Tuesday, September 6, 2011

Asking the Wrong Question

In academic terms, or in terms of the Capital Asset Pricing Model, known as CAPM, the risk of owning the market is called systematic risk. Nowadays, as one financial institution after the other seems in danger of collapsing, we hear much about systematic risk. Nevertheless, for professionals who try to manage risk in portfolio construction, it seems like a good trade-off -- business risk for market risk. As a result, portfolios are diversified by asset class, where each asset class is owned as a diversified portfolio of securities designed to eliminate the business risk of owning individual companies. The goal is to only capture market risk and returns. Of course, informed investors must then choose how to do so. They can buy an index fund to capture the risk and return of the asset class (by actually owning the market), or they can hire a money manager who is constrained to actively manage securities in the asset class the investor wants to own. Investors use mutual funds, wrap-accounts, limited partnerships, and other investment companies to hire money managers. It really doesn’t matter what the structure is -- we know from dozens of studies that, on average, if the active money manager is constrained by investment style and is only allowed to own securities in one market as defined by one asset class benchmark, the results are going to be very close to owning the index or market.

This question -- whether to own the market risk and return by owning an index fund or to hire a money manager and try to "beat the market" -- is what everyone means when they talk about active management. That's a shame, because we’ve known for more than a decade that everyone is asking the wrong question. The correct question is, if we have traded off business risk for market risk, then what is the “real-world,” practical risk of owning the market? Traditional thinking says there is little danger to owning markets, so long as you hold them long enough. In the short-term everyone agrees that no one can forecast the returns of markets, but in the long-term, market returns are expected to regress to their long-term mean (or average) return. In terms of asset allocation, 'buy and hold' means to own an asset class long enough for it to earn its long-term average return, and presumably do so with long-term average risk or volatility. The problem, as most everyone is now learning, is that risk markets have not reliably earned their long-term average returns for more than a decade, putting many financial plans -- not to mention pension plans -- at risk.

So what’s to be done?

Wall Street concocted a strategy that included another trade-off. Exchange the risk of markets for the risk of financial strategies that deliver returns that are not correlated to the markets. These new strategies, run by managers who are presumably smarter than the average style-constrained money manager, include private equity funds and hedge funds that are the darlings of institutional investors everywhere. Market-neutral, long-short, event driven, convertible arbitrage, global macro... the list goes on. All are designed to solve the problem of markets that are misbehaving, and can presumably generate positive returns when markets do not. Unfortunately, the uncorrelated strategy solution has its own problem: These strategies only work some of the time, and there is so much money chasing them that the returns are being arbitraged away.

It turns out that accepting business risk, market risk, and low correlation-strategy risk, all have their unique problems. Pinnacle’s solution to the problem is unique. Stay tuned for that.