Investment theory, which has been at the foundation of strategies used by Australia’s superannuation and funds management industries, has been upended in new research.
WHEN investing for your future, it is profitable to pause for a moment and acknowledge the power of panic – particularly when it has just knocked over a foundation stone of modern investment practice.
Australian investment portfolios before the financial crisis “mirrored the optimal allocation forecast of (Harry) Markowitz’s modern portfolio theory”, according to respected economist, Tim Toohey.
Mr Toohey and associates at Goldman Sachs JB Were have just trawled back over the past quarter of a century of Australian data to find out which asset classes work best, and why MPT failed us just when we needed it most.
“For a given return, MPT explains how to select a portfolio with the lowest possible risk,” Mr Toohey reported.
“At the depths of the (financial) crisis herd behaviour and panic took hold, decisions to sell assets had less to do with what the investment prospects of individual assets were and more to do with selling into any market that was still open for business in order to remain liquid.”
Hardly a comforting thought when you consider that Markowitz’s theory has been around for more than half a century and has influenced considerations about the majority of financial instruments used in wealth creation today.
If we cannot pick the brains of the 1990 joint-winner of the Nobel Prize for financial economics, whom can we trust?
Mr Markowitz had not long been in the field when he published modern portfolio theory – the year was 1952 and MPT has been overwhelmingly accepted ever since. It makes sense: diversify to reduce risk and select the right combination of assets in which to invest.
So why did the theory fail us at its most crucial test? Perhaps the fault is ours.
“(MPT) asserts that it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price,” Mr Toohey wrote.
“Importantly, during the financial crisis, asset classes tended to become positively correlated, because they all move (down) together.
“The real failure was not the financial theory but the blind adoption of a theory as being appropriate for all economic climates. To be fair, MPT was never designed to diversify away systemic risk. Events such as world wars, major financial crises and global pandemics cannot be diversified away.”
So, having put us on notice, why does Mr Toohey now struggle with the same question that confounds my industry year in, year out?
His research validates the out-performance of Australian hedge funds, which over time have consistently generated better returns with less risk than equities and other traditional investments.
Looking to shine a light on the way forward for investing post-GFC, Mr Toohey challenges Australia’s funds managers to significantly re-cast their asset allocations to a formula he says will produce optimal returns for investors.
He calculates that the biggest asset allocations of the Australian superannuation industry (which controls two of every three dollars under funds management) are 43.9 per cent to equities, 18.2 per cent to cash and 16.1 per cent to foreign assets.
Lagging down the list with just 4.5 per cent of the investment pie are alternative investments, mostly hedge funds.
Mr Toohey argues that funds managers will have to either radically change their asset allocations, or reduce their targeted levels of return, if they want to operate within pre-GFC margins of risk versus return.
He warns that if they are not prepared to change, managers will have to reduce expected returns from 10 per cent to 9 per cent – with “dramatic implications” for some asset classes.
“While the reduction sounds relatively innocuous, the optimisation procedure suggests exposure to different asset classes should now be evenly spread,” Mr Toohey says.
“This is a radically different recommendation which would keep cash holdings permanently higher, halve equity exposures and provide a much bigger role for asset classes like commodity index funds and gold.”
Unconstrained, Mr Toohey’s optimisation model based on years of performance would lead to portfolio allocations of more than 50 per cent to hedge funds to achieve a 10 per cent return. But reality strikes.
“Providing such a large allocation to hedge funds would appear somewhat unrealistic in an environment where mandates would rarely allow such a concentration, trustees and asset consultants remain sceptical of hedge funds, long-only managers are openly hostile and governments around the globe are eager to make hedge funds the scapegoats for the financial crisis,” he concedes
“Actively moving portfolios to this degree would cause significant upheaval in the financial sector and quite likely in the real economy as well.”
Mr Toohey proposes a more gentle solution; an optimisation model he says can achieve 10 per cent returns within past margins of risk – 40 per cent domestic equities, 33 per cent domestic fixed interest, 8 per cent offshore fixed interest, zero per cent offshore equities, 6 per cent gold, 1 per cent to the Goldman Sachs Commodity Index (GSCI) and 11 per cent to alternative assets.
Acknowledging the controversial aspects of that asset mix – nil offshore equities and a total 18 per cent committed to gold, alternative investments and the GSCI – Mr Toohey turns the challenge back to funds managers.
“It will be fascinating to see how asset consultants and trustees shift their portfolios in the post-crisis world,” he says.
“A failure to shift would be sub-optimal from a risk/return perspective. A dramatic shift would likely be sub-optimal from an economic perspective.
“In the interests of all market participants, perhaps it’s time hedge funds were acknowledged for the positive characteristics that they provide in portfolio construction and their wider adoption may just help minimise financial and economic volatility in the post-crisis world.”
That will be no easy argument to win – up front, I concede the hedge fund industry has an image problem. Like other sectors in the investment space, we have our share of cowboys whose actions have given us a bad name.
Education is the answer and, here in Western Australia, NWQ has endowed the University of Western Australia’s Business School with a visiting professorship as part of its commitment to education and de-mystifying alternative investments.
New York University’s Ed Altman will be the first of the visiting
He will spend a month here this month and in April, both on campus and in the business community.
But the lesson to be learned today by funds managers is that there is a new formula for investment post the global financial crisis; a failure to learn it will prove costly for investors.
Jon Horton is the managing partner of Perth-based hedge funds company NWQ Capital Management, which manages the NWQ Diversified Fund.