Chris Wang's  Instablog

Safety is the key to sailing the high seas, and ships must carry enough lifeboats for everyone aboard.  Today, pension funds, institutions and individuals are managing risk by using the “unsinkable” model of diversification.  But in a year like 2008 where virtually all asset classes went down, where was the lifeboat?

Looking back

Institutional accounts were managed very differently than they are today.  Roughly 40 years ago, an institutional account was managed by one portfolio manager whose portfolio contained two asset classes: high quality blue chip stocks and intermediate US treasuries.  The goal was safety and growth with a long-term horizon.  Bear markets came frequently, every 3-4 years, with 20-25% declines and lasted 6 months to a year.  The manager could shift portfolio weightings between the two asset classes depending on his/her view of markets.  In a bear market, the accounts often went down 10-12% and then recovered quickly.  The set up was simple and worked.  The most important defensive part of the portfolio was intermediate treasuries, in essence the lifeboat.  The lifeboat was a necessary tool for the portfolio manager to manage risk in a declining market.    

Today

Over the past two decades, as pension assets grew, consultants played a bigger role and asset classes expanded rapidly.  With more complex investments, consultants hired more managers and provided thick reports for clients.  Meetings with portfolio managers took days.  Portfolio performance measurement and reporting became more complicated.  The emphasis was on diversification to include more risky assets.  Perversely, the fee structure paid lower fees for the management of safer instruments like US treasuries and large market cap stocks; and higher fees to manage small market cap, private equity, junk bonds, real estate, hedge funds, international equities, etc.  The more illiquid and risky the instruments, the higher the fees.  In each asset class, the portfolio manager bought hundreds of issues driven by the theory that diversification would remove risks and then there was no need to worry about the downside.  The safe instruments were de-emphasized; and in essence, the lifeboat was removed.

Unfortunately, the bear markets came just as frequently but more severely and longer lasting. The most recent experience showed that almost all asset classes, defied the theory that non-correlated assets do not behave the same, went down together.  The losses for institutional accounts were huge. 

Painted into a Corner

In a way, they have painted themselves into a corner.  Today, portfolio managers have their hands tied by investment guidelines.  They are forced to stay within their asset class and aren’t allowed to raise any cash.  Portfolio managers are forced to comply with these guidelines, and it’s going to be ugly unless the institutions remember that they need a lifeboat.  The lifeboat was removed and the industry said, “Don’t worry the ship won’t go down.” 

Back to the Future

The investment industry received a vicious wake up call last year as the market sunk and there were no lifeboats.  So what is needed?  Simplicity and back to basics investing.  The old fashioned vehicle was called a balanced fund which was simple and worked well.  The advantage of a balanced fund was the client could take cover when the market environment became hostile; the portfolio manager could adjust the asset mix quickly or slowly depending on the client’s risk tolerance and the volatility of the external environment.  Removing the balanced account is in essence removing the lifeboat.  Unfortunately, many individuals, guided by their financial planner or broker, followed the institutional approach diversifying into many asset classes.  Do you have a lifeboat?  It’s bad enough to go sailing when the hurricane is here, but it’s even worse to sail without a lifeboat.