Last week, I noticed quotes from two influential bloggers that were featured in separate issues of the linkfest produced on the website Abnormal Returns.Abnormal Returns | Indispensable.
The first, from Eric Falkenstein: “In practice, low volatility portfolios are risky because they dramatically underperform in bull markets.”Falkenblog | Falkenstein often challenges the accepted notions of the definition of risk and its interplay with return. The posting from which it is drawn includes links and perspectives about low volatility investing, but the quote deals with the behavioral effects of benchmark risk (and its cousin, career risk). You would hope that the investors in a strategy would look at the nature of its performance across the arc of a typical market cycle and speculate what might happen as a result of outlier scenarios — and then not be too surprised when that nature is revealed over time. If they did, they wouldn’t get as caught up in inappropriate comparisons so often.
Contrast that mentality, which dominates the investment business, with the other quote, from David Merkel: “Good asset allocation marries the time horizon of an investor to the forecasts for future returns, conservatively stated, and considers what could go wrong.”The Aleph Blog | Merkel’s postings are wide-ranging and thoughtful. His retrospectives and series are especially worthwhile.
Look at the difference between Merkel’s description of how things ought to be and Falkenstein’s description of how things are. Much asset allocation and most manager selection processes are focused on historical returns, not “forecasts for future returns, conservatively stated.” Very often, “what could go wrong” is not examined in any structured way. And the time horizon varies dramatically based upon the circumstances of the day, but is almost always shorter than it should be.
All of this occurs because decision makers have great difficulty pulling themselves away from the benchmarks, time horizons, and norms of the industry — to meet their mandate by identifying the best opportunities in the marketplace, whether they fit accepted wisdom or not. In February, I wrote this note regarding the monthly commentary of Bill Gross:
Gross bemoans the markets, the market players, and the market manipulators of today. Of investment professionals, he states (in bold type): “As a profession we have failed miserably at our primary function — the efficient and productive allocation of capital.” The sentence previous to that one ends with a reference to the “80% of active money managers that underperform the market.” Gross misses the connection between the quotes; the relative performance derby has perverted the business.research puzzle pix | This digest sometimes features just a chart and other times a chart and some interesting links.
Decisions large and small are off kilter because the looming shadow of benchmark risk overwhelms almost everything else. The pension mess (public and private) is a good example. Expectations for returns have been way too high and remain that way. They should be set measurably below what might otherwise be typical return assumptions, because the big risk is shortfall, not whether you outperform an index or not. Yet pension officers stay busy comparing their investment managers and themselves to one another and to benchmarks, instead of pushing back against return assumptions used by their states or firms that lead to problems down the road.
And maybe they should consider a low volatility strategy, even if some “underperformance” in a bull market comes with it, since such a shortfall versus a benchmark is not really a risk that matters relative to other considerations.
Many of the benchmarks are, in fact, false ones. I dare say that the S&P 500 is not a natural liability for many individuals or organizations to fund. Nor is some broader market portfolio. These are made-up constructs and should not be the prime guide for decision making. But the business of investing is tied to them, to its detriment and that of its clients.