Changing times and unpredictable markets mean long-held assumptions about portfolio risk management and portfolio construction may need to be challenged and new methodologies explored.
The fifth annual PortfolioConstruction Conference, held in August this year, investigated this phenomenon by focusing on emerging trends, particularly in the BRIC economies (Brazil, Russia, India and China), and the increasing popularity of commodities and hedge funds.
Ken Solow, chief investment officer for Pinnacle AdvisoryGroup, a United States-based private wealth management firm, kicked off this year’s conference by sharing his thoughts on a fresh and innovative breed of planner that he calls the new paradigm investment adviser.
He challenged the widely accepted view of most US advisers that stocks would always deliver the best returns in the long run.
According to Solow, the reliance on equity returns to allow the portfolio to outperform inflation over long periods of time is a central assumption for the majority of strategic asset allocating advisers.
Such an approach to portfolio construction assumes investors will be rewarded with excess returns for taking risks over and above the risk-free rate of return.
Solow said this excess return, called the equity risk premium, was presumed to be positive and stable, so advisers could safely believe that the historically strong long-term average returns of equities would be realised when constructing strategically allocated portfolios.
However, he cautioned that: “A closer look at stock market returns illustrates that, in fact, stocks do not always deliver average returns over long-term [20-year] time periods.
“While earnings growth tends to stay close to trend over long periods of time, it appears that market multiples, which are a reasonable proxy for the premium that investors are willing to pay for investment risk, are not positive and stable, and in fact can vary significantly over time.”
Solow went on to compare the new approach to the practices of the old paradigm advisers, who he described as those that adopted a strategic asset allocation model for constructing portfolios.
In the old paradigm, portfolio risk management is based on the premise that over time asset classes would deliver their average historic returns along with their average historic amount of volatility.
It also assumed that diversification among many asset classes with historically low correlations would reduce portfolio volatility, that value-tilted and small-cap asset managers would outperform their equity benchmarks and that rebalancing would increase returns.
Alternatively, in the new paradigm, Solow said US advisers would predict long-term returns and volatility based on an assessment of market value and risk, and they would understand that asset class correlations could rise dramatically in severe bear markets, adding unexpected volatility to portfolio construction and reducing the protective benefits of traditional diversification.
Furthermore, he explained that new paradigm advisers would realise that ‘value’ was a subjective term with broad meaning, and at certain times new paradigm money managers would find value in traditional growth stocks.
Solow added that the new paradigm approach would weight each asset class in the portfolio based on its relative merits, as opposed to simply rebalancing the asset class or money manager within a strategic model portfolio based on historic returns, volatility and correlations.
The new paradigm approach would also require advisers to manage the risk posed by high market valuations by using several possible methodologies for valuing markets, including discounted earnings, discounted dividends or discounted cash flow models.
Ultimately, Solow said this new model of investing would present advisers with unique challenges for portfolio construction and practice management.
Some of these challenges include which valuation methodology to use, how to properly assess the market cycle, how much independent research is necessary and appropriate, what to do when the market forecast is unclear, how to communicate the new paradigm to clients and how to organise a practice to make good portfolio decisions.
Fortunately, the new approach carries with it the option of being implemented strategically by allocating portfolio assets to non-style constrained money managers, or outsourcing it altogether to larger, more experienced new paradigm firms.
Solow concluded by saying: “New paradigm advisers may have a number of challenging business decisions to make if they decide to change their investment approach from strategic asset allocation to the new paradigm in the future.”
But added that: “Advisers who implement the strategy in-house will become experts in the type of subjective decision making that allows them to adjust portfolio construction with a high amount of conviction.”
