A New Chapter For Narrative Risk

The Economist reports that “money is leaving emerging markets for riskier bets at the investment frontier.” So-called frontier markets are the new new thing in the frantic search for hot asset classes. “The rising interest is in part because GDP growth in China, Brazil and India has diminished. The things that made emerging markets exciting in the 1990s are now found in frontier markets, says Charlie Robertson of Renaissance Capital, an investment bank.”

Chasing returns is the oldest trick in the book in the world of investing, but it’s still a deeply misguided way to think about portfolio design and management if our time horizon extends beyond the next couple of months. There are no “good” or “bad” markets or asset classes, at least not inherently so. Instead, there’s a continually fluctuating set of attractive and unattractive expected returns. What was hot yesterday will turn cold tomorrow, and vice versa—across a wide spectrum of the capital and commodity markets. What we may think of as boring can become exciting courtesy of a fresh dose of volatility, and the transition works in reverse as well. The idea that particular corners of the global markets are permanently superior or inferior to others is setting you up for trouble. Indeed, there are powerful reasons for calling my first book Dynamic Asset Allocation.

The underlying logic isn’t open for debate. There’s a wide and deep pool of research that tells us that focusing on expected returns—as opposed to trailing returns—is a critical priority. One of my favorite books on this topic is Antti Ilmanen’s Expected Returns: An Investor’s Guide to Harvesting Market Rewards, a tour de force reference guide on the subject. Let’s just say that you can’t spend too much time on analyzing, projecting, and generally becoming intimate with ex ante performance. The stakes are high, really high.

Quite a lot of the mistakes that investors make can be traced back to flawed models, confusion and even total ignorance on the subject of expected returns. AQR Capital’s Cliff Asness, writing in the introduction to Ilmanen’s book, offers a powerful example:

Part of what we see as risk materializing during events like the 2008 financial crisis, and the 1999-2000 tech bubble, are more accurately seen as investors misunderstanding or misestimating expected returns. In both those cases the extreme denouement that followed occurred, at least according to many (and me), because before the disaster, investors were willing to accept far too low an expected return, first on stocks and specifically on technology stocks, and then a decade later on credit and real estate. In both the theory and the reality of these globe-shaking events, the discussions of risk and expected return are intimately linked.

In short, expected returns fluctuate. That empirical fact implies that we should spend a lot of our research budget on estimating expected returns. It’s an imperfect science, but a necessary one just the same. How to proceed? There are many analytical paths that can lead to the promised land, as Ilmanen’s book reminds. Being a contrarian investor to some degree helps. At the risk of oversimplification, let’s recognize that high returns tend to lead to low or negative returns, and vice versa. But just to keep us guessing, there’s the short-term tendency for return persistence (momentum) in the transition from one state to the other.

The art of investing is deciding how to navigate the reality that returns have a capacity for mean reversion over medium- and long-term time horizons while price momentum tends to dominate in the short run (up to one year or so). The basic message is that different asset classes offer different risk and return opportunities at different times. Granted, capturing the risk premia that’s associated with this volatility isn’t easy, although that’s largely due to our behavioral biases rather technical hurdles bound up with investment analytics.

In any case, there are some obvious places to start for boosting the odds for success with portfolio design and management. First, beware of investment narratives—this market’s hot, that one’s dirt and so it’s time to act in the extreme. Instead, invest across a broad spectrum of the major asset classes and spend a lot of time thinking about how and when to rebalance the mix. Along the way, keep an eye on the business cycle for some big-picture context. Indeed, quite a lot of what we think of as risk and reward is a byproduct of boom and bust in macro. Meanwhile, double up your efforts to ignore the qualitative judgments about markets based on trailing returns. Behavioral risk, after all, is forever tempting us to come over to the dark side.

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