In our last issue of 4Thought’s Compass & Crosshairs, we considered the ramifications of the world’s current financial crisis on the future of portfolio management philosophy. Specifically, we focused on the most recent arrows slung at Modern Portfolio Theory’s strategic asset allocation methodology, the most dominant form of asset management found among the world’ large institutional investment funds.

The two sides of the investment theory argument that have emerged are the Strategic asset allocation camp and the Tactical management camp. The former has been the most prolific methodology utilized from its advent in the 1960’s until the present, while the latter, having dominated in the form of active individual securities trading prior to the 1960’s, has now taken on several new forms in response to the beliefs of supporters of behavioral finance theory that Strategic asset allocation has been proven defunct by the current financial crisis.

While the effectiveness of strict MPT-style strategic asset allocation is supported by substantial historical statistical evidence, proponents of the tactical view hold that the tactical shifting of assets from one class of securities to another is more beneficial for client portfolios, as it can be more responsive to subjective client concerns, can limit downside risk during bear markets, and can help to add alpha during bull markets. While the long term historical evidence on this subject does not support this latter view, more recent history has begun to support the idea that tactical shifts by highly skilled investment managers can alleviate portfolio losses during market downturns. Proponents of tactical management claim that structural economic changes and behavioral finance have created a paradigm shift in which tactical management has become a newly feasible and potentially dominant force in asset management.

Oddly enough, both sides of the argument seem to be correct. Allow for the following explanation:

Strategic asset allocation is not dead, as some would claim, because math cannot be alive in the first place. It is just math. Modern Portfolio Theory, at its root, is simply the application of statistical data analysis and probability distribution curves to create portfolios that avoid heavily concentrated positions in favor of diversified risk-reducing allocation models that will in theory perform better on the downside than a concentrated portfolio, and could never be worth zero unless the prices of all securities held in the portfolio (of the sometimes thousands) were to drop to zero. On the upside they will in theory perform as well as a concentrated portfolio, as their performance is closely linked to the performance of the overall world economy, which historically has exhibited consistent long term growth since the dawn of man.

So over the long term and in theory, strategic asset allocation portfolios will inevitably perform better on a risk-adjusted basis and can be managed with less active managerial effort than a concentrated or tactical portfolio. Everything we have discussed so far, as a mathematical theory in a vacuum, is sound, and always will be, because it is based on pure math.

However, there are instances, as we have seen, when such a methodology may prove untenable – Specifically, this will be so in the absence of a healthy, rationally functioning financial system, and under a mathematical environment in which a “Normal” distribution curve (or at least near-normal distribution) does not exist. Under this latter scenario, which we are likely currently experiencing (and some would argue is always being experienced), those Strategic asset allocation portfolio managers who have based their probability distribution assumptions on a “normal” curve that does not account for skewness, kurtosis, or “fat tails” will inevitably experience unpredicted portfolio fluctuations of the unsavory type we are currently witnessing.

Since the advent of MPT, much of the practical application of the theory has strayed from the original mathematical truth behind it.

This has taken shape in the form of the development of certain traditions, such as the industry-wide use of benchmark-hugging mutual funds and separate account managers, the almost universal division of equity portfolios into “Large, Mid and Small Cap”, and “Value, Blend, and Growth” styles”, and the unwarranted overweighting of domestic securities vs. foreign securities. None of these are base tenets of Modern Portfolio Theory, but are simply the traditional means by which the theory has been applied. Just because it is tradition, it doesn’t make it right, and one could even argue that such adherence to tradition has resulted in a bastardization of the theory and commoditization of the industry.

What this all means for Strategic asset allocation is that Modern Portfolio Theory is still present and valid, but that it has not necessarily been applied sufficiently or correctly in most cases. So what may be needed is a re-application of the base tenets of the theory within the context of our newfound global economic/financial structure changes. The 40 year old theory needs updating.

But furthermore, behavioral finance/economics academic theorists hold that when the underlying assumptions of rationality, monetary incentives, and market efficiency do not hold up, then our theories and investment application must evolve to account for this. Hence, we find tactical investing gaining greater acceptance in the investment world.

Tactical-style asset allocation has found greater footing recently primarily because of its propensity to respond to subjective investor concerns in the short term, and its ability to rapidly adapt to an unhealthy financial system. Because pure tactical managers are usually not tied to a specific asset allocation model or to strict systematic underlying principles, they are not constrained to assume that they must “hold the course” for their clients. They are more apt to make rapid shifts in the portfolio and do things like go to cash at the request of a client. This has sometimes resulted in greater client retention because clients view this methodology as more clearly responsive to their wants, whether or not this is truly beneficial for the long term.

The layman client’s perception is that the management fee that they are paying is buying active expertise. Even if that expertise ultimately results in a reduced portfolio value relative to a strategic manager counterpart, with a tactical manager there is usually a more tangible portfolio result in the short term (either good or bad). Clients can see it and understand why they are paying the management fee.

While the tactical methodology has not been an effective one in the past in a long term, healthy, rationalist financial system scenario because of the generally high transactional and opportunity costs, during the current short term downturn and in past downturns “skilled” tactical managers have performed as well or better in some cases than their tradition-based strategic-style manager counterparts. This is because MPT’s diversifying strategic asset allocation methodology can only reduce “non-systematic” risk, and is not necessarily capable of reducing the risk associated with the global market system as a whole, whereas a tactical manager probably has more flexibility in this area through his/her ability to shift large chunks or all of a portfolio to cash or even to tangible practical assets.

We mentioned that some “skilled” tactical managers have performed better than their “tradition-based” strategic counterparts during downturns, but this has mostly been true for strategic managers that have not correctly assessed systemic risks on a forward-looking basis and have relied on the normal distribution curve assumption and the commoditized traditions often commonplace in the strategic management world (methodologies that some claim have been discredited). But on the flipside, it is strikingly clear that highly skilled MPT-based strategic asset managers who have correctly applied the theory’s principles in a forward-looking adaptable manner have been far more successful through the downturn than the majority of tactical managers (who might be seen as “unskilled”). Also, it should be noted that during the current downturn in general, highly diversified portfolios have not witnessed as significant drops in value as most tactical managers that have taken concentrated speculative positions.

The important point that we are now arriving at is that “It’s not the dog in the fight, but the fight in the dog, that counts.” An analogy used in our last issue stated that in the mixed martial arts competition known as the “Ultimate Fighting Championship”, a paradigm shift has occurred over the last several years in which it has become clear that is no longer the martial arts style of two fighters that determines the outcome of a fight, but in a world where multiple fight philosophies are available for use by highly trained fighters, the determinants of the fight outcome have become the skill level, adaptability, and conditioning of the individual fighter himself, and not the style. The same concept has applied to investment managers through the current financial system trial-by-fire.

The conclusion of our last issue of the Compass & Crosshairs stated that the solution for investment managers adapting to a changing economic landscape is not to choose between the various philosophies of investing, but to take the best of them and apply them appropriately when doing investment planning or advisory services for clients. In short, MPT must be extended not just to include diversification by asset class, investment style, security number, and manager tactics, but also to include diversification by investment method.

We need to apply MULTI-CONTINGENCY INVESTING, to improve on the existing theories as they’ve been applied in the past, and to create new theories and applications where necessary. The industry must adapt and evolve.

What Will Multi-Contingency Investing Look Like?

To start with, although so far we’ve primarily discussed only “Strategic” asset allocation and “Tactical” asset management, Multi-Contingency investing will include far more than these two basic philosophies, with many permutations within each of the philosophical components. Within a single client’s overall portfolio, several methods may be applied, and the investment manager may even apply several of these methods within a single client portfolio objective. The key to application of multi-contingency investing will be an ability of the overlay portfolio manager to shun dogmatic ideological principles as “absolute truths”. The underlying assumption of such a methodology is that there is no one best way to manage client portfolios, and that each philosophy must be applied by itself or in combination with others in order to increase the probability of achieving a client’s ultimate investment goals by reducing the risks impinging on those goals during the accumulation or distribution of assets.

A multi-contingency manager must be able to “multi-think” from a variety of different ideological perspectives.

Pre-2009 single-method investment managers had the luxury of believing in an unwavering and unchanging set of principles that could be applied to all client situations, whether they came from the MPT-based strategic school of thought, the tactical school, or an entirely different one. A multi-contingency manager must be able to “multi-think” from a variety of different ideological perspectives. This is no easy task, as it is akin to a religious believer practicing Judaism, Christianity, Hinduism, and Islam at the same time, accepting their tenets simultaneously. This will require a special type of portfolio manager that is highly technically skilled, familiar with multiple philosophical disciplines of investing, and is uniquely skilled in recognizing when and for whom to apply them. Although the difficulties of this are clear, if it can be applied with alacrity, the benefits to investors will ultimately be significant.

4Thought is currently in the process of acquiring the firm affiliations and expertise required to implement a multi-contingency form of portfolio management. In some cases, this requires the development of relationships with third party specialist management firms, and in others it has necessitated that 4Thought hire and develop the professional expertise to create an entirely new infrastructure from scratch, in order to provide these broader investment services to our partner firms and their clientele. Resources are currently being developed for the following investment methods where they do not already exist and are being augmented for those that do:

1. DIRECT ASSET/LIABILITY MATCHING

2. PURE FIXED INCOME CAPITAL PRESERVATION

3. INSTITUTIONAL STYLE STRATEGIC ASSET ALLOCATION

4. GLOBAL DEVELOPMENT PERSPECTIVE STRATEGIC ASSET ALLOCATION WITH TACTICAL CURRENCY HEDGING

5. YIELD TARGET DISTRIBUTION PORTFOLIO ASSET ALLOCATION

6. CONCENTRATED THEMATIC/OPPORTUNISTIC BUY AND HOLD

7. SHORT TERM 100% TACTICAL/OPPORTUNISTIC MANAGEMENT

Our next issue of the Compass & Crosshairs will feature an exploration of the above investment methods, when they should be applied, and for whom they are appropriate.