Mark Baumgartner Thinks It's All Changed

To see this article in digital magazine format, click here. 

 “The environment earlier this year was not normal. This is normal. This market turmoil, this spike in the VIX, is finally a recognition that we are in tumultuous times. The range of potential outcomes is vast. So what do we do? There are very few true Cassandras out there—so acknowledging the limit of our knowledge, and acknowledging the range of potential outcomes, is important. There are all sorts of concepts that investors draw on to try to make sense of extremes. Regression-to-the-mean is one—but the problem is that the mean might be changing. If you don’t step outside the last two decades of investing—where you had low inflation, declining interest rates, steadily rising corporate profits, and low sovereign risk—you might think the world will return to the way it was in the past. It may not. All investments have fat tails, all markets are irrational at times. However, something that is not widely acknowledged: You can reduce the impact of fat tails with good portfolio construction and “true” diversification. Diversification works. It must work. It’s like gravity. Diversification didn’t fail in 2008. What failed were the assumptions about asset class behavior that fell apart in the crisis. The concept of diversification is sound; the implementation often has been challenging. You have to make sure you are diversifying with risk factors, not just asset classes. Also, correlations can change, so you need to drill down and try to understand what drives them. Consider what really drives asset class behavior: growth, inflation, and risk appetite, and the interaction between them. You can’t avoid taking risk—you have to—and nothing guarantees an inflation-plus-five return. Cash doesn’t give you what you need. Beta, which used to give you enough premium to get to that target, may not anymore, and is increasingly volatile. So, you diversify and you seek alpha. It’s all about objectives—“objectives” being just another name for liabilities. What matters is the risk of shortfall, the risk of not meeting those objectives. Think about what money is. It’s purchasing power, the power to accomplish your mission. For us, we focus on inflation. For others, it depends on their particular liabilities. It is unique to each institution. If our target is inflation plus five, and we are entirely in cash, we have no volatility risk, but we have a high shortfall risk. Our objective is to put together a portfolio that gives us the best chance of beating our goal. In the past, that was easier to do—cash rates, expected beta returns, and the relative ease of obtaining alpha all made it so, But that’s all changed. Manager selection is even more critical in this environment. Given our aggressive target, and potentially low expected returns from cash and beta, we need to bring substantial alpha into our portfolio to have the best chance of meeting our goal. Alpha is not going away—but it’s getting harder to access consistently. We want positive, consistent, sustainable alpha—that’s the Holy Grail. However, that’s difficult to achieve. The future with managers may be in flexibility—those who have open mandates to seek opportunities across many different geographies, in a variety of asset classes. The desired skill set may be changing. This is what organizations need to think about in this new environment.”