Anyone who has studied basic portfolio construction understands that it’s possible to reduce the overall risk in a portfolio by adding an asset class that has low or negative correlation to the rest of that portfolio’s asset class constituents. At least, that’s what they taught us in Investing 101.
And lest we forget, it was in Investing 401 (or was it 501?) that we came up with the advanced theories that lie behind Long Term Capital Management’s management. Perhaps, then, we are reminded of a famous aphorism: “In theory, there is no difference between theory and practice. But in practice, there is.” In the practice of Long Term Capital Management, a series of negative events was coupled with an ever-increasing leverage ratio in a portfolio that all the mathematical models claimed should be fine. The only difference evidently was that mathematical models aren’t forced to make margin calls.
Where does this scenario leave us with the “add risk to reduce risk” concept? Does it, too, fall apart under such extreme circumstances? Before we put 2008 under the microscope, perhaps we should brush up on exactly what we are talking about when it comes to adding risk to reduce risk. We cannot forget that we are looking at adding distinct asset classes–defined as assets that behave similarly in the marketplace and are subject to the same laws and regulations as other alternative investments.
Really, there is a fuzzy line between low-beta and high-beta stocks. Yes, they behave slightly differently, but both kinds are stocks and subject to the same laws and regulations. But then, when the proponents of “add risk to reduce risk” speak, they’re wringing their hands in delight when we talk about managed futures, for example. Now that’s an asset class.
This alternative investment has (historically) had low or negative correlations to traditional asset classes and has certainly been subject to different regulations.
I think the term ‘managed futures’ conjures up heartburn for the uninitiated, but it is typical to fear what we don’t know or understand. Both investors and their advisors are quickly discovering that there has been a vast amount of scientific research carried on since the Capital Asset Pricing Model (CAPM) was first presented, even though it could be argued that the application of these scientific findings stopped making their way into portfolios decades ago. How many prospective client portfolios have you personally seen that have a 60% stock and 40% bond mix, and that’s it?
Sure, each asset class itself is well diversified, but in the information age, it takes about two hours of reading about ETFs before someone gets the idea they can cut out the middleman and live happily ever after, only to discover that human psychology applies to them, too. They bail out of their long-term, self-prescribed Investment Policy Statement at exactly the worst time.
Human behavior trumps sound logic for most investors. However, if you turn to embracing portfolio instruments whose genesis is derived from science-based research and not investment myopia, then the chances are that you will not only keep more clients, but find more clients. It is much easier to defend your recommendations when they are coming from academics whose only vested interest is being able to say they figured the stuff out first, as opposed to industry manufacturers who provide you with slick marketing materials and colorful pinwheels to explain what your bond allocation should be based on the age that you dial up on their online wheel. Their vested interest is getting you to allocate money to their investments and not make the best investment decisions.
Enter Dr. Lintner
Pardon the tangent here. Let’s get back to the wide world of managed futures which had their first serious look over 25 years ago when Harvard professor John Lintner presented his paper, “The Potential Role of Managed Commodity – Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds,” at the annual conference of the Financial Analysts Federation in Toronto in May 1983. The professor essentially asserted that combining managed futures into a standard portfolio of stocks and bonds increased risk-adjusted returns at every point on the efficient frontier. While it all sounded great, there was very little real-world application for retail investors because they couldn’t track managed futures indexes.