For years, portfolio managers and financial reps around the country have used Modern Portfolio Theory in managing their clients' assets. The seminal theory was first published by Harry Markowitz in the Journal of Finance in 1956. William Sharpe took those ideas to the next level with the Capital Asset Pricing Model and together with Mr. Markowitz and Merton Miller earned the Nobel Memorial Prize in Economic Sciences in 1990.
The math and science behind these theories was simple: Risk can be diversified away. According to Mr. Markowitz, determining the “efficient frontier” requires that we establish the expected return and standard deviation of a security, and the co-variance or correlation of each investment with all other possible investments.
It is this last variable that has proved to be the most challenging aspect of MPT and, not surprisingly, also the one that is the most misunderstood. The problem lies in the failure of MPT practitioners to recognize and react to correlation factors, resulting in withering portfolios and the erosion of the true benefit of MPT — diversifying away risk.
Mr. Markowitz, Mr. Miller and Mr. Sharpe were not wrong. The instantaneous global dissemination of information has made it exceedingly difficult to find non-correlated asset classes and provide the needed diversification. Asset classes once available only in “strategic-asset-allocation” portfolios but now offered on numerous platforms are now moving together. For example, between March 3, 2008, and March 2, the S&P 500 fell 48%, Japan's Nikkei dropped 42%, Great Britain's FTSE plummeted 38% and the iShares MSCI Brazil Index Fund decreased 58%.
How about that for non-correlation?
There is a paradigm shift occurring in the retail money management business in which clients are demanding investment solutions that provide an alternative and/or a complement to the standard buy-and-hold strategies. We refer to these as tactical-allocation and strategic-asset-allocation strategies. These solutions incorporate the same asset classes — equities, bonds, money market funds — as buy-and-hold solutions, but they differ in that the exposure to these common asset classes is through strategies that are non-correlated to the buy-and-hold approach.
Tactical solutions involve deciding where assets should be allocated, and even considering whether to tuck assets safely away in money funds during particularly volatile periods. Timing of those tactical movements is not based upon the calendar but instead on the movements of the markets. In many cases, the strategies may be set up for an intermediate term, which has the derivative effect of keeping transaction activity palatable.
Many in our industry have struggled to accept tactical solutions, especially since advisers have spent their careers recommending buy-and-hold strategies. Another big hurdle for registered representatives in incorporating a tactical strategy for part of their books is getting past the “market-timing” moniker. For years, everyone has been schooled that you can't time the market, that studies have shown that it does not work.
Really? I would like to see those studies. Are they aggregating many accounts and showing how flows into equity funds are highest at market tops and lowest at bottoms? True, most investors, and even reps, get caught in the trap of emotion when entering and leaving the market. In professionally managed tactical strategies, emotions have no place — never have, never will.
Then there is the “market-timing” label associated with regulatory violations in the late 1990s and the early part of this decade, when some mutual fund firms allowed daily trading. Of course, trading in and out of mutual funds has been vetted out, and there now are safeguards against such activity. But that is not the type of market timing investors need to thrive. Instead, incorporating intermediate-term trends can be very successful, without the craziness of daily in-and-out movements.
It is time to diversify client portfolio strategies and embrace this moment of change. The industry needs to adapt with the times and make sure the solutions recommended for client portfolios incorporate the “negative correlations” that are necessary for successful long-term outcomes.
Along with buy-and-hold strategies, consider incorporating tactical solutions for client portfolios. Such expansion will make your offerings and your practice more comprehensive, and ultimately make your practice better.
Sean Hanlon is the chairman, chief executive and chief investment officer of Hanlon Investment Management Inc., a registered investment adviser.
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