P&I: That sounds like market timing.
Manieri: Some may see this as market timing, but we believe that tactical asset allocation done right is inherently different from trying to time the market. Those who try to time the market, for the most part, rely on technical analysis or looking at patterns in market prices and trends, e.g., a reversal in a market that is considered oversold. Our tactical asset allocation decisions are based on fundamental analysis of the economy, corporate profitability, monetary policy, valuation and other factors that drive capital markets. It was this analysis that led us to be risk seeking in our portfolio positioning in 2019 but significantly reduce risk in early 2020.
P&I: You raise the point of actively managing asset class exposures to manage expected return and risk as market regimes shift, but most investors rely on diversification to achieve the same purpose. Are you surprised that even well-diversified multi asset portfolios suffered significant drawdowns in the first quarter?
Manieri: I am not surprised. We often hear that diversification is “the only free lunch that exists,” as renowned economist Harry Markowitz put it. But as we saw in the first quarter, during the financial crisis and other times of economic distress throughout history, many asset classes such as equities, credit, etc., fall in unison.
Diversification is not the holy grail many believe it to be. Diversification works in normal circumstances when correlations, volatility, etc., are fairly stable. But as investors, we need to recognize that most asset classes, whether equities, credit, etc., have economic sensitivity. Therefore, when the economy gets hit, correlations go up as these asset classes are negatively impacted. For example, during a recession, companies earn lower profits. As a result, the value of the company is lower, and equities decline. As profits decline, the risk associated with corporate bonds, especially high yield bonds, increases and as a result, credit spreads widen and bond prices decline. This also works for commodities. In a recession ― all other things being equal ― we use less industrial metals, oil, etc., and as a result of lower demand, the prices of these commodities decline.
Modern Portfolio Theory is based on the notion that an efficient portfolio can be created if we know expected return, correlation and volatility. The implicit assumption is that these variables are constant. But that is not true. Correlations and volatility increase during times of stress. The asset classes that do well in times of stress and protect the portfolio best during times of crisis are Treasuries, the U.S. dollar, gold, put options, etc. But these investments have low expected returns over time. Therefore, it is a real question whether, over long periods of time, you want to allocate enough to these investments to protect your portfolio during times of crises. Is it worth it to hold these investments in large enough allocations to help protect your portfolio during time of crisis?
P&I: What’s your answer to those questions?
Manieri: We would rather tactically allocate assets based on our fundamental views and reduce equities, credit, etc., if we believe the economy is likely to go into a recession, rather than having asset classes that are a drag on performance most of the time, but will benefit the portfolio during times of crisis, which by definition, do not occur most of the time.
P&I: But most institutional asset owners rely on diversification and a long-term time horizon, right?
Manieri: Most institutional investors do not rely or believe in tactical asset allocation. Some believe that the answer is in allocating a significant portion of portfolio assets to so-called alternatives, which they believe are able to outperform publicly traded markets in various market environments.
But if you examine the performance of endowments during the financial crisis, these funds did not outperform a simple portfolio of index funds. In our opinion, while alternatives can be useful under certain conditions, they do not obviate the need for tactical asset allocation. The approach that we have found to work best for our clients is to use a combination of passive and active funds along with alternative strategies in certain cases, but tactically allocate and manage our exposures based on fundamental analysis of economic and market conditions. ■