Fund analysts need to scrap those outdated models
This essay appeared in Citywire Selector on September 29, 2010.
With all of the excitement and noisy positioning around Newcits, hopes for broad adoption and strong inflows are sky high. But don’t confuse motion with progress. Without an evolutionary leap beyond dependence on an outmoded asset allocation framework, this whole thing is going nowhere in a big way.
The tools and theoretical perspective used to develop asset allocation strategies by many institutional consultants, advisers, private banks and retail platforms have been much slower to evolve than the innovations in investment products used to implement them. Regrettably, asset allocation theory remains stuck in pre-crash ways of looking at the world. No, not the crash of 2008, I mean 1987.
There is a long list of justifiable criticisms against modern portfolio theory and the tenets of the traditional approach to asset allocation. Key for the fund industry is that it forces investors into a framework of bipolar thinking. Funds are considered as either traditional or alternative and allocated to accordingly.
It is too often the case that the distinction is made arbitrarily by considering the wrapper and a broad categorisation or pre-determined peer group. The particulars of underlying investment strategy and the potential benefits on the overall portfolio get overlooked.
The development of what are considered by many as alternative investments was not solely an active construct on the part of the industry but reflected the inability of asset allocation modelling to categorise a range of products that did not fit a certain pre-defined mould.
While there are asset classes and investment approaches that must be considered as distinct from the core of the portfolio, there are funds using alternative strategies which should be considered alongside traditional investments.
The topic moves from theory to reality with Newcits funds. As approaches to asset allocation begin to slowly evolve and the universe of Newcits funds grows and matures, selectors will search from a significantly broader universe of managers than they do today.
Along with benchmark relative managers and index-linked products, selectors will integrate the analysis and potential inclusion of increasingly flexible and unconstrained managers in the same space. Though it does not provide a complete solution to our asset allocation problems, it gets the ball rolling.
Take for example the way selectors look at the broad group of equity funds investing in emerging markets. Between narrowly-focused index tracking ‘long only’ managers and the most aggressive, concentrated and illiquidity-seeking go-anywhere long/short managers, which remain offshore, is a rich variety of funds. It is becoming increasingly clear that investment products are more accurately considered along a spectrum than simply in two distinct buckets.
Funds within a particular group can be sorted by using several factors including liquidity constraints, beta exposures or expected risk/return. This means of analysis is at the heart of the current discussions about how a Ucits version of a hedge fund translates a given underlying strategy. Analysing the differences between funds managed by the same manager/process is a crucial exercise for analysts.
In most portfolios, a disproportionately large percentage, say 80-95%, is allocated to traditional assets. The remaining small percentage is allocated to other investment strategies that are not included in the mainstream of the portfolio. But within what has been considered alternative in a pre-Newcits world are a broad range of strategies that more closely resemble their traditional cousins than many had acknowledged.
To start, it is clear that equity long/short and a wide variety of credit/fixed income strategies exhibit significant correlations and beta with the asset classes in which they seek to generate performance. As appropriate, these types of strategies will be considered for inclusion in the broad categories in the main portion of the portfolio.
Diversification of potential alpha contributors is increased, while manager risk and dependencies are reduced. Optimisation of multiple funds within a portfolio takes on new dimensions.
Before the mass on-shoring of hedge fund strategies, Ucits had already become the regulatory framework of choice for the majority of well-established onshore managers selling cross-borders. Innovative investment strategies were already being launched years ago.
This progress was met with far less excitement than the current launches from hedge funds, but the implications for the current opportunity were no less important. It laid crucial groundwork in the progression of skills, operational and investment know-how of managers who were expanding beyond their benchmark constraints.
Analysts seeking to expand their universe of fund opportunities will need to do their homework. It should not be assumed that all long/short managers are appropriate for inclusion. An expanding universe certainly complicates the role and job of the selector – but this has been coming for years.
It positively encourages the increased coordination and the breaking down of the walls between the alternative and long-only camps, and the analysts of funds of all types. This is not too tough – those walls are paper thin anyway.