How Institutions Are Changing The Way They Invest And Why You Should Too
Portfolio Cafe | Jun 24, 2012 04:16AM ET
“Investors have been suffering from diversification deficit disorder. What they thought was diversified has become very highly correlated because of the global integration of the financial markets. Assets we thought were uncorrelated have started to move together, so we have to be much more thoughtful about asset allocation.” – Dr. Andrew W. Lo, founder and portfolio manager, AlphaSimplex Group In part II of this article, I will discuss some of the solutions cited in the research and how individual investors may construct their own portfolios using some of these ideas.
Institutional investors are increasingly questioning the common theories of how portfolios are constructed.
Why? …Because we are a long way from 1952 when Modern Portfolio Theory took the drivers seat for investing. And candidly, the model is broken.
In the next few minutes I will show you how broken and in my upcoming Part II, I will show how you can construct balanced portfolios using proven systematic methods.
Let’s start with Natixis Global Associates and the insights they published in a 2010 paper articles on “Adaptive Asset Allocation” that utilizes different factors such as volatility and momentum in addition to correlation.
The Macquarie presentation cites a critical flaw in modern portfolio theory — the foundational theory of asset allocation. Specifically, strategic asset allocation uses long-term averages in expected returns, expected correlations, and and expected volatility. But as the previous authors have cited, the long-term averages hide enormous variability over the short and intermediate term horizons that are meaningful for most investors.
In the past 10 years there has been a significant increase in correlation among most asset classes. Said differently … all asset classes have trended together. And this is why asset-allocation failed to insulate investors from the significant declines of ’08-’09.
And the result of asset allocation—as a investment strategy—has been a “superficial diversification.” Asset allocation misses the payoff from managing diversification based on underlying risk factors or return sources. In other words, diversification should not be based upon just historical correlations over a sample period – because they do and have, change.
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