Sunday, January 04, 2009

Investment Fiduciary Mulligan


Investors and investment fiduciaries may be wishing they could take a mulligan on their long term equity oriented investment strategies in the face of this decade’s second equity market implosion. Global equity (MSCI World) returns have been nil over the last decade ending November while global bond returns (MLGBM) were about 5.2% annualized.

Certainly, fiduciaries might surmise that, had they learned their lesson after the technology wreck in 2000, and either teed up a more conservative portfolio with less equity exposure or diversified their portfolios into alternative asset classes, they would be much better off today. Surprisingly this would not be the case. Since the market bottom in 2002 through November 2008, neither a more defensive asset allocation nor a more diversified allocation using alternative investments would have provided much relief.

Annualized returns for the period from the bear market bottom in October 2002 through November 2008 for various portfolios suggest that the positive equity returns enjoyed by investors over the intervening years was directly proportional to the losses they suffered in 2008. In other words, higher equity allocations lost a similar proportion of their past gains in 2008 as portfolios with lower equity allocations implying that the degree of equity allocation made only a modest difference in portfolio return over this period. The following benchmark portfolio returns illustrate this (Stocks=75% R3000, 25% MSCI EAFE, Bonds=Barclays US Aggr, rebalanced quarterly)

Portfolio 6Yr 1Mnth Return
Stock 80% Bonds 20%     4.16%
Stock 70% Bonds 30%     4.27%
Stock 60% Bonds 40%     4.36%
Stock 50% Bonds 50%     4.41%
Stock 40% Bonds 60%     4.43%
Stock 30% Bonds 70%     4.42%

Another investment strategy made popular by the large endowment funds was designed to diversify portfolios away from equity market risk. These strategies featured an asset allocation which included “alternative” investments. For all but the largest portfolios, this typically would have included allocations to real estate, commodities and hedge funds, through a fund of fund vehicle.

For comparison purposes we created a benchmark portfolio which included a 30% allocation to alternative assets (10% Wilshire global REITs, 10% HFRI Funds of Funds and 10% S&P GSCI) and an 80% allocation of remaining assets to stock and 20% to bonds. The 30% alternative portfolio returned 5.36% annualized for the 6 years through October 31, 2008 vs. 5.12% for the standard 80% stock 20% bond portfolio. The allocation to this set of alternative assets over this period added a modest .24% to portfolio returns (reduced porftolio volatility by a small amount) yet exposed investors to other non-statistical risk factors which are still playing out in the markets.

So, while all investors lost strokes over the last 6 years, mulligans were awarded for virtually every differential investment strategy. Investment fiduciaries have had the opportunity to learn a number of important lessons about the markets, about risk and about their own risk appetites and investment psychology. These should be carefully considered as part of their course management. Though no one knows what lies ahead in the markets, a big risk is that investment fiduciaries will rely too much on their “muscle memory” of 2008 in teeing up their investment strategies going forward.

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