Wealth Manager

There’s reason to wonder after a lengthy stretch that’s notable
for a conspicuous lack of red ink in markets around the globe.
Yes, some asset classes are showing signs of stress midway in
2007. REITs swooned in June, for example. But measured over the
past several years, gains still dominate losses as we go to press.
That’s worrying some investors. As veteran money manager Jeremy
Grantham of GMO recently put it in a research note to clients,
“It’s Everywhere, In Everything: The First Truly Global Bubble.”
No one’s complaining, of course—at least not anyone sitting
on tidy gains. In fact, some analysts take issue with the use of
the word “bubble.” Rising prices are warranted, thanks to a resilient
global economy and relatively low inflation, to name but
two reasons cited by the bulls. But the fact that the major asset
classes have been running higher since 2002 inspires
contrarian-minded questions, starting with: How much
protection will a conventional multi-asset class portfolio provide
in the years ahead?

Asset allocation’s value proposition flows from the historical
record that shows that owning a mix of assets with low and
negative correlations provides superior risk-adjusted returns in
the long run compared with a relatively undiversified portfolio.
Does the proposition break down if everything has taken wing
at the same time?

Few questioned the outlook for multi-asset-portfolios in the
past, in part because the strategy’s merits looked obvious. That
was due in no small part to the fact that a revolving mix of winners
and losers was almost always common among the broad,
conventional asset classes. In the unusual cases when everything
posted gains, the trend didn’t last.

In contrast, the current bull run is remarkable for its duration
and breadth. “So many asset classes have had massive run-ups
and almost everything is highly valued, or overvalued,” says Milton
Balbuena, chief investment strategist at Contango Capital
Advisors, Berkeley, Calif. “At some point, diversification isn’t
going to work very well [for conventional long-only portfolios],”
he predicts.

Perhaps, although statistically minded strategists may find
comfort in the varied matrix of trailing returns correlations between
the major asset classes. By that reasoning, one could argue
that the diversification value of holding the major asset classes
still looks compelling.

But correlations are just one factor in portfolio design. What’s
more, low and negative correlations don’t preclude future losses.
Neither do they insure that yesterday’s diversification will prevail
tomorrow.

For instance, based on recent history, REITs and commodities
still offer substantial degrees of independence relative to the
broad U.S. stock market. But all three asset classes have posted
strong gains in recent years, with only fleeting interruptions. For
some, the bull markets trump the correlations for calculating assumptions
of future risk and return.

Real estate and commodities “are losing their luster,” opines
Jerry Miccolis, senior financial advisor at Brinton Eaton Wealth
Advisors in Morristown, N.J. “As diversifiers, they’re not as good
as they used to be.”

In search of causes, some analysts blame the securitization
craze, which has transformed commodities and real estate, for
instance, into publicly traded products. The fear is that as a rising
slice of the planet’s assets are repackaged as ETFs and mutual
funds, Wall Street’s cycles of boom and bust will drive more segments
of the economy.

Another theory holds that globalization—and the related surge
in liquidity around the world—has spawned international bull
markets in everything from stocks and real estate to commodities
and art. Highlighting the spirit of the times is China’s recent
decision to diversify its foreign reserves by purchasing a stake in
the Blackstone Group, a private equity firm in New York.

Whatever the reason, independence among asset classes
seems to be falling. Perhaps it’s only temporary, but some worry
that when the cycle eventually turns—and the bears take charge—
the synchronous state of bull markets will unfold in reverse. If
so, portfolios that look diversified on a historical basis will in fact
be harboring far more risk than is generally assumed.

How should strategists respond? For many, the answer will
be more of the same: Diversification among the traditional
asset classes, tempered perhaps with higher allocations to the
original zero-correlation asset—cash. Others may embrace a
more frequent rebalancing strategy to exploit any sudden surge
in price volatility.

More ambitious types say that more fundamental change is
in order. “In a world where all the major asset classes are moving
together, what do you do?” asks Steve Persky, chief executive
officer of Los Angeles-based Dalton Advisors, which manages
money for wealthy clients and runs several limited partnerships
with specialty equity strategies. “You turn things a little bit away
from the traditional, accepted theory.”

For Dalton, that means shifting a portion of assets to equity
strategies that don’t fall under the usual headings. That includes
putting money into one or more of the firm’s proprietary funds.
One is what Persky calls an activist, concentrated approach on
Japanese small- and mid-cap stocks that are thought to be undervalued.
The strategy builds stakes in a half-dozen or so firms and
“works with management” as a lever for increasing share prices.
“It doesn’t fit neatly into a broadly diversified index strategy”
and therein lies the appeal, he reasons. “It’s volatile and it’s concentrated,
and it’s a way of diversifying a portfolio.”

Contango’s Balbuena holds up to 35 percent of client portfolios
in so-called absolute-return strategies. Contango uses a number
of funds and strategies, including Franklin Mutual Recovery. This
mutual fund has a broad and flexible mandate for investing in
stocks and bonds in pursuit of opportunities in bankruptcy/distressed
companies, risk arbitrage and undervalued stocks.
Brinton Eaton’s Miccolis hasn’t moved beyond the conventional
asset classes, but he’s considering the possibilities.
Among the choices under review: Covered calls and customized
structured notes for tapping risk/return profiles not otherwise
available in publicly traded vehicles.

Other possibilities include what Miccolis calls the alternative
commodity indices, such as the recently launched Rydex Managed
Futures, a mutual fund that tracks the S&P Directional Trading
Index. S&P DTI seeks to replicate the returns of the managed
futures industry with a mix of long and short positions in financial
and commodity futures.

Although Miccolis hasn’t made any final decisions, the fact
that he’s looking beyond the conventional long-only betas
speaks to the times. “All the things that we’ve been invested in
are getting more correlated,” he says. “Meanwhile, there are more
of these alternative/hybrid/synthesized asset classes coming on
line every day.”

On paper, some of the recent arrivals post the magical mix
of low correlation to traditional asset classes and respectable
performance. For example, last September’s IPO of PowerShares
DB G10 Currency ETF uses futures to replicate the so-called carry
trade—selling currencies with low yields while buying currencies
with higher yields. The ETF tracks a Deutsche Bank index that’s
always long the three highest yielding currencies and short the
lowest yielding ones among the G10 nations. The ETF is less than
a year old, but the index’s paper history boasts a low correlation
with the S&P 500 and equity-like performance.

The concept of adding something unusual, something different
to the standard asset allocation is pre-sold in 2007. One reason
can be found in the celebrations of David Swensen’s success
in managing Yale University’s endowment fund over the past 20
years. His use of alternative betas/ portfolio strategies is hailed
as proof that moving beyond the usual suspects can enhance
risk-adjusted results.

The past is clear on such choices, but the future may be more
complicated. One challenge is deciding if yesterday’s strategic
triumphs will look as impressive if the crowd follows Yale’s path.
History, after all, suggests that as money chases performance,
opportunity has an irritating fondness for receding.

There are other risks in trying to adapt Swensen’s ideas for
portfolios with individual clients—even wealthy ones. What’s
available for large institutional portfolios with long-term time
horizons can be problematic (if not entirely unavailable) for retail
accounts. Swensen’s use of private equity in the past, for instance,
is a tactic that’s still missing-in-action in its pure form for
the retail market.

Meanwhile, a related caveat comes from the pen of Harry Kat,
a finance professor at City University in London. Although he’s
a veteran advocate of the idea that a fair degree of hedge fund
returns can be minted with passive and semi-passive strategies,
not every effort on this front is a clear winner. It’s a timely
reminder now that new products have started capitalizing on
investable hedge fund indices. But caveat emptor still applies,
Kat warned in a recent essay that asserts that some of the new
benchmarks aren’t as alternative as some might think.

“The only [hedge fund] indices that can be replicated with reasonable
accuracy are the indices that contain so many different
funds that there is nothing hedge fund-like or ‘alternative’ about
them anymore,” Kat wrote.

His counsel comes just ahead of mutual
fund and ETF launches tied to said benchmarks.
But decomposing the underlying
factors that drive investable hedge fund
indices reveals a set of fairly conventional
betas, such as the S&P 500, Russell 2000,
MSCI EAFE, MSCI Emerging Markets and
U.S. Dollar Index exposures, according to
Kat’s analysis. In turn, that recipe minimizes—
if not destroys—the argument for
using investable hedge fund indices exclusively
as diversification agents.

Yet the list of alternative betas/strategies
repackaged in mutual funds and
exchange-traded securities is growing,
raising the possibility that genuine innovations
will become available. Perhaps,
then, the bigger challenge will be deciding
how to finance a reallocation to alternative
assets from an existing portfolio of
conventional design.

A recent paper in The Journal of Portfolio
Management, co-authored by the acclaimed
institutional strategist Martin Leibowitz,
asserts that choices about which asset
classes to cut back on are as important as
which asset classes to add when it comes
to managing a portfolio’s overall risk/return
profile. As an example, the article reviews
three ways to add a 20 percent REIT
allocation to a 60/40 stock/bond portfolio.
The first reduces stocks to a 40 percent
weighting; the second cuts bonds to 40
percent; the third takes 10 percent each
from stocks and bonds. The result: the
three new portfolios exhibit different expected
betas, volatilities and total returns
despite the fact that all hold a 20 percent
REIT weighting.

Then again, for all the worries about
asset allocation these days, the strategic
decisions will eventually become clearer
for those who can wait. What might
bring about a rise in clarity? A bear market
in one or more asset classes. History
is no iron-clad guide to the future,
but the past offers reason to think that
there’ll be a lot less ambiguity about
risk/reward tradeoffs in the wake of the
next prolonged sell-off.