The end of asset allocation

By Felix Salmon
July 13, 2009

It’s a pretty solid rule of investing: good ideas tend to become broadly adopted. And once enough people are all doing the same thing, that thing is probably not a good idea any more but rather a bad idea.

Case in point: asset allocation. John Kay seems to have taken a time-travel machine back to 2006:

The basic principles of asset allocation are diversification and contrarianism. Choose securities with returns poorly correlated to each other.

There are two huge problems with Kay’s prescription. The first is measuring correlation — something which turns out, in practice, to be pretty much impossible. And the second is that correlation measures, by their very nature, are always backwards-looking, and that you can be pretty sure future correlation will be very different from past correlation. What’s more, if there’s a crisis in the future, correlations have a tendency to move to 1.
Tom Lauricella takes the opposite tack from John Kay. Asset allocation, he says, is dead: the crisis killed it. And one of the contributing factors to its demise was one of the very things which Kay extols: the ETF. Kay loves ETFs, because they have low fees. But when investors piled into commodity ETFs over the past few years, in the name of diversification, all they really did was massively increase correlations between commodities and other asset classes. As a result, when stocks tumbled, so did commodities:

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.

“When people start buying an asset, the act of them diversifying ultimately makes the asset less of a diversifier,” says Pimco’s Mr. Bhansali.

Rick Bookstaber has dozens of examples along these lines, many of them much less obvious than the link between stocks and commodities. The fact is that if you think you’re invested in an asset class which will zig when the rest of your portfolio zags, you’re probably wrong. Look at the performance of so-called “market-neutral” hedge funds: they all went up in the up market, and they pretty much all went down in the down market. If super-sophisticated hedge-fund managers can’t get correlation right, there’s probably no point in the rest of us even trying.

Ultimately, I suspect that any investment strategy more sophisticated than “buy low, sell high” is doomed to fail eventually. If a certain strategy worked for your grandparents, that’s probably a good reason that it won’t work for you. (And yes, Warren Buffett counts as Gramps for these purposes.) In investing, nothing lasts forever. And the era of asset allocation is in its waning years. The problem, of course, is that no one has a clue what might replace it.


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