Throw out the policy asset mix and embrace market-timing with open arms, says Peter L. Bernstein, the octogenarian investment radical.
That's seemingly heretical advice to institutional investors from Mr. Bernstein, an acclaimed economic historian and head of the eponymous New York-based economic consulting firm. He's suggesting that pension, endowment and foundation officials turn their world upside-down.
Mr. Bernstein's startling conclusion: "Policy portfolios are obsolete." This pronouncement builds on themes Mr. Bernstein has been developing for months - questioning the value of the equity risk premium and asking institutions to loosen the shackles on their managers.
But he has taken the issues a giant step further.
When he first presented his concept to attendees at a conference for endowments and foundations in late January, Mr. Bernstein said, he was overwhelmed by the response, which continued for hours after his talk.
The expected risk premium is so small for the foreseeable future - say, the next 10 years - that locking into a portfolio where equities comprise a majority of assets "is a very dangerous decision because you're not going to get enough compensation for the interim volatility," Mr. Bernstein said in an interview with Pensions & Investments.
Investors aren't being paid for the risk they're taking, with average dividends at 2.2%, near their historic low, he said. Plus, the prospect of further terrorism is a new threat that challenges equity markets.
When he wrote his March 1 newsletter to clients, he expanded the argument, saying rigid adherence to a policy portfolio should go out the window - forever.
"The time has come to take off the policy portfolio corset and breathe freely - for the indefinite future, not just in today's world" he wrote. "The main message is that we must abandon fixed views of what the future is going to be like," he concluded.
As a result, institutional investors need to be far more flexible than they have in the past and must embrace asset mixes that meet far different economic and investment climates, he said.
At the heart of Mr. Bernstein's argument is his belief that investors took Jeremy Siegel's book, "Stocks for the Long Run," too much to heart. Stocks do not always outperform bonds for virtually every 10-year period, Mr. Bernstein noted. Stocks should outperform bonds "in the very long run," he said, or capitalism would collapse.
What investors forgot in the 1990s is that equities are riskier than bonds. "If that uncertainty vanishes, you get Dow 36,000 and come to the end of the story," he wrote.
The alternative is belief in reversion to the mean, long-embraced by institutional investors. The problem, he writes, is volatility can kill you first.
About the long run
Mr. Bernstein cites John Maynard Keynes' famous quote: "... the long run is a misleading guide to current affairs. In the long run, we are all dead. Economists set themselves too easy, too useless a task if in the tempestuous seasons they can only tell us that when the storm is long past, the ocean will be flat."
What that means is that economic storms are the norm. "The ocean will never be flat soon enough to matter. Equilibrium and central values are myths, not the foundations on which we build our structures. We cannot escape the short run," Mr. Bernstein wrote.
He now suggests a "bipolar portfolio" positioned to respond to both good and bad news. He recommends an equity core in case the stock market receives a positive shock.
The equity exposure would be balanced by a set of hedges designed to protect against extreme outcomes. He would use gold futures, cash and foreign-based instruments to protect against a fall in the U.S. dollar and geopolitical risks, while employing inflation-protected bonds and long bonds to protect against risks of inflation and deflation, respectively. Specific weightings would depend on investors' outlooks.
He excludes real estate and corporate bonds "because their response to good news would be too muted even if positive and because the hedges in the portfolio take care of defense needs."
Mr. Bernstein's call for flexibility has challenged the status quo. At the January conference, investors questioned how Mr. Bernstein's approach would affect their existing portfolio structures, such as style boxes for mandates, he said.
"The present structure has a lot of conveniences, it's a very easy way to organize the way we go about doing our business. It sets up clear-cut marching orders for consultants and other people to tell us to do particular jobs," Mr. Bernstein explained.
"All of that suggests a degree of neatness about the investment process (but) there's nothing neat about it. It's very hard," he added.
Michael Rosen, principal at Angeles Investment Advisors LLC, Santa Monica, Calif., thinks Mr. Bernstein has gone too far. While agreeing that expectations for stock returns need to be lowered and that non-traditional assets - such as commodities, currencies and TIPS - should be included in the portfolio, he disagrees that the policy mix should be tossed out.
"Human emotion is too frequently, if not nearly always, counterproductive in investing," Mr. Rosen said.
Nor is rebalancing the same as market timing, as Mr. Bernstein suggests. "Rebalancing imposes a discipline that is contrary to emotion, thus serving to lessen (if not eliminate) emotion from the decision-making process," Mr. Rosen wrote. "One must strike a balance between rigidity and emotion, as either extreme is likely to be detrimental to investment results."
All the same, Mr. Bernstein is winning followers.
"It's illogical to have the highest weight in history to equities at the end of a 20-year bull market," said Mark Yusko, chief investment officer for the $1 billion University of North Carolina at Chapel Hill endowment fund.
Rob Arnott, chairman of First Quadrant LP, Pasadena, Calif., who co-authored an article on the equity risk premium with Mr. Bernstein, said he agreed that "benchmarks are the root cause of some of the worst mistakes made in institutional asset management."
But he added Mr. Bernstein is "tilting at windmills" because people will insist on being measured. Instead of focusing on tracking error, Mr. Arnott thinks institutions should focus more on "adding value and managing risk ... instead of merely stamping out risk."