Returns, risk management and free lunches

This article appears in the February 2021 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

While Milton Friedman and others maintain that there’s no free lunch when it comes to investing, Harry Markowitz’s modern portfolio theory (MPT) claimed an exception: diversification could offer less volatility without sacrificing return.

MPT uses diversification as its main risk management tool and, for almost 70 years, both individual and institutional portfolios have pursued non-correlated returns. The low correlation between stocks and bonds went negative in the late 1990s: stock prices went up when bond prices went down and vice versa, improving risk control.

But today’s low nominal interest rates and negative real rates make it costly to use bonds for diversification. Should traditional 60/40 portfolios be abandoned to reflect the performance drag of bonds? [Read more about this on p. 12.] Should alternative asset classes and strategies, increasingly available via ETFs, replace them? What about pension plans charged with achieving 4% to 6% real rates of return while benchmark 10-year government bonds yield less than 1%? What message do negative real-return bond yields send to retirees?

In short, how much are you willing to pay for diversification?

The cost of diversification

Diversification is not a new idea. Antonio in Shakespeare’s The Merchant of Venice found that limiting exposure and spreading risks between ships, destinations and across time was sound policy, declaring “My ventures are not in one bottom trusted.”

Today, affordable ETFs that are mostly individual packages of pre-diversified risks offer exposure to a growing list of both conventional and exotic strategies.

Thinking about diversification has changed over time. The Harvard endowment — America’s largest at US$41.9 billion as of June 30 — listed holdings of only two asset classes in 1980: stocks and bonds. By 1991, the fund had added real estate, private equity, foreign equity and leverage. By 2013, there were 13 asset classes.

But beware: the Harvard Management Corporation, responsible for investing the endowment, has had five CEOs since 2005; the current boss fired half the 230-person staff in 2017. Poor returns have plagued the fund. Harvard’s experience should warn advisors that broad diversification alone is not enough.

Alternatives

Alternative investments are different than mainstream long-only assets and strategies. Foreign equities, real estate and commodities were considered alternatives 30 years ago; today, private equity, private debt, infrastructure and hedge fund strategies qualify.

There were 27 alternative ETFs in Canada with a combined $1.3 billion in assets as of September 2020, according to National Bank. If we include leveraged, short, option-hedged, derivative-based and commodities strategies, listed alternative assets in Canada surpass $10 billion.

How should these products be used? Reducing volatility allows portfolio returns to compound more efficiently, but bonds can also do this. Investors shouldn’t forget about returns when shopping for alternatives (remember Harvard).

Procedural quirks make some alternatives appear more useful than they are. Examples are real estate, private equity and private bond investments that value their portfolios “infrequently,” leading to a lag in actual valuation but providing low price volatility. Regulatory valuations are more rigorous today but pricing methodology still requires scrutiny.

Without public market pricing, some assets demonstrate an “illiquidity premium.” This can be a two-edged sword, as anyone trying to redeem one of these funds during 2020 knows.

Infrastructure projects like roads, highways and power plants provide low but stable long-term returns for investors, perfect for meeting long-term liabilities like defined benefit pension obligations. Most publicly traded vehicles labelled “infrastructure” invest in companies involved in the design and construction of the projects, not the developments themselves. The risks and rewards are different.

Data have shown that active managers usually fail to outperform broad indexes, contributing to the growing popularity of low-cost passive ETFs. Alternative strategies should be viewed similarly.

Performance histories are not long enough yet in Canada for comprehensive analysis of most alternative fund strategies, but their fees are known. Average asset-weighted management expense ratios (MERs) range between 0.90% and 1.00%.

Many alternative investments also have performance fees. Investors like the idea of performance fees because compensating managers for doing a good job makes sense. Today’s fees are lower than the traditional two-and-twenty model. But performance fees can still provide incentive for some managers to take outsized risks. Manager payoffs can be huge relative to their own investment as they leverage investor capital when swinging for the fences. MERs compensate them when they fail, which can misalign the risks.

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.