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December 06, 2013 at 10:03 AM
It must be de rigueur in many schools of finance to teach certain rules. Many of the graduates seem to hold the instructions sacred. They are hammered into student brains, where they quickly harden and become indestructible, diamond-hard.
These rubrics encompass tired ideas like this one: 5 percent into small-cap, 5 percent into mid-cap, 20 percent into large-cap and, by the way, make sure to be 60/40 equities to bonds and a ratio of X value to Y growth.
Why else, for example, would an investment annuity company, when a living benefit is selected by the customer, limit his or her choices to unimaginative diversified sub-accounts instead of, say, Ivy Asset Strategy, Templeton Global Bond or BlackRock Global Allocation? All three are flexible in ways that academic diversification is not, and all three hammered most traditional diversification plays over the last 10–15 years.
Yet, if the customer had purchased the annuity without the living benefit, thus having no investment restrictions, and used one, two or all three of the flexible funds, he or she would have historically cleaned the clocks of the diversified choices, even if, to make the game fair, you deducted 3 percent yearly for living benefit add-on expenses.
See also: 13 ways an annuity can benefit an estate plan
Forget annuities. Why else, other than hard-wired finance brains, would giant fund companies, acting like dinosaurs, reject the idea of flexibility and the thought that there may be new ideas on the horizon?
If school-learned diversification is all that great, why did one company lose some $240 billion of investor money in the 2008 debacle? Why are people afraid of equities, the funds that specialize in them and stocks?
Investment professionals know the truth, of course, and the truth is simple and axiomatic. It’s one simple mantra echoed by customers far and wide: We don’t want to lose money!
Managed what?
Things work until they don’t. An example: Hard-wired financial brains gamed for years the system with managed futures. Lots of smart math whizzes trading 24/7 (maybe not 24/7, but globally close to seven days weekly), trying to make a penny here and a penny there on commodity and other bets.
In the beginning, lots of pennies added up to something. But, as more and more people learned and joined the game, it became harder, and earnings might be measured in mills and not pennies, and then parts of mills, and so forth. Ever-faster computer systems and software — to say nothing of algorithms — make it harder and harder to find a trading advantage. Hundredths of mills don’t add up to much. And more and more people joined the game.
Size matters
As to certain types of trading, a company can do very nicely right up until it hits a wall of reality. An SMA, for example, may get big enough so that it can’t effectively trade. We could argue at length about free markets, but the truth is that mutual fund managers get angry if a customer, like an SMA, with several billion invested, withdraws in one fell swoop, say, $2 billion. And most SMAs use funds.
To counter the idea of big all-at-once withdrawals, the fund managers levy extra charges if one gets out early, which limits the flexibility to trade advantageously, e.g., if a signal says to an SMA manager “exit now,” and there’s a 2 percent penalty for the resulting liquidation, the manager may think twice. Once an SMA can’t follow its signals or hesitates to follow its rules-based system, performance may die — it does not matter so much the reason. A 2 percent hickey if the signal is taken may be as bad as the downtick if it is not.
