You have to run faster just to stand still. That's the message in Bill Bernstein's recent e-book Skating Where the Puck Was: The Correlation Game in a Flat World. As markets become ever more globalized, and the financial industry persists in securitizing assets that were once obscure, earning a risk premium at a given level while keeping a lid on risk becomes increasingly difficult. That's old news, of course, but it's forever topical, as Bernstein reminds.
This timely monograph tells us that the challenge of managing assets isn't getting easier, despite the proliferation of exchange-traded products that tap into a broader array of assets. Huh? On first glance, it appears that this trend means that the odds of success in portfolio matters are moving in our favor. For instance, by my reckoning there are at least 14 major asset classes available in ETFs-15, if you include cash. There are many more, of course, if you slice and dice the list into more granular definitions. Meantime, several asset groups are relatively recent arrivals as publicly traded products. In sum, it's never been easier to build a broadly diversified portfolio. That's at once good news, and bad.
The financial industry's habit of securitizing more asset classes is productive for investors because it opens the door for expanding strategic horizons and tapping into risk factors that aren't tightly correlated with the usual suspects. The problem is that good news travels fast. As the crowd loads up on "new" asset classes, the features that made these markets so attractive in the first place-low correlations with traditional assets and relatively high expected returns-tend to fade as a general proposition. In other words, correlations across asset classes tend to rise while expected return falls as more investors chase a finite supply of assets.
"Elders of the investment tribe long enough in tooth will recall the refrain of a popular song from the distant 1970s," Bernstein writes. "'Call someplace paradise, kiss it goodbye.' Well, the same is generally true of diversifying asset classes: as soon as a new one gets discovererd, it's already gone."
That's not exactly news, even if we like to pretend otherwise. But it does present a challenge, as it always has and always will. As Gary Brinson explained in 1995 in The Portable MBA in Investment,
Market risk varies across assets, reflecting different volatilities and correlations with the market. There, the risk premium must vary from asset to asset. And what of the other component of risk, the nonsystematic portion that is unrelated to the market? [The capital asset pricing model] predicts that, in equilibrium, investors should expect to be compensated directly only for the market or systematic component of an asset's risk. In the end, there is no compensation for nonsystematic risk, because it can be diversified away.
As investors diversify away the various risks by broadening their asset allocation and taking advantage of a wider spectrum of risk factors, the expected return for the global portfolio inevitably falls. Market efficiency, we might say, rises through time. Okay, so what to do? We might start by lowering expectations. If you diversify broadly and take a passive approach to asset allocation (i.e., buy and hold), your realized risk premium will probably decline. Exactly how far it falls and how fast is debatable, but it's reasonable to assume that the return on the "market portfolio" is destined to slide, albeit slowly and perhaps imperceptibly in the short run, but slide it will.
Don't confuse this point with assuming that beating the market portfolio will get easier through time. Assuming otherwise has long been a fool's errand, as I recently discussed. It's still possible-likely, in fact-that everyone will be earning less and still find it difficult to deliver benchmark-beating returns. But I digress.
The good news is that there's no law that says you must be totally passive on asset allocation at all times. There are two broad choices available for earning a premium over the market portfolio benchmark. First, hold a portfolio that differs from Mr. Market's asset allocation. Overweight this, underweight that, trade this, trade that, or ignore certain asset classes entirely. Ideally, such decisions will be informed by your high-confidence forecasts of risk premia (along with some intuition about where we are in the business cycle).
That's a high bar for most investors, which leaves us to consider rebalancing-the second major opportunity for earning a superior risk premium vs. what you'll earn simply by buying and holding the unmanaged market portfolio. History suggests that periodic rebalancing is both a risk-management tool and a performance-enhancing strategy. There are good reasons for assuming no less going forward, although quite a lot of our capacity for excelling on those fronts-especially with performance-depends on how much discipline we can muster in managing our emotions at critical periods, i.e., times of high market volatility. Buying stocks in the fall of 2008 is one of the more trenchant examples from recent experience. Indeed, most of us were selling at the point, just as most of us were buying in 2007 and early 2008. But again, I digress.
Ultimately, the solution to overcoming, or at least slowing, the challenge that Bernstein outlines is one of doing a better job at rebalancing. This means spending more time monitoring and analyzing the interactions of asset classes and becoming more deeply attuned to the associated opportunities and risks. It's also a good idea to do all this more frequently in search of opportunities that might be overlooked by reviewing the portfolio, say, once a month or quarter.
In other words, more of the same, with a bit more intensity. It's been clear for some time that the capital and commodity markets are dynamic. Expected return and risk aren't constant, but in fact fluctuate, sometimes violently. Therein lies the hazard… and the possibility for strategic salvation. Asset allocation, in short, should be dynamic in a world of dynamic markets. That's no sure path to success. But neither is sitting idly by and watching returns on an unmanaged portfolio fade ever deeper into mediocrity.