This is the fourth in a short series of posts which address four important and inter-related problems with Wealth Management and by extension Asset Management and in conclusion offers a Solution.
In a sense, this fourth problem is actually our original one; the truth is that one of the biggest (albeit largely unacknowledged) problems for the Wealth management Industry at the moment is that one of the central investment frameworks, the 60:40 balanced fund model, is essentially no longer fit for purpose. This is basically because of the underlying problems with its component parts, problems we have discussed in the three previous posts in this short series. To recap:
- In a world of rising prices and tapering after a decade of Quantitative easing, Bonds offer the prospect of negative nominal, let alone real, returns for investors and have become short term trading instruments rather than long term investment vehicles. Meanwhile their increased correlation with equities and their increasing volatility as they take on often unacknowledged additional risk, has removed any further reason for holding them in a balanced portfolio.
- Standard Equity Benchmarks, such as the S&P 500 have become very skewed towards a small number of stocks due to momentum from passive investors, significantly altering the nature of the ‘passive equity’ element of a balanced portfolio and introducing unwanted (and unwarranted) levels of concentration risk, in both sectors and stocks.
- Part of the response to skewed benchmarks has been the development of a wide range of alternative indices, often branded under the title of ‘smart beta’, along with a wide range of ETFs to track them and in particular the development of Thematic indices and ETFs. Ironically, rather than solve the problem of 2) this has caused a further problem. Specifically, it has damaged the ability of active managers to provide an alternative to passive investment for the Equity component of Balanced Funds by limiting their ability to extract Alpha from idiosyncratic (stock specific) risk in the short to medium term due to the share prices of many mid cap stocks becoming largely a function of liquidity and momentum chasing Thematic baskets.
In general, the response to this has, so far, tended to be to try and stick with the 60:40 model but to try and ‘fix’ the component parts. However as we have noted this not only tends to lead to other problems but also means that, explicitly or otherwise, managers take on more risk to achieve returns without actually appearing to take on more risk. Thus, for example, the bond component has tended to end up as a bar-bell of ultra short dated bonds and high yield bonds, which are only ‘risk free’ to the extent that their default is limited by the existence of equity to take the full loss. Because the technicalities of the existing structure is that the biggest weightings for ‘passive’ High yield bond funds are in the companies with the most debt, underlying investors are almost certainly exposed to economic structures that the supposedly higher risk equity component would have nothing to do with (Chinese property for example). Similarly, the low tracking error equity component has a huge skew to a small number of Mega Cap US Tech stocks if it has the US as a benchmark. In other countries, there is a different skew, but one just as sub-optimal, such as towards Financials or Resource stocks. One way around this has been to increase exposure to active managers and/or Thematics, but these also have their problems, mainly due to the unintended effects of two new and largely hidden sources of risk, leverage and liquidity. The impact of subscriptions and redemptions into Thematic ETFs and other baskets can in many cases dominate the share prices of many small and mid cap stocks that are their components and by extension introduce much higher volatility into the active equity funds, something that the traditional Volatility obsessed risk managers will often use as an excuse to, once again, revert to passive (where the risks are ‘hidden’ to the extent they are not measured).
The other response has been to attempt to revert to something similar to the “Yale’ model, as originated back in the 1980s and subsequently outlined in Yale CIO David Swenson’s original 2000 book . Back then, he too shunned bonds and essentially replaced them with a mix of other, often illiquid, assets, with a greater emphasis on real assets like real estate and forestry and alternatives such as Private Equity, Private Credit and Hedge Funds. This endowment (and a lot of look-alikes) ran into problems after the financial crisis, but in the last two or three years is once again being re-appraised. However, this still runs into well documented problems of access and liquidity (not to mention the sort of fees that are multiples of those given as a reason to avoid any other sort of active management). The success of the Yale model over a long period of time was also partly due to the fact that they were one of the few endowments doing so at the time. Smaller, more recent funds have struggled to gain the exposure the ‘model’ requires. Note from the Institutional Investor graphic that the smaller endowments still have a meaningful exposure to Bonds and (likely benchmark) equities as well as a much larger exposure to hedge funds and a lot less to the ‘Real Assets’ espoused by the late David Swenson.
Smaller Funds looking at Alternative don’t have access to the same opportunity set as larger ones
One of the problems here of course is that the smaller endowments face a similar issue to that of Wealth Managers generally, in that the while the Yale model acknowledges the problems with fixed income and passive equity, its solutions are not easily replicable, the difference in performance between the top and bottom managers in areas like venture Capital , Private Equity and Hedge Funds can be enormous for example and access is limited. Moreover, while small endowments still have the luxury of being genuine long term investors, wealth managers rarely have the luxury to take that amount of illiquidity risk, their customers need relatively immediate access to cash.
If that all sounds too bleak, in the next post we will aim to offer a solution, an update on the Balanced Fund, one fit for the new environment we find ourselves in, both as regards markets and also as regards economies.
