The Final Frontier Of Investing

Financial researchers have had great success over the years in deciphering some of the mysteries of asset pricing. Much of it boils down to recognizing that the source of excess returns—risk premiums—can be traced to various betas, or specific types of market risks, or factors or investment anomalies or whatever term you prefer. As productive as this effort has been, it’s only half the battle. The next phase of deciphering Mr. Market’s secrets—indeed, the critical phase—has only just begun. Figuring out how to efficiently manage risk factors–dynamic asset allocation—is still in its infancy. Nonetheless, this is the holy grail of investment strategy.

That’s old news, of course. Financial economists are already in hot pursuit of this strategic quarry. A recent study, for instance, surveys a broad array of return predictors and considers how they compare for managing portfolios. In fact, if we look back over recent decades, it’s clear that the possibilities are extensive for forecasting risk premiums across the major asset classes. There’s lots of hazards, of course, but we’re not quite so blind as it appeared in years past.
“Expected returns are now commonly seen as driven by multiple factors,” writes Antti Ilmanen in the recently published Expected Returns: An Investor’s Guide to Harvesting Market Rewards. Dissecting these factors is the first step to building better models and making superior forecasts. It’s hard work, but success never comes easy. The big change in finance is that there’s a reliable map to follow.
Having identified a rich array of factors linked to risk premiums, the challenge of how to manage these sources of excess returns is receiving more attention—in academia and in the general investing community. “Investing success does not come in one flavor,” notes financial writer Lawrence Light in his new book Taming the Beast: Wall Street’s Imperfect Answers to Making Money “Many strategies must be explored to get to that blessed state where you can say, ‘I’ve got plenty of money to sustain me, thank God'” He goes on to explain,

The new approaches to investing that have sprung up each have devoted adherents. The trick is to be sufficiently flexible to dip into any or all of them, but by the same token know their limitations.

Indeed, there’s a rainbow of risk factors at our collective fingertips, as the exploding menu of ETFs and ETNs reminds. Some betas that were once considered the sole province of active managers are now repackaged as investable indexes.
The investment theory for managing these betas is still very much a work in progress, however. It’s fair to say that while cataloguing the broad spectrum of risk factors has become quite sophisticated and routine, the equivalent for dynamic asset allocation is comparatively undeveloped.
That’s not surprising since recognizing, classifying and evaluating risk in all its variations is the first step in this process. With a fair amount of progress under the industry’s belt, it’s only natural that financial economics as well as practical-minded investors are turning to the final frontier: asset allocation.
Unfortunately, this obvious research focus isn’t going to give up its secrets easily or quickly. In contrast with looking for the drivers of risk premia, asset allocation revelations are problematic because the solutions, such as they are, tend to be investor specific. My optimal asset allocation may be irrelevant or even dangerous for you. That’s not fatal for analyzing portfolio strategy, but it surely makes life more difficult.
Difficult or not, the research on asset allocation is essential. The good news is that this thorny but fundamental topic is being analyzed from multiple angles by a growing number of researchers and investment practitioners. (For example, see this recent survey of literature on the connection between asset allocation and systemic risk; also, consider this intriguing study on tactical asset allocation and a complementary analysis here.)
It was probably inevitable that asset allocation would become the prime focus ever since Markowitz established the framework of modern finance in his celebrated 1952 paper “Portfolio Selection.” Markowitz’s seminal work, and his elaborate follow-up book, has guided financial economics over the years. The revelations inspired by this research to date are nothing short of extraordinary, as Ilmanen’s book reminds. But the grandest discoveries for investing are yet to come.
It’s hard to overestimate the importance of developing intuition for anticipating risk premia. This, after all, is at the core of investing. But peeling away some of the mystery about how risk premiums interact, and what that implies for blending them to generate a more efficient risk-return tradeoff, is a much-bigger prize. What we really need is a general theory for asset allocation. Unfortunately, all we have at the moment is an awkward mix of rough rules of thumb and a patchwork of theory. Meanwhile, the world awaits the Markowitz of asset allocation. He or she is out there somewhere.