Asset allocation is NOT the primary driver of portfolio returns. Many say it’s almost all that matters but the landmark studies are dangerously flawed. That mistake has dominated portfolio construction for too long and has wrecked retirement systems the world over. Trillions are misallocated due to such nonsense.

It was a BIASED sample conclusion because asset allocation is what the CHOSEN investors already focused on. In contrast smart investors pay attention ZERO attention to asset class allocation and focus on to long short security selection and market timing. Good hedge funds select securities and time markets using skill. I have no interest in unskilled asset classes. They NEVER compensate for their risk – even in bull markets.

The Greeks got it right: alpha comes before beta. If corporate pensions invested 100% in their plan sponsor’s equity the “experts” would have concluded that ONLY security selection drives returns. If investors flipped coins each year to be all stocks or bonds then market timing becomes the SOLE driving factor. You only have to look at the risks and losses in traditional portfolios to see that “bet on betas” asset allocation urgently needs re-thinking. NEVER BET ON BETA. That applies to stocks, bonds, commodities and hedge funds. Alternative beta is an even dumber “investment” than traditional beta.

A stock and bond asset mix determines variation of returns if you DECIDE to emphasize beta. It’s easy to debunk the asset allocation dictum. If you encounter any “consultant” claiming that asset allocation accounts for over 90% of returns, don’t walk away, run. Risk averse people like me eliminate beta and invest in alpha. The true determinant of superior risk-adjusted returns is investment SKILL not percentages in UNSKILLED asset classes. It’s the manager mix NOT the asset allocation. Check out the dire funded status of DB and DC pensions that bet on betas due to bad external advice and conventional “wisdom”.

Bad “science”. Decide the conclusion you want then choose a data set you know IN ADVANCE will “confirm” it. If Brinson BHB et al had confined their dubious analysis to high frequency strategies obviously they would have found that ability at high frequency trading drove performance! Is it a valuable conclusion to “discover” that asset allocators’ returns mostly depend on asset allocation? In contrast top performing portfolios focus on alpha so why waste so much time and money on beta decisions? α yes, β no. How did those pathetic papers ever get through “peer” review? Would not happen in the REAL sciences.

It was a GREAT decade for the S&P. No beta for “passive” index funds but every day offered an opportunity set of fluctuating securities to capture alpha. It was an even better quarter century for the Nikkei. No beta since 1984 but vast alpha was generated from security selection and market timing by those with talent. Some “experts” say investors ought to have more in risky assets due to higher “expected” returns. Instead people would be wise to focus on 100% in skill. For those with liabilities to fund, intolerance of volatility or dislike of deep drawdowns, alpha is the prudent investment. Can’t beat beta? Forget about beta.

In aggregate, “stocks” can underperform “bonds” for decades. 60/40 sounds prudent until rephrased as 90/10 risk. Why have a high risk appetite when unhedged equity indices NEVER compensate with sufficiently high reward even in bull markets. Last century’s 8% return on 16% volatility was an insult but a last decade’s negative total return with even more risk is absurd. Most bonds also do NOT reward enough for their risk. Do not go near index fund garbage. It is for speculators NOT fiduciaries.

Alpha beta separation is trendy but beta tends to swamp alpha as we saw in the downs and ups of 2008/2009. That led to the mistake inherent in the crazy concept called portable alpha. It was a beta-centric way of getting some investors into hedge funds but failed because it kept asset allocation front and center. It diluted the absolute return attribute and changed it into just another relative return index based product. The high frequency trading of Jim Simons’ Medallion Fund times thousands of liquid securities over shorter holding periods down to microseconds. Producing alpha depends on your knowledge and technology edge applied to appropriate time horizons.

Beta bets drive many portfolios because that is what most investors do. It is like those who assume carbon is necessary for life because the science they know and only lifeforms they have analyzed are carbon-based. The anthropic principle applied to finance. It is false logic similar to the “all swans are white because every swan I’ve seen is white” phenomenon. Asset allocation fit nicely into the established body of theory which is why it remains popular despite its woeful weaknesses. Efficient, unbeatable markets imply the non-existence of skill! Choose beta because alpha is just “random” luck in a zero sum game? The much cited Brinson Hood Beebower paper has cost too many investors too much money. Beta people advocate index funds since they want you to invest in “the market”. But the optimal way to achieve absolute returns at the total portfolio level is to be alpha-centric.

Beta vendors don’t manage risk, don’t market time and outsource ACTIVE security selection to benchmark construction firms. They even stay fully invested long only in bear markets! A beta-centric portfolio is where investors decide policy asset allocation and then hire managers to basically deliver the return from asset classes and hopefully a bit of alpha on top from tracking error constrained active mandates. Most long only funds have an R-squared with their benchmark over 70% – ie beta explains most of their returns. Alpha strategies and manager selection shouldn’t be secondary but that is the result when beta bets dominate the allocation of investment capital.

Alpha vendors see a market of securities offering long/short opportunities in many time horizons within and between asset classes. An alpha-centric portfolio is where investors hire managers to analyze, trade and hedge for absolute returns. Of course you have to be good and work extremely hard to find alpha. Any manager that depends on beta is NOT running a hedge fund. A truly efficient portfolio does not pollute itself with beta. Dismissing all hedge funds is like avoiding all stocks because Enron, General Motors and Nortel fell to zero. Don’t invest in bonds because some default and there is no such thing as a risk free rate? Nortel stock lost -100% while a Nortel bond is up +700% but most missed it.

Pure alpha sources do not fit well into the beta allocation process that some find so compelling. Since they are not assets, treating hedge funds as an asset class is wrong. The dispersion of returns across the industry is very high. So variable that AVERAGE performance has little meaning. 10,000 hedge funds, 10,000 strategies. People like to know if “hedge funds” were up or down each month. But what does that mean? Some made money and some lost money. Likewise I am often asked where I think “the market” is going. That is a beta question. Some stocks go up and others go down. Seek alpha.

Do I want “hedge funds” that outperform? No. I look for hedge funds that make money which is a very different target. I know that good hedge funds will have high risk-adjusted returns and bad ones will not. Alternative beta is just another beta and is therefore to be avoided. Most betas are becoming more correlated whether by geography or the equity, credit and real estate correlation to the economy. I am not concerned whether a hedge fund is “market neutral” or not. But it must be able to deliver absolute returns that are “economy neutral”.

Alpha is the REAL diversifier because there are so MANY different ways of generating it. Focus on alpha if you want good returns regardless of the economy. Why pay attention to asset classes when investing in SKILL-BASED STRATEGIES makes more sense? Others are welcome to unhedged beta bets but for conservative investors like me beta with a bit of alpha is inferior to an ALPHA ONLY portfolio. Making money is simple: do the opposite of “Nobel” Prize economists.

Read More