a Fail-Safe Strategy Sends Investors Scrambling
By TOM LAURICELLA
of the Wall Street Journal.
stood before a group of fellow financial advisers recently and voiced frustration
and fear that a fundamental tenet of investing had been proved wrong.
name is Carl, and I'm a recovering asset-allocationist," the Raymond
James Financial adviser quipped.
a bedrock of investing for decades, appeared to fail miserably in 2008. The
conviction shared by most investors -- that they should spread their money
across myriad asset classes to minimize losses -- was shaken as nearly all
markets tumbled in unison.
crisis has sent many financial advisers, academics and investors back to the
drawing board. Mr. Mahler told the group he was rewriting the playbook he
had followed for much of his 41 years in the markets. "Asset allocation
did not work," he says. "Everything went into the abyss."
came away from the carnage believing that last year was an anomaly -- that,
in times of severe stress like that experienced in 2008, disparate markets
will all tumble together as investors scramble to sell whatever they can and
move into cash.
But a number
of influential investors and analysts, from managers of massive funds such
as Pacific Investment Management Co., or Pimco, to those at small school endowments,
argue that asset-allocation strategies are fundamentally flawed. This wasn't
a one-off failure, they say, but one that's been long in the making.
increasingly seeing a breakdown" of perceived relationships between asset
classes, says Mohamed El-Erian, co-chief investment officer at Pimco. "And
that was way before the latest phase in the markets, which accentuated the
Mr. El-Erian contend that the problems warrant rethinking those relationships
to account for broad changes in the global economy and financial innovations
that change the way people invest.
agrees. Last month, Fidelity Investments issued a report to clients defending
the strategy. "Diversification didn't fail in the recent market downturn.
It worked -- just to a lesser degree," the report said.
On the surface, diversification is a simple concept: Combine investments that
don't move up or down at the same time, or at least by the same degree. The
goal is to smooth out returns, to hedge portfolios against big losses on single
investments, and to position investors to benefit if one corner of the market
posts outsize gains.
spawned a whole range of investment options. Among the most popular are target-date
mutual funds, which offer a mix of stocks and bonds tailored to the investor's
age, wealth and risk tolerance. Some investors in these funds lost so much
money last year that they would have been better off putting their money into
a stock-index fund.
By the time
the Standard & Poor's 500 stock index hit its recent low on March 9 --
a decline of 47% from a year earlier -- nearly four dozen target-date funds
had done even worse, including funds from Goldman Sachs Group, OppenheimerFunds
and Alliance Bernstein. At Fidelity, one of the leaders in such funds, the
Freedom 2050 Fund lost 48% in the 12 months ended March 9.
The theory of
asset allocation emerged in the 1950s when economists such as Harry Markowitz,
who would later win a Nobel Prize for his work, developed mathematical models
for ways to improve investment portfolios.
Along the way,
asset allocation became ingrained in nearly every corner of Wall Street. For
brokers, tinkering with asset allocations was among the basket of services
for which they charged clients flat fees year after year. Pension-fund consultants
built a lucrative business screening money managers.
companies, asset allocation was a cornerstone of their buy-and-hold philosophy,
which helped them hang onto assets. They expanded their businesses beyond
plain-vanilla stocks and bonds to funds that reaped higher fees. Target-date
funds have become the centerpiece of most 401(k) plans.
Yet in recent
years, while Wall Street was promoting diversification and formulas that purported
to capitalize on it, the relationships among asset classes were changing.
Investments that weren't supposed to move in sync, such as stock markets on
opposite sides of the globe, had begun moving in similar ways. That reduced
the benefits of diversification through asset allocation.
is a statistical measure of the degree to which investment returns move together.
Between 1991 and 1994, the correlation between the S&P 500 index and high-yield
bonds was low, at 0.2 or 0.3, according to Pimco statistics. (A correlation
of 1 means returns move in perfect sync.) International stocks had a correlation
with the S&P 500 of 0.3 or 0.4, and real-estate investment trusts had
a correlation of 0.3, according to Pimco data. Commodities showed little correlation
to U.S. stocks.
By early 2008,
investment categories of just about every stripe were moving significantly
more in sync with the S&P 500. The correlation on international stocks
and high-yield bonds rose to 0.7 or 0.8, and real-estate investment trusts
to 0.6 or 0.7, according to Pimco's data for the previous three years. Commodities
were showing a slightly negative correlation -- returns were moving in opposite
direction -- of 0.2 or 0.3, the data indicate.
Then came the
meltdown of 2008. In a year when the S&P 500 lost 37%, the MSCI index
of major markets in Europe, Asia and Australia lost 45%. The MSCI emerging-markets
index fell 55%. Real-estate investment trusts declined 37%, high-yield bonds
lost 26% and commodities fell 37%.
At Pimco, the firm's head of analytics, Vineer Bhansali, points to commodities
as an example of how diversification strategies can break down. Even as stocks
and bonds struggled in early 2008, commodity prices were in the midst of a
historic rally. Wall Street rolled out research showing the lack of correlation
between stocks and commodities.
But that history
didn't take an important point into consideration. Prior to this decade, investing
in commodities was a complicated process due to the complexity of the futures
markets. The advent of exchange-traded mutual funds, or ETFs, allowed investors
to buy and sell commodities with the click of a mouse. By the summer of 2008,
ETF investors had poured billions into commodities in just a few months.
As the financial
crisis worsened and stock and bond prices collapsed, ETF investors who needed
to raise money found it easy to bail out of commodities, too. That contributed
to a 37% drop for 2008 in the Dow Jones AIG Commodities Index.
start buying an asset, the act of them diversifying ultimately makes the asset
less of a diversifier," says Pimco's Mr. Bhansali.
who until this month oversaw Wake Forest University's entire $1 billion endowment,
felt this firsthand in the school's portfolio.
A $90 million
portion of the endowment, called the Tactical Fund and still managed by Mr.
Morrell, held everything from commodities to emerging-market and big-cap stocks.
Mr. Morrell, involved with money management since 1968, had honed a strategy
based on the idea that you could have a portfolio filled with investments
ordinarily considered risky and volatile -- but if they didn't move in sync,
you could have higher returns without higher risk. For many years, it worked,
even during bear markets. During 2001, for example, the Tactical Fund lost
0.1% while the S&P 500 dropped 15%.
Last June, the
Tactical Fund had nearly 30% invested in commodities, 16% in emerging markets,
19% in other non-U.S. stocks, and 24% in U.S. stocks -- investments that historically
didn't move much in tandem.
clobbered," he says. The Tactical Fund lost 44% last year and the overall
endowment fell 25%. Late last year, he and his team began working on a new
allocation strategy. Rather than treating large-cap U.S. stocks, emerging-market
stocks and international stocks as separate categories, the team put them
under one "stocks" umbrella. They also switched their view on commodities
and gold, which they felt were linked more to inflation than to stocks.
Fund still has a healthy slug of commodities as an inflation hedge, and emerging-market
stocks now make up 24%. Corporate and government bonds account for 14% of
the portfolio, down from 42% at the end of March. Thus far, the new approach
is paying off. The Tactical Fund is up 14% this year, through Tuesday, compared
to a 2.5% drop in the S&P 500.
strategies were mathematically correct and gave a sense of a lot of discipline,"
Mr. Morrell says. However, "they were too backward-looking."
Associates, a Chicago firm specializing in asset-allocation strategies for
big investors such as pensions and mutual funds, chief economist Michele Gambera
also has gone back to the drawing board. It's been a topic on his mind for
the past two years, he says, but 2008 heightened his scrutiny. "There
have been reasons to question diversification, no doubt about that,"
he says. "It's been humbling."
says a telling picture emerges by tracking performance during extreme market
moves. He found that many investments can do more damage on the way down than
they do good on the way up.
in months where U.S. stocks rose more than 6%, European stocks rose on average
by three-quarters as much, and Japanese stocks by half as much, according
But when the
U.S. market fell by more than 4.5% in a month, Europe and Japan tracked the
declines far more closely. Stocks in Europe on average posted declines equaling
86% of the U.S. drop, and in Japan, 66%. Real-estate investment trusts matched
about half of the U.S. market gains in the best scenarios, but two-thirds
of the declines.
it's important to add an investment for diversification, people have to consider
the costs," he says. "And we're learning that there are a lot of
implicit stock-market bets in a lot of asset classes."
As Mr. Gambera
sliced and diced the numbers, he concluded that only a few asset classes besides
cash proved to repeatedly help a portfolio during a sharp decline. He determined
that in the 45 months since 1973 where the U.S. stock market lost more than
4.5%, gold produced positive returns 71% of the time, and intermediate-term
government bonds, 67% of the time. During the 20 big monthly declines for
stocks since the launch in 1997 of Treasury Inflation Protected Securities
-- government bonds whose payout is adjusted for inflation -- TIPS provided
gains 85% of the time.
As a result, Mr. Gambera says, Ibbotson is now recommending bigger holdings
of U.S. Treasurys for certain clients.
At Raymond James, Mr. Mahler also has retooled the way he builds portfolios.
This was no easy decision, he says. Even after the bear market that ended
in 2002, he didn't make any changes to his models.
I lived and breathed," he says. He is keeping the basic structure of
his portfolios, but he's adding money managers with a go-anywhere mandate,
including actively betting against stocks by going short.
He is coupling
that with greater cash holdings in accounts. His goal is to make a portion
of clients' portfolios more flexible, while at the same providing a greater
cushion for whenever stocks next decline.
He says he is
convinced there is a way to make diversification work. In fact, after the
strains of last year, he says, many investments are behaving more like they
did before 2008.
he says, "might well have been injured....But I don't think it's gone