Observer: Time to bury the investment rulebook

Peter L. Bernstein is probably the most well-known investment writer alive. His books, such asAgainst the Gods,The Remarkable Story of RiskandThe Power of Gold, present esoteric finance topics in a highly readable form for the interested investor.

His 1992 bookCapital Ideastraced the history of Modern Portfolio Theory (MPT), which forms the basis of conventional investment management and portfolio construction today. While a well-written and even entertaining account, the book’s admiring tone towards the founders and development of MPT has gone missing in Bernstein’s more recent comments.

In a recent interview, Bernstein encouraged investors to totally reconsider the framework for constructing portfolios by saying, “in a world in which the longer run expected returns on bonds and stocks appear to be very closely aligned, many of the institutional money management rulebooks that have been compiled over the last 30 to 50 years ought to go out the window”.

While it is only one view, Bernstein’s standing in the investment industry means his comments should be of great concern to the majority of planners (and institutions) putting portfolios together using a conventional MPT framework. Further, while Bernstein’s comments are very US-centric they apply to almost all diversified portfolio investors.

One of Bernstein’s main points is that we cannot rely on the long run as a guide to setting up a portfolio today. He says: “We’ve reached a funny point where the long run doesn’t work. Where long run evidence doesn’t suit circumstances as they are today.” He is simply reiterating the point made by a number of others recently, that looking forward, the expected equity premium is so small (and uncertain) that the simple view most adopt that equities will comfortably outperform other assets, even in the long run, is flawed.

As Bernstein points out, the research shows “starting price matters”. When starting from high valuation levels it is not reasonable to expect returns as high as in the past. Buy a market at high PE ratios and low dividend yields and on average you will receive a poor return over the long-term.

High long-term returns can be expected on average when purchases are made at low PE ratios and high dividend yields. The main problem is despite falls over the last three years, the US share market (and to a lesser extent the world because of US dominance) is still on valuation levels that have more commonly signalled market tops (and therefore low long-term returns) not a bottom. As Bernstein says: “Investing for the long-term works only as long as people don’t believe it.”

Bernstein’s general advice to investors is to be “much more unstructured, opportunistic and ad hoc than in the past”. He suggests that the approach of fixed strategic asset allocation should be abandoned and that some form of actively managing asset allocation over time needs to be considered.

He also suggests that non-traditional assets should make up a bigger proportion of portfolios. “The options have to fall in the general category of non-traditional assets: hedge funds, venture capital, real estate, private equity, and so on.”

Bernstein also suggests the industry has become too constrained in the way it categorises and selects fund managers and that good managers should be given more latitude. Without mincing words Bernstein says: “In this looser, more opportunistic environment, I see the abandonment of the dreadful, depressing, defaulting process of putting managers into cubby holes — large cap growth, small cap value and such foolishness — along with this stifling, stupid obsession with tracking error instead of absolute returns and risks incurred.”

Of course, all this is music to the ears of someone who holds similar views, many of which have been put forward in previousMoney Managementarticles. Indeed, these articles have earned me my fair share of critics. But why listen to me? When the guy who wrote the book about modern portfolio theory says it is all wrong for today’s investor, shouldn’t we at least take that seriously?

Bernstein suggests that some institutional investors are already making some progress towards a more flexible approach.

“The good news is that investors are becoming accustomed to portfolios more complex than just stocks, bonds and cash. And that adding non-traditional diminishes covariances within portfolios, making the overall package less risky than it used to be.”

Perhaps this is true but the investment industry still has much further to go.

While more non-traditional assets are appearing on recommended lists, this is often a reactive rather than proactive response and there is little guidance provided on how to use these. In addition, most of the diversified funds offered by fund managers and the asset allocation models provided by research houses are still heavily wedded to the MPT-based approach of static strategic asset allocations across traditional assets with minimal allocation to alternatives.

Most financial planners depend on research houses for guidance on these issues. Perhaps they are expecting too much. After all, the economics of the research business demands that they mainly cater for the current wants of the majority of planners and investors. It is highly unlikely that this majority will be particularly forward looking or innovative when it comes to new investment approaches or products.

This point was brought home recently when, on its online forum, one of the managed funds research houses gave the following response to an investor asking for research on a particular alternative investment:

“Our main focus is covering most funds in the traditional asset classes. When possible, we attempt to cover as many alternative products we can. We tend to be selective with these products, choosing the more credible products and ones that are expected to be used by advisers and retail investors.”

In response to this situation, some planners try to cover the investments themselves. However, they have to ask themselves whether they are in the investment business. Do they have the time, the background, and the interest to analyse new investment approaches or products? It is easy to agree with the Bernstein view that “nothing is easy in this business”.

There is no doubt that a much better time for investors to have come to Bernstein’s conclusions and alter portfolios in response was three or more years ago. However, I know from experience that promoting such an approach back then was extremely difficult.

The irony is that given the tortoise-like progress this industry makes in implementing new investment ideas, by the time most investors start accepting a different approach, much of the rationale for doing so may be gone. If the current major bear market is similar to others before it, valuations will eventually become so cheap that a portfolio skewed very heavily to equities will once again be positioned to deliver very attractive returns with little downside risk.

Of course, when that time comes, the pain that many investors will have experienced will mean they would not dare touch such a portfolio. Such is life in the investment world.

As one writer puts it: “In investments, like nowhere else in life, nothing succeeds worse than success.”