Thursday, May 14, 2009

Portfolio Management: Focus on the Future

Failures in Conventional Thinking

As we near the end of the first decade of the new millennium there are several new terms we use that rarely appeared in common conversation just 10 years ago, terms such as GPS, MP3, Blog, Plasma TV, Subprime and Stem Cells to name a few. All around our society, information describing our world expands at daunting rates and this explosion requires advancing analytics to make sense of it all. For most of the investment advisory business, portfolio building techniques and analyses sit in a conventional state lacking in thinking adapted to the world we know today.

Synonyms for diversification are words such as assortment, divergence, variety, and potpourri. In the in vestment business though, diversification has a very specific meaning: “A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”

The notion of this specific diversification definition shows up on a wide variety of advisory websites under common concepts such as ”reduce the fluctuations”, “moving in the opposite direction”,” least amount of fluctuation”, “reduce the overall variability”, and smooth out the ups and downs.”


Truly, combining one asset class in the top quartile of the correlation continuum and one in the bottom quartile will smooth returns. However execution of this concept fails theory. Over time, asset classes have become highly correlated mathematically, defined as the top quartile in the correlation continuum – or correlation values of 0.5 to perfect correlation of 1.0.


Consider these facts:
* There are over 300 benchmarks correlated to the S&P 500 and average correlations have increased from 0.38 in 1996 to 0.63 in 2008 – an average solidly in the top quartile where little diversification exists.
* Bonds which used to be uncorrelated to U.S. stocks have moved from a negative correlation (-0.77) during the period from 1997-2002 to a positive correlation (0.68) during the time period 2002-2007.
* Corporate bonds which were clearly not correlated to all stocks10 years ago moved from -0.686 to a positive correlation over the last five years of 0.203.

Many investors have noticed the increased correlations of the capital markets. In a recent study of wealthy investors by PNC, the following quote appeared:
“The ultra wealthy likely are looking longer term, knowing that historically the stock market has advanced when interest rates are falling.”


Actually, investment theory says that a market that is good for bonds (falling interest rates due to recessionary pressure) is bad for stocks. In recent years though, it’s clear that the stock market benefits with interest rate declines and suffers with interest rate increases - to cool down an overheating economy. We also can see in the newspapers that global markets are highly integrated with our markets, reflected in a correlation of the MSCI EAFE (Europe, Australasia, and the Far East) index to the S&P 500 of 0.9 – remember 1.0 is perfectly correlated!

What we end up with is a portfolio built with the presumption of return diversification – smoothing returns over time – but in reality, a portfolio that delivers little real benefit.
Many advisors are quick to show reduced return and volatility factors using a mixture of asset classes. This is a bit of investment sleight of hand. Correlations reflect patterns of returns, the ups and downs of the market as shown in the chart below. High correlations between investments do not mean the actual returns are the same, just the pattern of returns. That does not mean investment diversification has been achieved. Think of it this way, varying the ingredients will make cakes look and taste different, but, in the end, you still have cake!

The world is flat and correlated
A successful portfolio funds your future needs or liabilities; anything short of this is a failure. It makes sense, then, that the portfolio must handle future events, not those of the past. Investment analysis uses past returns as the essential data for risk and return statistics. Consequently, the advisory business puts too much emphasis on past returns of funds and managers, when in fact it is subordinate.
Returns are the result of an economic environment. An economic environment has vast numbers of variables that play out in unpredictable ways, to this point, would anyone dispute that a single industry (banks) can alter an economy? A portfolio defined today must play out in the uncertainty that is the future.
Proper diversification weights the portfolio toward asset classes with the strength to handle the future.

Chris Blakely - May 2009

Sources: Dictionary.com, Investopedia.com, Bloomberg L.P., Investment News (12/14/2007)