David Swensen, Yale’s endowment manager, recently delivered a lecture in London to an audience of charity trustees. Forget stock picking and market timing, he told them: asset allocation — the choice between broad classes of assets, such as equities and bonds — is the only investment decision that adds value.
Mr Swensen justified his conclusion by pointing out that both stock picking and market timing are necessarily zero sum activities: one investor’s gain is necessarily another’s loss. In truth, all secondary market trade is zero sum: only investment activity that improves the return on the underlying assets can benefit savers taken as a whole.
His claim finds stronger support in the research of Roger Ibbotson and Paul Kaplan, who analysed the dispersion of investment returns across a sample of fund managers and found that asset allocation accounts for most of the variance.
But here again there is a subversive explanation. Most institutions hold very similar equity portfolios. Asset allocation appears to matter because variation in equity proportions accounts for most observed differentiation of investment strategy.
The keys to Mr Swensen’s success lay in a high equity exposure and in becoming an early, and large, investor in successful private equity and hedge funds. But the title of the book he wrote about his approach — Unconventional Success — reveals its limitations. The first hedge funds and private equity funds were often run by talented individuals with idiosyncratic styles. As other investors piled into these “alternative” investments, these came increasingly to resemble mainstream portfolios but with much higher fees.
That evolution reveals a general problem in emphasising asset allocation. Conventional asset categories are largely arbitrary and change their meaning over time. Investors have mostly come to recognise that the distinction between domestic and overseas equities lacks relevance. One way of gaining emerging market exposure is to buy western companies whose brands are prized by China’s rapidly expanding middle class. Shell and ExxonMobil, like GSK and Pfizer, resemble each other more than they resemble other companies whose head offices are located in the same jurisdiction.
The issue goes wider, however. Owning property occupied by a supermarket may not be very different from owning shares in the supermarket, as recent pressure on the sector has demonstrated. Yet perhaps there is a difference. Financial engineering via sale and leaseback deals from large food retailers created investment opportunities that were classified as “property” but in fact bore more resemblance to inflation-linked bonds.
The proliferation of complex securities made it more necessary to inquire into the exact determinants of the underlying cash flows on which the security was based; but the global financial crisis showed that many investors had not really understood this, or did not much care so long as a rating agency gave the answer they sought.
Diversification is essential to prudent investment but the herding behaviour of modern investors means that in the short term almost every asset is correlated with every other, even if the underlying characteristics of the assets are completely different. Quantitative easing has boosted all asset prices and exacerbated this problem.
The consolation for charity trustees is that their time horizons are long enough that they should not have to care. There are two questions: what is the expected absolute return; and how differentiated are the determinants of these cash flows from those already held in the portfolio? Asset allocation should be the outcome, not the driver, of such decisions.
This article was first published in the Financial Times on June 3rd, 2015.