By Yves Choueifaty
The asset management industry exerts unprecedented influence on the global economy – one of its most fundamental purposes being to invest savings back into the latter. In this context, ‘core’ asset managers, who represent the bulk of investors’ portfolios in order to deliver returns in line with their long-term strategic asset allocation, need to support this by creating wealth for investors.
Importantly, the real source of wealth is not the “skills” of portfolio managers, but the “skills” of employees working in the companies in which savings are invested – it is labour which combined to capital that creates wealth for the investor. Thus, core asset managers act as a link between savings and labour, and for this to be as pure as possible, investors’ core portfolios needs to be immunised against speculation.
Whenever investors build a core allocation to any asset class, it is done believing that risk will be rewarded by a risk premium – the return generated by the undiversifiable portfolio. This involves building portfolios focusing on the existence of a future risk premium, and protected from hypothetical phenomenon. A manager who speculates exploits mispricings in the financial markets by forecasting which factors will rise and fall, therefore offering hypothetical added value through their potential ability to forecast, resulting in a biased portfolio.
The role of core asset managers has been misunderstood because of the ambiguous concept of an ‘efficient’ market, which suggests all information, whether publicly available or not, is taken into account in asset prices. In efficient markets, it is therefore difficult to forecast differences in risk/reward ratios in the future – and even more so in real financial markets; therefore the only alternative for investors is to diversify.
For managers to maximise the risk/reward ratio, they need to build a portfolio that offers access to “pure”, neutral beta in the most diversified way possible. Passive investing, often described as beta investing, has interestingly nothing to do with neutral: capitalisation-weighted benchmarks are biased, as they attribute greater index representation to stocks or factors as they appreciate and less as they fall – which means investors are making maximum allocations to stocks on the day they crash, and minimum allocations on the day they start rising. Passive management is thus a costly process, which destroys value for savers and the economy as a whole.
An efficient portfolio is on the efficiency frontier, along which the reward available for a given level of risk is maximised. For a portfolio to provide immunity through diversification and capture the full risk premium available for a given universe of securities, it must maximise diversification by selecting a range of stocks within the given universe that minimise the degree to which the constituent parts of the portfolio are exposed to the same source of risk. This means neutrally allocating across the effective independent sources of risk. In other words, correlation, not portfolio weights, must drive diversification.
A portfolio has the greatest immunity from bias at the point of maximum diversification. To achieve the Most Diversified Portfolio (MDP) the correlation of the overall portfolio to its constituent holdings must be equal and as low as possible. As such, adding any of the excluded assets within the universe into the portfolio would increase the correlations of the portfolio. Because the MDP eliminates biases, it is not subject to the same volatility as passive benchmarks and contributes to a more stable economy while offering better risk/return than passive investment in the long-term.
Yves Choueifaty is a member of the 300 Club and president and founder of TOBAM
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