I note comments by El-Erian over Central Bank’s inability to suppress volatility as a bigger risk than China and I would agree although I would qualify this in terms of the immediate asset price risk. Asset focussed money supply growth and asset price relatives (relative to GDP growth and income growth as well as its distribution) are all deeply negative for asset markets when liquidity dynamics, amongst others, change.
Recent commentary by Zero Hedge on the winding up of Nevsky Capital is also worth reading: the Nevsky Capital report suggested that a disciplined structure can no longer be counted on to realistically manage risk and return given the uncertainty of an increasingly skewed distribution of possible outcomes in an environment worryingly distanced from fundamentals/exposed to unconventional monetary policy; liquidity dynamics in the market place also impacted.
Another interesting piece of data shows the 10 year rolling returns on commodities that I found in a tweet from @zatapatique.
I have written on the issues of excess asset focused money supply and liquidity for some time (relevant posts of mine).
Many portfolio management structures depend on expected return/correlation/standard deviation assumptions that would be very much exposed to a break in the direction of money flows towards assets. All statistical measures of risk and co variance are drawn from the impact of monetary demand flows for assets. In an environment where monetary policy is accentuating flows to asset classes as well as expanding the quantity of money and reducing the supply of certain asset classes the natural flow response to risk and return in the environment are muted. As unconventional monetary policy recedes, additions to the quantity of asset focussed money and interest rate support reverses, the natural flows not only start to reassert but the prior excess flows adjust to the new environment. We get a break out of trading ranges and covariances.
This is all incredibly risk and uncertain for those dependent on traditional statistical measures of asset price sensitivities and covariances.
They both pass some genuinely rationale advice…if you have a long term portfolio structured cognizant of risk then there is no point in reacting to a boundary you have already accepted you will cross numerous times. But just what are the boundaries that you have accepted and just what are the risks since it is the context in which the statement is made that matters?
The report stated that the funding status of state and local pension funds was at some 72% of liabilities and would likely rise further assuming a return to historical returns. The report did look at current funding liabilities under a range of equity return scenarios none of which were as low as many pundits (Hussman, GMO and myself) would model. The lowest return figure of 4% (all assets combined) would yield a liability with a net present value of $3.8trn or circa 22% of current GDP or 32% of personal consumption expenditure ….this translates into my vague assumption that if future GDP rates are based on current consumption, then future return assumptions would need to incorporate pension fund liability shortfalls.
As I work my way back into the mental state required to hold the data points I just wanted to make one key point. Many have commented on the pointlessness of market timing and therefore the pointlessness of listening to those who believe that a large negative market movement is around the corner. I have never been one for wholesale market timing transactions, but I do believe that high market valuations impact one critical dimension of the portfolio and need to be treated with respect. The higher a market is valued, in an out of equilibrium world, the lower the future expected returns. Therefore, without an adjustment for future returns the liability demands on the portfolio (which have likely been revised higher due to higher portfolio values) will place undue and increasing stress on the portfolio’s ability to meet those returns, especially in the event of an eventual market adjustment. As markets rise and as the time frame of significant market risk extends, for a given level of liabilities, it makes sense to adjust asset allocation towards lower risk/fixed return asset classes. We cannot ignore valuations and we cannot ignore their impact on the management of income and capital liabilities over time.
One of the most important determinants of asset allocation is the risk premium on risky investments.
The lower the risk premium on risky assets the less rationale there is for their inclusion and the longer the time frame of “risky asset risk” that a portfolio will need to manage. Asset allocation decisions that involve allocating to longer term higher risk growth assets to provide the differential expenditure (income and capital liabilities less portfolio dividend, interest and other income) are about capturing differences in risk premiums.
But this also requires that asset allocation is also framed in terms of units of liabilities as opposed to just units of assets, such that risk management uses size and timing of liabilities as the primary determinant of rebalancing transactions and asset allocation decisions. The time frame of risk for risky assets is framed likewise in liabilities.
This post is in response to a recent article by Rob Carrick on “conventional” asset allocation approaches, titled Longer lives, new investing approaches. It commented on asset allocation rules of thumb to give you your equity allocation and bond allocations.
The trouble is these rules of thumb are meaningless in terms of deriving optimal asset allocations. How you construct a portfolio should depend on a number of things. One of the most important determinants of of asset allocation is the liability profile, which in layman’s terms is income and capital needs as a % of the portfolio value.
How you construct a portfolio should depend on your world view of risk and return, your investment discipline, your resources, systems and expertise, how liabilities are met from assets and the way in which withdrawal risks (of which longevity risk is one of many risks) are managed, the risk and return assumptions you use to assess what liabilities a portfolio can meet (in the face of risk) and how an optimal allocation is adjusted for risk aversion and performance preferences.
But in reality it can be whatever way the wind is blowing and this just does my headin. At times, you really have to believe that the only thing keeping us humans where we are, are the shoulders of giants, because without these giants the extraneous weight of our ignorance would surely crush us.
And to the point…….I have been meaning to comment on some of the many articles I have seen recently on “conventional” asset allocation approaches. A recent article by Rob Carrick, Longer lives, new investing approaches was a mark I could not ignore: