Of course calling a book The Art of Asset Allocation is just asking for trouble. Back in the olden days of investing, you bought assets, the primary uncertainty being what fraction of your investable wealth was to be allocated to which broad asset category. These days this has been generalised to strategy allocation, for the financial industry (and for a growing number of individuals too). You allocate to equity long short, to volatility arbitrage, to mergers and acquisitions, to capital structure arbitrage, to convertible arbitrage. Each strategy, in other words, could contain long and also short positions, subject to financing costs and limited by a degree of leverage typically offered to hedge funds.
A key fact about successful trading strategies is that, by definition, they become popular and 'over funded' (tragedy of the commons), leading to more money (and, on average more diluted talent) chasing the same market. This fact ought to be written in stone on any 'guidelines for strategy allocation' work. It is continually chipping away at the returns associated with these second generation strategies.
The first generation of strategies are the purchase of assets and liabilities on a buy-and-hold basis. Here, the term would have been relevant. The primary question facing first generation investors was: how much of which asset class to hold, and for how long until the next re-balance process. This first generation of strategies of course is still around, and super slim, in the form of the burgeoning ETF markets. For a modern take on the first generation investors, there were two paths you could go down. The old (but still popular) and CAPM-ignorant (pre Markowitz) strategy of not just buying the market, but attempting to buy sectors (or themes) in ratios not related to their market cap ratios. This shades into thematic investing. The idea here is the investor knows something the market doesn't The finance professors are usually not so keen on this strategy, which I'll call gen-1-slanted.
The second path a modern investor may take when it comes to their buy-and-hold allocation is to buy the market en toto and to fine tune your risk appetite via using leverage to achieve whatever level of relative volatility (or beta) you'd like. If you want to own the market, the path is clear, with ETFs and futures. If you currently express a less fulsome risk appetite, you place some of your funds in cash or treasuries, then achieve your <1 beta. Consequently if you want more risk, you lever up your ownership of the market (eg in futures, in leveraged ETFs).
Which brings me to Darst's use again of 'art' here. If the real problem which he's expecting his investor clients to solve is one of understanding the relationship between all these strategies, then that's a big ask for many investors. Especially the part where he asks investors to understand not only the returns, volatility of each of these scenarios, but to understand their fundamentals and valuations, together with technical and liquidity dimensions, plus market psychologies on top of all that. In other words he's claiming it is an art then expects the truly hard part to be performed by the investor (or perhaps a further set of costly advisers).
A key philosophical question which comes up, and for which the Markowitz approach may not be sufficient, is how many different kinds of strategy could there be, and how does one allocate between them. How stable can they be? What is the evolution of their life-cycle returns?
There's a great confluence of fairly simple mathematics here - gambler's ruin, covariance matrices, regression / series analysis - which will provide the intellectual backbone to a proper look at modelling the act of optimising the spread of your investment wealth across an unknown number of life-cycle-sensitive strategies in the face of uncertainty. This book doesn't go anywhere near this, but I shall carry on reading it.
The first generation of strategies are the purchase of assets and liabilities on a buy-and-hold basis. Here, the term would have been relevant. The primary question facing first generation investors was: how much of which asset class to hold, and for how long until the next re-balance process. This first generation of strategies of course is still around, and super slim, in the form of the burgeoning ETF markets. For a modern take on the first generation investors, there were two paths you could go down. The old (but still popular) and CAPM-ignorant (pre Markowitz) strategy of not just buying the market, but attempting to buy sectors (or themes) in ratios not related to their market cap ratios. This shades into thematic investing. The idea here is the investor knows something the market doesn't The finance professors are usually not so keen on this strategy, which I'll call gen-1-slanted.
The second path a modern investor may take when it comes to their buy-and-hold allocation is to buy the market en toto and to fine tune your risk appetite via using leverage to achieve whatever level of relative volatility (or beta) you'd like. If you want to own the market, the path is clear, with ETFs and futures. If you currently express a less fulsome risk appetite, you place some of your funds in cash or treasuries, then achieve your <1 beta. Consequently if you want more risk, you lever up your ownership of the market (eg in futures, in leveraged ETFs).
Which brings me to Darst's use again of 'art' here. If the real problem which he's expecting his investor clients to solve is one of understanding the relationship between all these strategies, then that's a big ask for many investors. Especially the part where he asks investors to understand not only the returns, volatility of each of these scenarios, but to understand their fundamentals and valuations, together with technical and liquidity dimensions, plus market psychologies on top of all that. In other words he's claiming it is an art then expects the truly hard part to be performed by the investor (or perhaps a further set of costly advisers).
A key philosophical question which comes up, and for which the Markowitz approach may not be sufficient, is how many different kinds of strategy could there be, and how does one allocate between them. How stable can they be? What is the evolution of their life-cycle returns?
There's a great confluence of fairly simple mathematics here - gambler's ruin, covariance matrices, regression / series analysis - which will provide the intellectual backbone to a proper look at modelling the act of optimising the spread of your investment wealth across an unknown number of life-cycle-sensitive strategies in the face of uncertainty. This book doesn't go anywhere near this, but I shall carry on reading it.
No comments:
Post a Comment