Book Review: Exploding the fairy tale
• Essays in Positive Investment Management, Pascal Blanqué,
This book starts with a candid admission: the world of investing now has fantasy elements usually found in children’s books. Blanqué, CIO and deputy CEO of Amundi Asset Management, has written an unusual book for an investment professional. He demolishes the entire edifice of the modern portfolio theory (MPT).
Looking back at the events of the past 25 years through a practitioner’s lens, his book contains 11 thought-provoking standalone essays classified under three sections. A range of burning issues come under microscopic scrutiny, offering fresh insights to investors.
It is hard to do justice to all of them in a short review, so I shall focus on two topics that I found especially absorbing.
The first is that the old ways of investing are a recipe for disaster in today’s environment. Asset managers can no longer respray old stuff and sell it as a Holy Grail that seeks to capture risk premia on hidden fat tails. The reason is simple: for too long, the investment shed has sheltered sacred cows that survived under the dangerous comfort blanket of the MPT. They are now being slaughtered as part of the classic post-crisis cathartic exercise.
Prominent among them are: there are risk-free assets; government bonds are risk-free; diversification adds returns; concentration adds risk; there is a hierarchy in risk premia; asset classes are not highly correlated; asset allocation boils down to a trade-off between risk and return; equities outperform all other asset classes in the long term; and, finally, the higher the liquidity risk, the greater the risk premium.
Blanqué’s forensic analysis leaves these beliefs floundering. He enjoins us to look at risk in a different light. For example, “alpha is a long-term concept, which measures what is left when all risks have materialised. In the meantime, risk premia collected on hidden (future) fat tails may and will expose a wise investor to severe underperformance that may last years.”
He also argues that diversification is not dead. The issue is what should be diversified. High-conviction investing is not a bad idea, so long as there is a single-factor risk exposure.
Overall, though, he favours diversification based on risk factors rather than asset classes. On this argument, active and passive are fragile concepts since they both incorporate an ‘active’ exposure to risk factors. He also favours other approaches such as smart beta and risk parity.
Blanqué’s central contention is hard to fault: investors live in a world of dynamic risk, so any formulaic approach will end in tears. Risk is at its highest when it is close to certainty, as the sub-prime debacle showed in 2008.
That brings me to my second chosen topic. The new regime ushered by the QE programmes on both sides of the Atlantic marks the end of the so-called Volcker Revolution, under which the primary aim of monetary policy was to contain inflation. Henceforth, the price of financial assets is both the result of monetary action and a factor influencing it.
The implied circularity is great when markets are doing well but disastrous when they reverse. Thus, while central bank action continues to override fundamental value drivers, fat-tail events may be the norm: “Monetary nature of the risk premium is generally underestimated, which makes it even more enigmatic.” While markets are currently flirting artificially with their all-time highs, such words of wisdom cannot go unheeded.
Central bank action has forced investors into uncharted waters. Notions of ‘fair value’ and ‘equilibrium price’ remain shrouded in mystery.
Hence, it is time to get real, the author cautions. That means an open, honest dialogue between investors and managers on what can and can’t be delivered. As part of expectation management, asset managers must avoid making exaggerated claims about future returns. Investors must avoid aggressive return targets that set managers up to fail. This is common sense. But common sense is not common practice currently in the world of the fairy tale. The book is a brave attempt at rectifying it. It deserves to be read widely.
Amin Rajan is CEO of CREATE-Research