Clever investors are continually seeking out so-called anomalies and inefficiencies to boost opportunities, and for a brief time the edge is available to the early adopters. But the secret leaks out eventually and the outsized returns retreat. History is rife with examples.

Consider hedge funds, which thrive by exploiting unnoticed opportunities. Nice work if you can get it, but the relentless competition has dulled their edge. Some of those competitors are ETFs and mutual funds attempting to replicate hedge strategies for the masses—at a fraction of the cost.

“Many hedge funds simply repackage or lever cheap benchmark indices and sell it as expensive outperformance,” said Howard Wang in a conversation with Bloomberg. Wang is a former analyst at legendary hedge fund shop Bridgewater Associates and has started his own firm, Convoy Investments. “While true uncorrelated active management is more valuable than ever, investors need to make sure they are getting what they pay for,” Wang said.

Good advice, but easier said than done when you consider that the average hedge fund has dramatically underperformed broad U.S. equity indexes. The HFRI Fund Weighted Composite Index is ahead by an annualized 5.8% for the five years through this past July, according to HFR Inc. A modest return, far below the 16.8% annualized total return for the S&P 500 over that span.

Inexpensive ETFs have promised investors diversification far and wide. As they have drawn more assets, the results have been predictable: higher correlations. Consider how four formerly exotic markets compare in terms of rolling three-year correlations with the U.S. stock market (Figure 4).

A decade or two ago, it was relatively rare for investors to go into foreign stocks in developed and emerging markets or to own commodities and REITs. But now it’s become ordinary, thanks to the rise of publicly traded funds offering access to these markets at index product prices. The result is that there’s a lot less disparity between the returns of these investments and those of U.S. stocks. The diversification benefits are less.



Strategy For A New Market Order
If returns are headed lower and correlations higher, what does that imply for portfolio design and management? Business as usual could mean fewer gains with more risk (since assets likely to move together are also likely to suffer in unison).

What to do? You may decide to simply grin and bear it. But planners seem to recognize that a different, or at least evolving, approach to portfolio management is necessary. A recent study by Natixis Global Asset Management (The 2013 Global Survey of Financial Advisors) found that 59% of advisors around the world “agreed there is a need to replace traditional diversification techniques with new approaches to achieve results.”

There are sound reasons to do it, but it’s not obvious that the majority of recent converts to tactical asset allocation, say, or the like will triumph.

Brent Schutte, a CFP licensee who’s also the senior investment strategist at BMO Global Asset Management in Chicago, says his long-standing preference for tactical asset allocation was the exception a decade ago but has since become widespread. Either the crowd has become enlightened or, as Schutte asserts, it’s still Wall Street’s penchant to chase fads.

“I agree that risk is going to be higher and correlations will be closer to one than they have been,” notes Kevin Karrh at Karrh & Pierce Wealth Management Group in Plano, Texas. What’s driving the change? “A lot more money in the system chasing returns,” says this self-described veteran of the “trend following” approach to portfolio management.

More advisors may be using some form of dynamic asset allocation, such as trend following, arguably because it’s the only way to remain competitive. But that doesn’t mean success is ensured. By some accounts, it will be that much tougher to reach financial objectives as these strategies draw more players. A higher share of assets linked to trend-following signals exaggerates market volatility.

In turn, there will be greater risk in market-timing techniques, which are the foundation of many (if not most) dynamic portfolio strategies at the asset allocation level.

“The industry has jumped the shark regarding tactical asset allocation by confusing absolute and relative return strategies and redefining risk as peak-to-trough returns,” says Ken Solow, a partner at Pinnacle Advisory Group and author of Buy and Hold Is Dead (Again): The Case for Active Portfolio Management in Dangerous Markets. “The result is that short-term market-timing strategies that are almost 100% technically based and drawn from a rules-based, back-tested performance history are now considered OK.”

Solow isn’t against quant strategies, per se. The problem, he explains, is a growing tendency to adopt these strategies in the extreme—at the expense of long-term market-risk exposure. “A strategy that shouldn’t go down in a bear market isn’t suitable as a core holding,” he emphasizes. “There’s a risk that investors don’t get back in and don’t participate in the future.”

Finding an intelligent balance between core and satellite holdings is essential, he adds, although Solow has his doubts that most advisors rushing into tactical strategies will find this equilibrium. “This isn’t going to end well.”

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