Low yields and fairly full equity valuations put pension funds in an awkward position. Too much reliance on Treasury bonds or other very low risk securities makes it hard to account for future liabilities, but investing in riskier assets that put principal in jeopardy is usually constrained (and rightly so). But for Public Employment Retirement System of Idaho (PERSI) CIO Bob Maynard, the problem isn’t that fund managers are ignoring risk, it’s that they overestimate their ability to control it.
“The Financial Crisis of 2008/2009 increased plan sponsors’ desire to control risk—and we are still seeing the unfortunate effects,” Maynard writes in Illusions of Precision, Completeness, and Control: A Case for Simple, Transparent Portfolios. “Many approaches adopted to control risk are illusions of risk control” published by the notable value firm, Brandes Investment Partners.
Brandes – Assumptions behind mean-variance models limit their usefulness: Maynard
Maynard takes plan sponsors to task for their overreliance on mean-variance optimization. He doesn’t dismiss the model entirely, but argues that many people don’t realize that the underlying assumptions should restrict its use to monitoring portfolios instead of designing them to spec.
First, the mean-variance model assumes that investors will behave the same way to gains and losses of equal size, but behavioral finance has found that losses are twice as influential as gains in determining what people will do. Second, most models assume a log-normal distribution of returns even though the returns that we see are skewed with fatter tails than a log-normal distribution would give, what Maynard calls ‘milder and wilder’.
Five-year rolling returns smooth out a lot of variance, but even then the assumptions made by mean-variance models don’t match actual returns.
Finally, Maynard is unimpressed with excessive diversification, pointing out that after a certain point adding more asset classes causes volatility to start increasing again.
“Critics may point to the higher Sharpe Ratios more complex portfolios can generate, but Sharpe Ratios are useless in a fat tail/high peak world,” he writes.
Brandes – Maynard’s four ‘near certainties’
Instead of just focusing on what shouldn’t be done, Maynard also offers four ‘near certainties’ that he thinks every investors should bear in mind: there’s a trade-off between risk and reward, and deciding on an acceptable level of risk is essential; asset allocation is the most important factor in determining returns; too much focus on individual parts can miss weaknesses at the aggregate portfolio level; and markets are efficient at reflecting opinions, but not the actual value of a security.
The full study from Brandes can be found here illusions-of-precision-completeness-and-control.
