What is an Investor to do today?
So what is an investor to do? Near-term, with unemployment falling in the US and the housing market improving, growth should accelerate toward 3.0% by the end of 2013. Also, the Chinese economy appears to be rebounding as well. Infrastructure spending is accelerating, manufacturing PMI’s are rising, and broad money and bank loans have all strengthened. Given an improving cyclical backdrop, use any near-term pull-back in equities to increase your exposure. We fully expect the S&P 500 to reach 1600 before the current cyclical bull market ends.
What are then implications for the future?
Given the oddity of the current bull market in bonds, equities, and commodities, it is clear correlations have turned decidedly positive across asset markets. At the end the current expansion, therefore, the worse portfolio will be a diversified portfolio. As the market approaches 1600, go to cash, get out of debt and select some high risk strategies that offer exceptionally high returns. Keep the powder dry, you will be able to buy these assets for cents on the dollar. Once excess debt is rung out of the system, the greatest bull market in financial history will begin. However, only those with cash on hand will have the resources to participate.
What should we be advising clients to do?
Form a pension fund or foundation and endowment perspective, benchmarks should be redesigned to protect in the coming bear-market. Historical optimization techniques that promote global diversification will not work over the next 10 years. Benchmarks should be designed that have a much lower beta to bond, equity, and commodity markets. Risk budgets should be designed that place substantially more risk on alpha, as opposed to beta. In other words, clients need to discontinue diversity investment strategies. They need fewer managers and alpha sources that are fully understood and quantifiable. Beta strategies should be targeted toward the liability structure, but that will outperform in a bear-market. Only asset classes that better match the liabilities or that offer meaningful return opportunities should be considered for the next down turn.
What are the products of the future?
The products of the future will be those that provide yield, down market protection, alpha, or long-term returns that are attractive enough to cause one to weather the coming storm. The “all weather portfolio” of the past will be the wealth destroyer of the future because they are based on the premise that diversification wins over time. Investment processes, whether they are alpha or beta centric should be designed based mostly on long-term sustainable return potential. Yes, near-term dynamics and technicals have proved helpful and may help one gradually shift into a more defensive strategy. However, trend following is so prevalent today; my guess is that when the fire starts only a lucky few will be able to exit the party.
Processes need to be put in place to fully separate alpha and beta within hedge fund and traditional strategies. If we shift to a alpha centric strategy clients mush know and quantify the bets they are taking. Secondly, the cycle of the alpha and beta exposures should be fully quantified and understood in the context of the long-term drivers. If a manager provides alpha, and it is not clear as to its source, and/or, its cycle of performance, it should not be in the structure at all, or only in small proportions. The winners of the cycle ahead will be those that are bold enough to step forward, and put in simple, fully understandable (in terms of forward return potential and cycle of performance) alpha and beta structures. Product should not be diversified, but rather targeted with an eye toward to future.