 2016

A New Look At Asset Allocation

During the financial crisis, it could be argued that the majority of diversified asset allocation strategies failed to achieve their intended goals as asset class correlations all seemingly dove toward 1.0 as the situation worsened.  This left investors holding a bag full of investments that had collapsed in value.  Equities, parts of the bond markets, commodities, real estate (obviously), and alternative investments (for the most part) were all crushed.  Add to that the illiquidity of certain areas of these markets and people learned that they had really been thrown for a loop by their investment portfolios and the advisors that had pitched them.

In a new study, Richard Bernstein Advisors has set out to prevent such situations from unfolding in the future with their Asset Allocation 2.0 program.  We wanted to share because, at first glance, the concept does seem to have merit.  So many advisors tell their clients that they need to own this or that simply because it’s a “common” asset class.  Well what if many of their other holdings closely resemble it in terms of risk and return profile?  Is that doing more harm than good? In their words:

“Traditional asset allocation models seem obsolete. The much heralded “Endowment Model” failed in 2008, yet asset allocators continue to cling to it as much as the Peanuts character Linus hung on to his blanket. However, the global financial markets have changed dramatically, and the macroeconomic backdrop that fueled the success of the endowment approach no longer exists.

RBA’s approach, Asset Allocation 2.0™, is based on a different asset allocation construct. We no longer pigeonhole investments into traditional categories, such as Large Growth or Value, Small Growth or Value, High Yield or Distressed debt, Absolute Return, or the like. Rather, we group investments based on their returns and risk characteristics.”

RBA’s work argues that, “2008’s asset allocation debacle could have been mitigated or maybe even prevented” had such strategies existed back then.  We’ve linked to their introduction to the study here.

This current correction in the markets so far feels more like your run-of-the-mill pullback (or maybe even a cyclical bear) and not something more sinister like 2008.  However, you never know when a confluence of events can quickly suck asset classes into behaving in similar ways when investors just want to press the sell button.  You should read the paper but if you’re strapped for time we’ve listed their conclusions below:

➜ The so-called Endowment Model failed in 2008, yet investors continue to cling to the framework and ignore that the macroeconomic backdrop that fueled much of the Endowment Model’s success has significantly changed.
➜ Asset Allocation 2.0™ is a different method for allocating assets. Rather than relying on traditional asset categories, it seeks to exploit sensitivities or characteristics within the global financial markets.
➜ Traditional correlation analyses can be manipulated and should be used judiciously. Secular correlations seem much more useful.
➜ There is a spectrum of sensitivities. Investors need to judge the cost/benefit of gaining exposures to those sensitivities.

➜ Asset Allocation 2.0™ is a dynamic process that removes the traditional asset allocation boundaries to search for the most effective way to gain factor exposure.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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