More than one year after the collapse of Lehman Brothers and the subsequent meltdown in the financial markets, many long-held investment tenets are now being questioned. The validity and utility of modern portfolio theory as the prescription for prudent portfolio management is being re-examined. Dealing with this issue and developing solutions to cope with the revelation of newly uncovered risk is imperative if we are to successfully guide our clients through this tumult. It is equally imperative for our own survival to meet this challenge directly and develop strategies to navigate the financial minefield.
With two major declines over the past eight years, the stock market is on pace to underperform every decade over the past century, including the 1930s. During this time, modern portfolio theory represented the investment methodology most widely employed by advisors. It mandated a strategy of allocating funds to a wide array of asset classes in an effort to lower risk. The Holy Grail was to identify lowly correlated or even negatively correlated assets that would allow a portfolio to withstand the most severe declines.
In fact, even during the tech meltdown in 2000, modern portfolio theory seemed to work as advertised. While growth stocks plummeted, performance for asset classes such as bonds and REITs flourished. Those portfolios that allocated sufficient funds to these assets were generally able to rebound within 12 to 18 months after March 2003, the unofficial end of the tech meltdown.
When Long-Term Capital Management collapsed more than a decade ago and placed the financial system on the brink of systemic failure, it was only a harbinger of the more widespread and dangerous situation we would experience in 2008. Instead of learning from the mistakes that led to that episode, firms such as Bear Stearns and Lehman Brothers actually escalated the danger by engaging in similar activities with derivatives. While the benefit of derivatives in risk management clearly had been demonstrated, the abuse of these vehicles and the lack of regulation over them created entanglements where the bottom-line financial exposure was simply incalculable. After years of sparse regulation, there was finally an explosion.
There had been early warning signs all along, but the majority of us failed to take heed. In addition to this derivative frenzy, three other developments-the securitization of formerly illiquid assets, the growth and significant impact of the futures market and a global economy awash with cash-resulted in higher rather than lower correlations among global markets. When the subprime mortgage market began to unravel in 2007, these forces combined to create a liquidity crisis not experienced since 1929.
All assets, including REITs, commodities, bonds and stocks experienced historic declines as investors rushed to cash. Even renowned investors such as David Swenson, the legendary portfolio manager of the Yale Endowment, experienced severe losses despite investing in esoteric and seemingly non-correlated assets such as timber. For those investors who remained loyal to the tenets of modern portfolio theory, there was no refuge and many portfolios lost as much as half their value.
While the recent 50% rebound in the S&P 500 has at least temporarily allayed some fears, many stock market historians suggest that this represents a short-term rally in a secular bear market where further declines are imminent. Investors continued to be wary as new money remained largely on the sidelines and only existing investors have participated in the rally. The great fear among many advisors is that if another precipitous decline occurs, many investors who stayed the course will capitulate this time and be unlikely to return to the market anytime in the near future, much as the Great Depression generation remained on the sidelines for decades.
Even before events began to unfold, some lone wolves in the forest warned us about the perils in the system. Professor Nouriel Roubini of NYU predicted the housing bust, oil shocks and declining consumer confidence that would result in a deep recession. He also warned that venerable Wall Street firms could collapse as a result of the severity of the crisis.
Another obscure economist, Hyman Minsky, dead for 13 years, prophesized a scenario of financial decimation eerily similar to what occurred. In fact, the term "Minsky Moment" has been coined to describe the types of conditions experienced last year.
While Roubini and Minsky warned all who would listen about their financial meltdown scenario, another voice offered an interesting and novel approach to dealing with catastrophic events. Nassim Nicholas Taleb, a former options trader and hedge fund manager, wrote the book The Black Swan where he dismissed the laws of probability as a guideline to investing and instead urged investors to focus their investment strategy on the unknown rather than the known. Taleb argues that despite the seemingly miniscule possibility of unexpected yet catastrophic events occurring, the ramifications of failing to account for these events can be disastrous. Examples of highly improbable yet calamitous events are Black Monday (1987), 9/11 and, of course, the 2008 meltdown. Taleb claims that almost all consequential events in history arise from the unexpected. He argues that a portfolio must not only protect itself from negative events but also be positioned to exploit positive ones.
Taleb contends that small bets on improbable events can produce enormous gains as multiples of the actual investment. A recent example is the estimated $2.5 billion that hedge fund manager John Paulson reportedly earned by betting against financial companies heavily involved in the subprime mortgage fiasco.
Largely because of their significant gains last year, managed futures have been viewed by some as a possible panacea for black swan events. However, last year's financial meltdown occurred over a period of time rather than in a single moment allowing managed futures programs to take advantage of what they do best-invest in established trends.
Managed futures do not attempt to predict events. Rather, they take advantage of discernible trends that continue for a reasonable length of time to produce maximum results. In fact, their worst performance historically has tended to occur at sudden and unanticipated inflection points, the very definition of a black swan event.
The investment community has responded to the recognition of black swan events in several ways. The introduction of 130/30 investments and the promotion of dormant market neutral investments represented the first response of financial companies to the existence and ramifications of a black swan universe. More recently, financial companies have introduced strategies such as absolute return investments that allow the manager discretion to migrate to any asset, including cash, in an effort to avoid the impact of severe declines and to participate early in unique opportunities that the manager might foresee.
Other approaches include strategies based on technical analysis that again allow a manager to have full discretion, though the investment universe may be restricted to stocks, bonds, ETFs and cash. While all of these alternative strategies deserve consideration, they do not represent an answer to the black swan issue.
As investment advisors, it is our obligation to perform due diligence on new products and strategies in an effort to prevent another round of severe portfolio losses. Many analysts contend that we are unlikely to experience another meltdown of the magnitude last year. However, I believe that the financial system continues to represent the 21st century's version of Russian roulette. Recently, some major Wall Street firms repaid their TARP money, and were free once again to pay exorbitant bonuses to executives and traders and to engage in some of the dangerous trading activities that led to last year's meltdown. While anger and outrage has led to a call for an overhaul of the regulatory system for securities, the Obama administration seems to be preoccupied with health-care reform, Afghanistan and the economy. And the globalization of the securities markets creates inextricable ties that can replicate the events that caused last year's calamity.
Some advisors have responded to Taleb's call to anticipate meltdowns and seek to take advantage of their occurrence. The action of some advisors to short Treasurys and use leverage to enhance possible returns represents a strategy to position portfolios to potentially benefit from the predicted bubble in long-term Treasury bonds. Allocations to gold can be viewed as another attempt to take advantage of black swan events.
While I am not suggesting that modern portfolio theory be discarded, it is imperative that it be re-examined in light of the danger in this fragile global financial system. Modern portfolio theory is effective during "normal" market behavior. But in an era where black swan events are likely to become more common, advisors operate at their own peril if they fail to install appropriate safeguards. In the past, many of us have relied on modern portfolio theory as the explanation and, perhaps, the excuse for all portfolio actions.
Going forward, I do not believe that clients will be satisfied with small changes to the portfolio for rebalancing purposes in an effort to maintain strict percentages in the various asset classes. Furthermore, I contend that since black swan events create great opportunities for seismic gains for prescient advisors, the current and future era of investment performance will result in a clear line of demarcation between advisors who remain devotees of modern portfolio theory and those who incorporate black swan strategies.
In our competitive and shrinking industry, those advisors who adjust to this new reality will most certainly be the big winners for themselves and their clients.