Altering allocation to account for new risks

Asset allocation deals with a lot of assumptions about the return projection of asset classes and the correlation of assets within a portfolio. Unfortunately, lessons from this most recent downturn mean investors may have to rethink those assumptions, one seasoned asset allocation strategist says.

At the recent CFA Institute’s Annual Conference in Orlando, Darren Sasveld, a chartered financial analyst and senior investment strategist with Strategic Investment Group, gave a presentation called Asset Allocation in the Presence of Fat Tails.

Fat tails are typically periods in a marketplace when market return standard deviation goes much wider than with a traditional norm. It gets the moniker from the shape of this event on a chart that tracks the standard deviation of returns, in which it creates a curve with wide-tail ends.

Sasveld’s first point was that high volatility is not unprecedented; investors are not entering uncharted waters. Working back to the Great Depression, investors will see there are historical precedents for some of the events happening now. Only that time period gives some template of what has happened to the debt markets where unprecedented default levels have been priced into non-government bond yields.

“The unwind of the dotcom bubble in the late 1990s would have been impossible to forecast on a monthly or even quarterly basis without appropriate weight given to the Great Depression,” he said. “The last year or two has essentially been a 100-year flood for credit. I think it’s excusable that asset allocators could — in regard to capital market expectations — build expectations that didn’t include Great Depression levels for investment grade credit.”

When it comes to equities, he said there have been plenty of precedents for the downturn.

“There is no excuse for saying this was ‘unforecastable’ on equities,” Sasveld said. “We’ve been here before in the 1970s; we’ve been here in the late 1980s; we’ve seen the unwind of the dotcom bubble and the Great Depression in the U.S. and U.K. [create three standard deviation events],” he said.

Still, with 70 years of market history, it’s difficult to determine just which market cycle is the most instructive for opportunities that may present themselves in the future.

Sasveld suggests that asset allocation strategists might want to ignore the period from 1966 to the mid-1990s, since the economic factors of today seem quite detached from the reality experienced during those 30 years.

“If you look at the period from the 1960s to the mid-1990s, I think you have to ask yourself whether that period is really relevant for the world of the near future, which looks at a dramatically lower interest rate regime for a variety of countries and a zero or negative fixed-income correlation to equities in virtually almost every market in the world,” he said.

Lower return expectations

Sasveld warned that, apart from a rally in equities from the bottom of this bear market, investors have to brace themselves for much lower risk premiums on equities in the future. This is partially due to the fact that national economies continue to stabilize over a long-term horizon.

“If you look at GDP volatility in each of the four major regions in the world, the three- year rolling volatility of real GDP has actually declined dramatically from the 1970s until now with one exception, which is emerging markets,” he said. “The current observations are troubling in that GDP volatility is rising. So it’s not necessarily a Goldilocks situation [of low inflation and moderate growth].”

Once economic recovery takes hold, there may not be the levers that existed in the previous bull markets to drive market returns to new highs — most notably, Sasveld pointed out, there will be less leverage, less of a “functioning” banking system to facilitate financial growth.

Industrial production in countries like Japan continues to plummet, so the ability of industrialized economies to fuel real growth at a torrid pace seems unlikely.

In fact, even during the last two big bull markets, Sasveld pointed out that real income growth for companies was nowhere near their earnings per share (EPS). He compared the S&P 500’s operating EPS to the National Income and Product Account (NIPA) earnings, and found real earnings growth was fairly flat.

“These are real economic earnings from the Bureau of Economic Analysis, in the United States. You’ll note that, during the dotcom bubble, the NIPA earnings do not show the excesses of that two- or three-year period. It was flat for a long time,” he said. “Even during the most recent period, the NIPA earnings were flat in terms of earnings growth in 2008 and part of 2007. It would have been possible by the fall of 2008 to realize there was a clear difference between what companies said they were doing and what they were [actually earning].”

Opportunities in credit

Sasveld’s seven-year return outlook for credit surpasses his expectations for equities. For some of the most beaten-down sectors like the U.S. residential mortgage-backed securities, expected annualized returns could surpass 10% as the asset class comes off record high default rates being priced in.

The same sort of logic could apply to U.S. high-yield corporate debt. A depression level default rates are priced in, assuming the catastrophic economic lows of the Depression are not repeated, then there is a nice margin to work with as credit yields come off their record highs. If a historical default rate of 15% was attributed to corporate high-yield debt, there could be a significant return.

“From a top down macro perspective, the ultimate expectation is 25% default and 35% recovery for high yield; that’s pretty outrageous compared to history. That’s the highest default rate on record for high-yield bonds,” he said.

Sasveld said that, in the credit environment, investors now have to pay attention to what was previously a small concern — government policy. Trillions have been earmarked by the U.S. to fight the financial crisis in various stimulus packages. Much of this money is being funneled into the credit markets directly.

Sasveld noted that the most effective measure thus far has been the Temporary Liquidity Guarantee Program, which is used to insure the default risk on designated securities. The preference on this has been to backstop residential mortgage-backed securities.

He suggested there could be a wide divergence in performance between residential mortgages and commercial mortgage-backed securities, depending on how government money is deployed.

Lessons from institutional portfolios

Liquidity management should be a key pillar of portfolio management, Sasveld said. Otherwise, well diversified portfolios have been obliterated in this downturn by an inability to sell assets.

When selecting an asset class, Sasveld says portfolio managers now need to cover off the portfolio’s risk by ensuring an even balance between assets that could be sold if there is a need to raise capital, and non-liquid assets that have long-term growth potential.

Even more fundamental is an acknowledgement that managing downside risk is more important than future gains. There is a recognition by pension managers that chasing extra basis points of returns on high growth/higher risk assets should be avoided if the fund already has its future liabilities funded.

This means setting up an asset allocation that is designed to meet specific and targeted goals. Reaching those goals is more important than adding risk to the portfolio to chase returns.

For “those in our business who say ‘expect the unexpected,’ sometimes the unexpected is a reversion to some sort of equilibrium. I think HNW individuals [still] have to be careful not to get too aggressive in their asset allocation policy,” he said. “For pension funds that are fully funded, there is no reason for them not to lock down [their strategy] and become a liability-driven investor. [In the U.S.,] the excise tax on corporate pension plans removes the incentive of generating returns above your liability.”

(05/19/09)