Asset Allocation Mistakes Cost Billions

The painful crisis now underway has spawned a rash of articles about the failure of diversification, efficient markets, buy-and-hold investing, risk models, hedge funds, compensation systems and many other aspects of the process by which we as an industry seek to allocate savings in a manner which results in the achievement of our clients' long-term financial goals. Like you, I read them carefully, and think about their meaning for my business. Many of them strike close to home, for they show the extent to which this crisis has represented a gross failure to pay sufficient attention to asset allocation and hedging downside risk, whether through diversification, options or moving into cash.

For example, a recent column by John Redwood (of Pan Asset Capital Management) in the Telegraph ("Expert Advice for Pension Trustees", 24 February 2009) succinctly captured the painful questions now being asked by too many investors and plan sponsors: "Many pension funds will have lost more than a fifth of their value and some as much as a third...The Trustees will have to decide what to do, and how to tell the members the bad news...The Actuaries will point out how there is now a bigger hole in the pension fund...The Sponsoring Company will be expected to make up [with higher savings contributions] for the black hole in the pension fund...The [Fund Managers] will say they were not responsible for the main cause of the loss. They did what they were asked to do, implementing an asset allocation laid down by someone else...The Trustees, they will say, made the overall asset allocation decision...The poor old Trustees will be left pondering how come they had spent a small fortune in fees, yet lacked [adequate] advice on the one thing that really matters." In a similar vein, Johan Magnusson, the managing director of AP1, one of the Swedish National Pension Funds, recently declared that "we want to raise the level of ambition in strategic asset allocation, which has the greatest influences on the fund's ability to deliver long-term returns...We will take a more flexible approach and achieve greater freedom in our reallocation than at present."

In sum, all of the articles I have read have only reinforced my belief that there is too little good analysis and advice available to investors and trustees on the critical issues of asset allocation and hedging downside risk. They have also made it clear that we are on the right track intellectually. Over the past twelve years our company has developed a distinctive approach to asset allocation and hedging downside risk that is grounded in complex adaptive systems theory and the adaptive markets hypothesis. This leads to a strong focus on how investor decisions result from the interplay of rational, emotional and social processes, producing a constant interaction between fundamental value and momentum strategies that can cause asset classes to sometimes become severely over and undervalued. This is why we also spend a lot of time on methodologies for improving decision making in the face of uncertainty (not just risk), including sensemaking, situation awareness, pre-mortems, model averaging, analysis of competing hypotheses, and modeling trade-offs between fidelity to historical data, robustness to uncertainty, and confidence in prediction. Our focus on continuous learning and innovation has resulted in the constantly improving quality of our publications over the past ten years. We now offer very detailed monthly asset class valuation reports, political and economic forecasts whose methodology is explicit and whose conclusions are clearly linked to potential changes in asset class returns, and our wide-ranging product and strategy notes, in addition to our tools for balancing financial goals and portfolio allocations. As a result of this relentless focus on improving our offering, over the past twelve years we have evolved from a publication about the advantages of index investing targeted at individual U.S. investors, to a much more sophisticated investment strategy journal with a global subscriber base that is now primarily composed of investment managers, financial advisers, and sophisticated individual investors. This evolution has been a symbiotic process, with improvements to our offering attracting more demanding subscribers, who have stimulated even more innovations in our methods and writing.

However, when people ask me what I am most proud of after twelve years of hard work, I point to the impact we've had on investors' portfolio returns, and the life goals that depend on them. I like to point to the warnings we issued in March 2000 and May 2007 about dangerously overvalued asset classes, and the emails we later received thanking us, describing the size of the losses that were avoided as a result of acting on our recommendations, and above all what that meant in terms of people's lives. At the end of the day, that is what the investment management business is really about, and that is why it is so important for all of us to get it right. With that in mind, I also like to point to the emails we've received saying how much professional advisers and asset managers value our distinctive methodology, independent point of view, and explicitly reasoned arguments as inputs into their own asset allocation and risk management processes. Clearly we are serving an important market need for high quality asset allocation analysis that can generate very large economic benefits, particularly when it comes to protecting against large downside risks.

I found further confirmation for this view in a new EDHEC report, "A Long Road Ahead for Portfolio Construction." Their survey of practitioners found that "in many respects, current practice falls short of the state of the art in portfolio management techniques." More encouragingly, "95% of those surveyed believed improvements must be made in portfolio construction practices", 86% agreed that "further education was a highly important means of closing this gap", and 79% believed that "better explanations of the practical applications of academic research are highly important."

I read these comments, and have no doubt we are on the right track, as one of the few providers of independent research that focuses on high quality asset allocation analysis, advice and education. As the world economy passes through a period of unprecedented uncertainty, this information is more important than ever. I also know, that given the value of our readers' assets under management, our price amounts to, at most, only a few basis points per year - which pales in comparison to the size of too many investors' losses over the past two years because of asset allocation mistakes. So I am confident, our subscribers will continue to recognize the high quality and value of our content, and keep recommending us to their clients and colleagues as a unique source of asset allocation insight and education.

Thank you for your support, and for your continued suggestions on how we can better serve your needs.

Sincerely,

Susan L. Miller
Publisher

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