Resisting The Chase: Reimagining Liquidity And Diversification

November 9, 2015

by Douglas A. Dachille and Mark G. Alexandridis

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Mutual fund bond investors have reached an unwelcome crossroads. With interest rates at historic lows, they have spent much of their post-crisis existence cautiously ascending the risk ladder in search of yield. Over time, each step up has offered less compensation for incremental risk, but investors have been unwilling – or too fearful – to abandon their positions and sacrifice hard sought, yet often meager, returns. While the liquid alternative space has been touted as fertile ground for diversification and non-correlated returns, it has fallen short of delivering the kind of liquidity and diversification today’s retail investor really needs.

That risk ladder dynamic is an unfortunate, but predictable, result of monetary policy set by the Federal Reserve, which has rendered fixed-income performance unattractive and left only a handful of asset classes capable of generating any return. Bonds, for their part, are no longer a trusted source of negative correlation. They once provided a defined, modest cash flow and the ability to manage liquidity needs while offering protection from marketplace pricing whims. Monetary policy has concentrated risk and reduced diversification benefits as investors have been herded into high-risk assets in the form of public equity, private equity and high-yield. It has become exceedingly difficult to liquefy or diversify; banks no longer have the financial capital to purchase those assets and efficiently remove investors from those positions, reducing the magnitude of losses and market volatility.

These forces have driven mutual fund investors to lurch from asset class to asset class, chasing investments that have most recently generated the highest returns. But they do so in a vacuum, making decisions based on the anxiety of the moment and not on any meaningful macroeconomic forecasts. Such behavior has created a need to reimagine the role of liquidity and diversification, once the domain of traditional fixed-income investments.

The impatient driver

Let’s consider, for a moment, how that investor behavior would play out in a different setting. Envision the proclivities of an impatient driver on a congested highway, darting from one lane to the next, reacting to any sign of movement in bumper-to-bumper traffic. The driver feverishly changes lanes based on the perception that he can reach his destination more quickly by following the kinetic energy. But his decisions are not based on any material knowledge of the road ahead, which is obscured by other vehicles. Ultimately, the driver ends up achieving little while expending much physical and mental energy before crashing into another driver.

This is an apt comparison to retail mutual fund investors who chase returns with the same random logic, shifting money from one asset class to the next based on an unreliable belief in recent price movement. In the end, price-driven investors become unwitting victims of their own naiveté and impatience as their transaction costs accumulate and they are rendered helpless in their battle to maintain diversification. Without thoughtful research and in-depth market insights, their frequent asset reallocations inevitably lead to suboptimal performance at best and a portfolio accident at worst.

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Liquidity