EUROPE - Institutional investors should rethink their obsession with chasing alpha and 'go back to basics' with asset allocation models based on beta or fundamental risk, claimed Luis Viceira at the 12th Annual Portfolio Management Conference in Frankfurt.
"The last 10-20 years has been a Golden Age of Alpha," said the Harvard Business School professor of business administration, "and we can all see the resulting shift in institutional investors' portfolios."
This made sense in the post-1980s world of declining interest rates and an equity bull market that saw the 10-year expected return on stocks plummet as P/E multiples climbed way above long-term averages, and when "fixed income couldn't meet your liabilities, and neither could equities," said Viciera.
US endowment funds therefore increased exposure to alpha strategies to plug the gap, and other institutions followed their lead.
Yet activity in the markets last year reversed this logic, argued Viceira. Alpha strategies suffered severe losses, and although market dislocations have created opportunity, constrained liquidity and credit is likely to cap expected returns on alpha.
"But the silver lining is that expected returns on equity have increased," Viceira observed. Market corrections mean that the 10-year expected return on stocks has jumped to almost 7%, up from 4.7% last August.
"It's time to go back to basics," said Viceira. "The endowment model isn't dead, but it needs some serious tweaking."
Alpha is still useful, he explained, but it is essential to separate it from beta to avoid risk overlaps across portfolios.
Similarly, investors need to disaggregate their beta exposures to avoid overlaps and better combine fundamental risks with alpha.
"We need to get away from the mindset of having 'buckets' of asset classes," he urged.
This would enable investors to refocus on their three basic risks: equity beta, interest rates and inflation. Viceira said he strongly believed that inflation-linked bonds should be investors' default 'risk-free' asset though he also warned that asset allocation decisions must take account of the fact that expected returns on assets vary through time, as do their correlation characteristics.
"I don't advocate trading in and out of markets, but rather introducing some tactical tilts," he explained.
More specifically, he picked out the Phillips Curve as an effective guide to medium-term asset allocation, because inflation is so critical in moving stock/bond correlation. When it is stable, as in the early 1960s and 2000s, inflation falls as unemployment rises, stocks and bonds are negatively-correlated, and nominal bonds act as an effective hedge against the main downside risk of deflation. When the Phillips Curve is unstable, as in the 1970s and early 80s, stagflation is symptomatic of inflation and unemployment moving in tandem, stocks and bonds become positively-correlated, and nominal bonds fail to protect invetors while inflation-linked bonds provide the perfect hedge.
"We are at a crossroads right now," said Viceira. "Are we headed for stagflation, as the monetarists maintain, or for Japan-style deflation? Your opinion on this clearly should have a huge impact on your asset allocation for the medium-term."