Asset Allocation is Difficult with Correlating Risky Assets

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Asset Allocation is Difficult with Correlating Risky Assets
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Asset Allocation is Difficult with Correlating Risky Assets

Asset allocation is tough, because the correlations are not stable.  Here’s an example: in the 90s, at many conferences that I went to, I was told that one of the smartest moves you could make was to invest heavily in every new class of Asset Backed Security [ABS] created, because they all tighten in yield spread terms after issuance, leading to price gains.

I didn’t believe it then, and that was a good thing, because the most exotic of ABS classes got whacked in the financial crisis.  As it was was, I had already seen debacles in Franchise Loan ABS (spit, spit), and Manufactured Housing (post-1997 vintage).  At a conference for Life Insurance, I was a skunk at the party in 2006, as one ignorant presenter suggested that AAA structured assets never went bad.  History already taught us better, and as I tried to say to the then-CEO of Principal Financial as he was exiting the conference, he needed to look at the mezzanine and subordinated structured product in his company.  Free consulting, but but worth more than the consensus.  As far as I can tell, he didn’t listen.  For many reasons the stock price is lower today.

Li Lu On Why It’s Better To Be A Generalist Investor [New Interview]

At the end of last week, Bruce Greenwald, the founding director of the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, sat down for a Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital as part of the 13th Columbia China Business Conference. The chat spanned many different topics, Read More


I have many other tales where in fixed income (bonds), everyone “followed the leader,” which worked in the short run, but failed in the long run.  The point is that investor behavior correlates asset classes.  There may be underlying economic differences, such as owning a natural gas producer and utility that uses natural gas, but most of those differences get erased as most investors seek portfolios immune from factors of secular change.

So as new asset or sub-asset classes are introduced, in the short-run they are uncorrelated, and likely rally, because few own them.  But after the rally, many now own it, and the future correlations are high because so many own it.  The correlations ultimately depend on two things: the underlying economics, and investor behavior.  Investor behavior is the dominant aspect of pricing.

I don’t think there is a lot of diversification in most risky asset classes from an economic standpoint.  Does it matter whether a business is public or private?   I think the answer is no.

What that means in the present environment is that there is a gap between business risk, and those that finance business risk.  In other words, there is a difference between investment grade bonds, and risk assets.  That’s the negative correlation in this market.  Do you want diversification?  Buy some ETFs that invest in long high investment grade debt.  You will not get any effective diversification out of buying different classes of risky assets.  Those are already owned by those that compete with you.

Promises to pay from sound entities that can be relied upon in the future behave very differently than risky assets.  In your asset allocation, to the degree that you need real diversification, look at that as the critical distinction.  All other distinctions are secondary at best.

By: alephblog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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