by Mark Harrison, CFA
During the financial crisis, one mangled term to gain widespread use was "diworsification," the counterintuitive idea that carrying all your investment eggs in one basket might be a better idea than old-fashioned diversification. In recent years, tactical asset allocation and trading out of trouble seemed to protect capital better than traditional approaches. One recent study even suggested that concentrated portfolios may be completely rational for those investors with little financial wealth relative to income.
In contrast, during other investment eras some investors have actively managed portfolios with as many as a thousand constituents, in other words grossly over-diversified. For example Peter Lynch, an acclaimed Fidelity fund manager, was successful in running an expansive portfolio of outperforming large and smaller companies.
A primary duty of the fund industry, along all of its often complex chains of intermediaries, is to professionally execute choices to allocate investor capital between competing investments and ensure a good risk / reward trade-off for the investor, whatever market conditions might prevail. These choices traditionally begin at a client level by identifying client characteristics, objectives, and risk tolerances to better inform decisions. According to one recent study decision makers should take also careful account of human capital and behavioral biases.
At an asset allocation level, the challenge is usually to first consider strategic and tactical allocations, weigh assets between asset classes, set the allocation of domestic versus international, and determine the split between passive versus various more active techniques.
At a portfolio level, choices lie between particular security groups and within individual securities. Still helpful in evaluating all these choices is Harry Markowitz's famous explanation of the advantages of portfolio diversification, or modern portfolio theory, which manages risk using empirically derived historic means, standard deviations and correlations, or in Markowitz's terms, the process of mean-variance optimization.
In the financial crisis, as equities collapsed and bonds seemingly offered little upside, some asset allocators became intolerant of inflexible strategic asset allocations that did not seem to work at that moment in time. The development of a plethora of novel alternative asset classes and techniques may have hindered rather than helped asset allocators by offering additional and often untested choices which many institutions lacked the proper resources to evaluate and which had immature advisory infrastructures.
The good news is that portfolio optimization is now evolving. For example, Thomas M. Idzorek, CFA speaking at a recent CFA Institute conference, argued in favor of incorporating the higher moments of skewness and kurtosis, which are highly appropriate to increasingly popular alternative investments. According to Sébastien Page, CFA, speaking at another recent CFA Institute conference, asset allocation is developing to encompass forecasts driven by macroeconomics and risk factor diversification. In factor investing, assets are viewed as bundles of underlying risk factors which are used as the basis of diversification rather than using fixed definitions of equities and bond asset classes.
In one recent study about factor investing, Richard Roll from the University of California at Los Angeles argues that traditional correlation measures obscure true factor exposures across and within portfolios and should be de-emphasized. In another new study, a trio of authors suggest that the use of a dynamic asset class weighting framework based on fluctuating market liquidity conditions can enhance portfolio performance. Whether asset allocators are choosing traditional or alternative assets for their investors, the list of helpful and innovative tools and techniques seems to be a fast growing one.
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