ASSET ALLOCATION PRINCIPLES FOR UHNWI - Panthera · 6. 12 Asset Allocation Imperatives for UHNWI 11...

PSC#8/12KommtdieBankenunion?EineAnalyse.

PantheraSolutionsStrategicAssetAllocationIntelligence

1PSC#13/13

3GENAssetAllocation.APractitioner´sGuide

ASSET ALLOCATION PRINCIPLES FOR UHNWI

A MONACO PRIVATE LABEL

WHITE PAPER

Written by Mag. Markus Schuller, MBA, MScFE

Panthera Solutions

October 2015



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TheAuthorofthisWhitePaperisMarkusSCHULLER,ManagingPartnerofPantheraSolutions,oneofMonaco’sleadingAssetAllocationConsultants.AboutPantheraSolutionsPantheraSolutions–basedinthePrincipalityofMonaco–isanadvisorycompanyofferingindependentanalysesforprofessionalinvestors,basedonsoundproprietaryresearchandmethodologies.Weofferstrategicassetallocationintelligenceandinvestmentprocessoptimizationforthemanagementofmulti-asset-portfolios.Oursolutionsarebasedonthethirdgenerationofassetallocationprinciples,reasonedbyappliedbehavioralWinance.

WeareateamofinternationallyrenownedspecialistsindifferentWields.OurassignmentsandpublicationshaveprovenustobeinnovationleadersinEurope.PantheracooperateswithanumberofStockExchangesinEurope–DeutscheBörse,ViennaStockExchangeandBorsaIstanbultonameafew–forofferingindependentandstate-of-the-artseminarsonassetallocation-relatedtopicsforUNHWIandprofessionalinvestors.AboutMag.MarkusSCHULLER,MBA,MScFEAsseasonedAssetAllocationExpert,AdjunctProfessorandbookauthor,MarkusSchullerlooksbackat15+yearsexperienceintrading,structuringandmanagingstandardandalternativeinvestmentproductsfordifferentbanksandassetmanagersinEurope.In2007,hewasoneoftheWirstinEuropetoWithedgefundstrategiesintoUCITSfunds.Since2009,MarkusisteachingasadjunctprofessorattheInternationalUniversityofMonaco,arenowedprivateuniversityinthePrincipality(twocourses:PortfolioTheory&AlternativeAssetsandInvestmentBanking).Markusisaregularkeynote-speakerandmoderatoratinternationalinvestmentconferences.In2014,MarkusSchullerco-authoredthebook„PortfoliomanagementinUnternehmen“atSpringer.In2015,hecontributedachaptertotheOECDbook„OECDInsightsonAgeing:TheNewOld".HisWinancialmarketcommentaries(“PSCs”)areregularlypublishedinEuropeanqualitynewspapers/magazinessuchasInstitutionalMoney,DasInvestmentandInstitutionalInvestment.

AssetAllocationPrinciplesforUHNWIWhitePaper



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TableofContents

1.  ContextDescription 4

2.  AssetAllocationNeedsofUHNWI 4

3.  EvolutionofAssetAllocationGenerations 5

4.  TraditionalAssetAllocationLimitationsataGlance 6

5.  ThirdGenerationAssetAllocation 6

5.1GlobalTransformationProcesses 7

5.2RiskFactorDiversiWication 7

5.3AppliedBehavioralFinance 8

5.4VehicleandJurisdictionAgnosticism 9

5.5Evidence-driven,rule-basedDSAAProcess 10

6.12AssetAllocationImperativesforUHNWI 11

7.SpecialAssetAllocationTopics 11

7.1EthicsandAssetAllocation 11

7.2UnethicalAssetAllocationMethod-Example 12

7.3AlternativeRiskMeasuresinAssetAllocation 13

8.Bibliography 14


1.  TheContextItisdifWiculttodescribeWinancialmarketoper-ationsintheircomplexity;deWiningtheirpurpose,however,isn’t.Marketparticipantsneedtoassessthebehaviourofotherparticipantswhilealsoassessingthemselves.Eveninlessglobalisedareasoflifethisisanon-trivialobjectivewhenitcomestoovercomingcomplexity.HowcantheWinancialmarket‘sscopebeperson-centredwhenitshowssuchaclearpreferenceformathematicsandthepossibilitiesofmodellingandalgorithmicrepresentationitoffers?Thisshouldn’tcomeasasurprise.Financeispartofeconomics.Economics,inturn,arepartofsocialsciences,i.e.theareaofresearchthatseekstounderstandinteractionsofindividualsandgroups.Quantitativemethodscanthereforebeusefultoolsthatdon‘t,however,absolvetheWinancialmarketparticipantsfromtheirultimateresponsibilitytoassessthemarketandthemselves.2.AssetAllocationNeedsofUHNWITheperiodicallypublishedCapGeminiGlobalWealthReportindicatespreferencesandneedsofUHNWIinvestors.

Currenttrendscanbesummarizedasfollows.EquityallocationspulledslightlyaheadofcashasthedominantassetinUHNWIportfoliosQ1-2015followingaWive-yearglobalbullmarket.Equitiesmovedupto26.8%ofHNWIs’portfoliosglobally,whilecashdeclinedto25.6%.HNWIsinJapanandLatinAmericaexpandedtheirequityholdingsthemostcomparedtoQ1-2014.

Allocationstointernationalinvestmentsremainedmoderate,holdingsteadyat35.8%,comparedto36.6%ayearearlier.HNWIsinAsia-PaciWicandLatinAmericainvestedthemostinopportunitiesbeyondtheirregionalborders.



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CreditWiguresprominentlyinUHNWIportfolios,anditsavailabilityisabigsellingpointforsomeHNWIs,althoughdemandvariesbyregionanddemographic.(source:CapgeminiWorldWealthReport2015)

Both,reportandinfographichighlightastronghomebiasandanattempttoincreasethediversi-Wicationeffectviaabasicmulti-asset-allocation.

WhatareUHNWImostlyconcernedabout?:§  Willassetslastfortheirlifetime§  Abilitytoafforddesiredlifestyleinretirement

TheirexpectancyfromtheselectedWealthManagers:§  Clearunderstandingofrisktolerance§  Feetransparency§  Stronginvestmentperformance§  AbilitytounderstandUHNWIconcerns&needs

ThisWhitePaperintendstomapoutthatgiventhedivergencebetweentheircurrentassetallocationandtheirneeds,themismatchneedstobeaddressed.

InthisWhitePaper,weanalyserecentassetallocationdevelopments.WeintendtoprovideguidancetoUHNWIonhowtoallocatetheirassetsgloballywhentargeting

capitalpreservation.

WhilebeingbasedinthePrincipalityofMonaco,wetakeaglobalviewonhowtoallocateassetsrobustlyconsideringallgeographies,assetclassesandstrategies.

Weintendtoanswerhowtoreplacetraditionaloptimizationmethodsbyproposingpracticalbuildingblocksforthethirdassetallocationgeneration(3GEN).The

WhitePaperreaderbeneYitsfromtwelveconcludingassetallocationimperatives.


2.TheEvolutionofAssetAllocationGenerations

Withhisdissertation”PortfolioSelection“,USeconomistandNobellaureateHarryMMarkowitzdidabigfavortotheWinancialindustry(Markowitz,1952).HeintroducedtheMean-Variance-OptimizerascorecomponentoftheModernPortfolioTheory(MPT).Theindustrywelcomedthesingle-factor,singleperiodtoolasitstheoreticalfoundationandpracticalimple-mentationallowedanewsetofbusinessmodels.MarkowitzmodelhasbeensimpleenoughtoteachittobusinessschoolstudentsandcomplexenoughtoimpressinvestorswithefWicientfrontier-basedallocationexplanationsforthelast5decades.Tobeclear,Markowitz´modelmarkedamilestoneinprofessionalizingtheassetallocationprocessbydeWiningandmeasuringriskandreturnaswellashowtocombineassetsthrougharepeatable,standardizedprocess.Itactedasstartingpointforaseriesofcomplementarysingle-factor,single-periodmodelsliketheCapitalAssetPricingModel-CAPM(Sharpe,1964).TheEfWicientMarketHypothesis-EMH(Fama,1970)addedacontextualframeworkforarationality-drivenworldandcompletedthetriumvirateofMPT-CAPM-EMHthatlaidthetheoreticalfoundationforWirstgenerationofassetallocationstrategies-1GEN(1950-2000).Thederived1GENstrategieslikeBalancedPortfolios(60/40Portfolios),Long-OnlyorBuy-and-Holdledtotheriseofthemutualfundindustry;asuccessstorythatstillmanagesaboutUSD31trillionworldwide(ICI,2015).However,theproblemisasfollows:Ofthethreeinvolvedparties,mutualfundmanager,mutualfunddistributorandmutualfundinvestor/UHNWI,onlytheYirsttwobeneYitfromthesuccessofthissegment.TheinvestorpayshighfeesforinsufWicientlydiversiWiedportfoliosandanunfulWilledpromiseofalphaexposure(Carhart,2002;Gottesman,2013).DrivenbyanemerginginsightofinsufWicientdiversiWicationeffectsofWirstgenerationbasicassumptionsandmodels,institutionalinvestorsbegantoaddfurtherassetclassesandstrategiestotheirclassicbalancedportfolioallocation.

Thesecondgenerationarose(2GEN).Multi-Asset,Long/ShortEquityandRiskParitystrategiesserveasanexampleforthewideningalternativescopeduringthe2000s.Multi-factor,multi-periodmodels,academicallydevelopedduringthe1970sand1980s,wereusedasquantitativeoptimizationtechniquesforthissecondgeneration.Itsharesmostofthebasicassumptionswith1GENmodelswhiletryingtoovercometheirlimitations.Exemplary,econometricmethodslikeautoregressiveconditionalHeteroskedasticmodels-ARCH(Engle,1982),GeneralizedAutoregressiveConditionalHeteroskedasticity-GARCH(Bollerslev,1986)andCopula(Nelsen,1999)methodscanbenamed.Despitetheefforts,thoseoptimizationtechniques,combinedwithalternativeassetclasses,couldnotbuckthetrendofincreasingcorrelationsofholdingsinportfolios.Especiallyhedgefundsbegantosufferfromwhatwecall“mutualfundization”,aclassicmain-stream-effectasaresultofhedgefundinvestmentsturningfromaHigh-Net-Worth-Individual(HNWI)playintoaninvestmentalternativeforinstitutionalinvestors(Asness,Krail,andLiew,2001).Overall,2GENissufferingofthefollowingproblem:onthebasisofcongruentassumptionswith1GEN,riskremainsdeWinedasvolatilitymeasuretominimizecorrelationbetweenallocatedassets.Evenwhenincludingmoresophisticatedmathematicalmodeling,supportedbycomputer-programmedalgorithms,volatilitybasedriskperceptionimpliessigniWicantblindspots.Exemplary,VaR-optimizedportfolios(Schuller,2012)orRiskParityportfolios(Schuller,Kula,2012)canbenamedaspartofthisundesirabledevelopment.Furthermore,duetoadynamicallyencompassingglobalizationandanincreasinglyheterogeneousdeWinitionofassetclassesasamixofstrategies,structuresandgeographies,thepotentialportfolioimpetusofthoseblindspotsincreases.



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4.TraditionalAssetAllocationLimitationsataGlancev  Theyignorethestrongevidenceofregimedependence,regimepersistence,andtime-variationinlong-termassetreturns.

v  Theyassumerebalancingisthebestformofrisk-management,ignoringaroleforhedgingstrategiesorbubbleidentiWicationasalternativeriskmitigationapproaches.Besidesignoringthecostsinvolvedinanyrebalancingofportfolios.

v  Itassumesstablestock/bondcorrelationsandstablediversiWicationbeneWits–itignoresthefactthatstocksandbondsarepositivelycorrelatedin2outof3macrostates.

v  Riskweightsarenotthesameas$weights–ina60/40mixofstocks/bondsequitiesaccountforaround95%ofportfoliovariability.

v  Lengthyandseveredrawdownsarecommon.v  The60/40portfoliowasill-equippedtohandlethestagWlationarymacroenvironmentofthe1970s,aperiodbearingsimilaritiestotoday.

v  Mostalternativesareshortsystemicliquidityrisk,andsocancompoundlossesofaequity-centricportfolioinacrisis(high“stressbeta”).

Althoughempiricalevidencesuggestsotherwise,ModernPortfolioTheoryanditsdescendantsarestilldominatingtheinvestmentcommitteesofinstitutionalinvestors.EspeciallyfordeWiningtheriskbudgetsperassetclassduringtheStrategicAssetAllocation(SAA)process,thetraditionalapproachesenjoygreatpopularity.

Ifnothingelse,sincetheGreatRecessionnowfollowedbyaFinancialRepressionindevelopedeconomies,institutionalinvestorsdonotknowhowtogetanyfurtherastheyrecognizethelimitsoftraditionalassetallocationgenerations.

Giventhegrowinglevelofdespair,UHNWIareincreasinglyaccessibletoreason.Anexample:ThePortfolioWhiteboardProject(Rittereiser,2013)broughttogetherthenextgenerationofUHNWIwithassetmanagerstodeWineanassetallocationmodelforthefuture.ThegroupagreedthattheWinancialcrisishadseriouslyunderminedthevalueofModernPortfolioTheory,yetMPTcontinuestodominateformanagerselectionandassetallocationframeworks„Howcanweunlearnalotofthat?“,askedoneinvestor.Inthispaper,weintendtoanswerthisquestionbyproposingpracticalbuildingblocksforanewassetallocationgeneration.

5.ThirdGenerationAssetAllocation

Whenlookingatallthedeconstructedmythsoftraditionaltechniques,theneedforanewstartbeyondpassinginvestmentfadsisimmediate.

Thethirdgenerationassetallocation(3GEN)representsemancipationfromtheMPTfamilybybreakingwithitsbasicassumptions.Thehomooeconomicusactsnolongerasstartingpoint.3GEN´sacademicfoundationreachesbacktotheearly1990swhentheprospecttheorylaidthefoundationforabehavioralWinancebreakthrough.

In2004,thethirdgenerationbecameitsphilosophicalframeworkthroughAndrewLo´scombinationofneuro-science,evolutionandeconometrics,postulatedasAdaptiveMarketHypothesis(Lo,2004).LodeWinesmarketefWiciencyfromanevolutionaryperspective.

Hispostulateofadaptivemarketsledtoanewassetallocationframework.Whatotheraspectsneedtochangeinapost-crisiscontext(Azmi,2013b)?:

v  Managingriskisverydifferentfrommanagingstrategy.Riskmanagementfocusesonthenegatives(threatsorfailures)ratherthanopportunitiesandsuccesses.

v  Anewinvestmentstrategyisneeded,onethatplacesriskWirstinitsmultitudeofdimensions.

v  Riskwaseitherimproperlymeasured,orconsideredadistantsecondtoreturn.Thisnowneedstochange—forever.

v  Riskmetricsbasedonvolatility,suchasValueatRisk,areinherentlyshort-term,makingthemunsuitableforinstitutionalinvestorsorlong-terminvestors.

v  Risk-factoranalysisiscriticaltoanyinstitutionalinvestorinordertoidentifyunderlyinginvestmentriskfactorsthatdescribethereturnvariationinaparticularportfolioorasset.

Thereareseveralissuestoconsiderforproperassetallocationaspartofthe3GENparadigm.Examplesinclude:emphasizingsoundinvestmentprocess,properriskmeasurementandmitigation,balancedrealdiversiWicationwhichaccountsforbehavioralimplicationsoninvestments.

However,thequestionremains:whichempiricallysoundbuildingblockssatisfythenewassetallocationframeworkofthethirdgenerationofassetallocationmethods(3GEN)?



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5.13GENBuildingBlockIGlobalTransformationProcesses

TacticalAssetAllocation(TAA)hasbeenthenameofthegameformorethantenyears.ItisdeWinedascreatingextravaluebytakingadvantageofcertainsituationsinthemarketplace.USWinancialadvisorshavediscovereditinrecentyearsandpresentthemselvesasskilledmarkettimers.Asamatteroffact,theskillofmarketparticipantstotimethemarketforgeneratingoutperformancehasbeendismalsinceWilliamSharpeintroducedCAPMin1964asequilibriummodeltoevaluateassetpricelevels.Take,forexample,WilliamSherden´sresearchresultsinhisbook“TheFortuneSellers”(Sherden,1998).Sherdenreviewedtheresearchandforecastingaccuracyofeconomistsonpredictingbusinesscycleturningpointsfrom1970to1995.Heconcludedthateconomists´forecastingskillisaboutasgoodasguessing.Noeconomictheoryincreasedsophisticationandnotevenconsensusforecastingoffersimprovement.JamesMontierconWirmstheWindingsofWilliamSherden(Montier,2007).Analystsandeconomistsarelaggingindicators,althoughtheyselltheirexpertiseasleadingindicators.Toonlynameafewmore,DeanBaker(Baker,2002),BarryRitholtz(Ritholtz,2008)andMichaelMcCracken(McCracken,2009)alsoconWirmintheirpublicationsourinabilitytopredictturningpointsineconomicorassetpricecycles.

Conclusively,theanticipationofturningpointsdoesnotworkfordecades.Despitethatfact,markettimingstrategieslikeTAA,sectorrotationorcountryrotationstillrepresentpopularvehiclesinthedistributionchannelsoffundmanagementcompanies.

Drivenbyarobustglobalizationprocesssincetheearly1980s,openeconomiesexposethemselvestoimportingvolatilityfromtradingpartners.Giventhat,theirbusinesscyclesbecameincreasinglyfragile.Marketparticipantswouldbeill-advisedtousefragilebusinesscyclesastheirstartingpointinportfolioconstruction.Evenmoresoiftheywouldtrytotimethem.

TheAlternative:Globaleconomicorsocialtransformationprocesses,forinstanceinfrastructure,emergingconsumerordemographictrends,arestableenoughtoreducetheimpactofbusinesscyclechanges(short

cycles)andbetterquantiWiableandisolablethanKondratieffcycles.Those15-20yearongoingcyclesgenerateareal-economydrivenyieldinthesingledigits(RolandBerger,2012).

BydeWiningthereplicationofglobaltransformationprocessesastheassetallocationprocess´overallobjective,investorsincreasethelikelihoodofachievingcapitalpreservationduetotheirrelativelystable,value-addingcharacterinrealeconomicterms.Exempligratia,thishypothesisisbasedontheinsightofinvestorsavoidingtotimemarkets,thereforebeinglessexposedtomarketandproductfashionsandreducingtheiroverallcostsduetounnecessarilyhighportfolioturnover.5.23GENBuildingBlockIIRiskFactorDiversiYication

Ingeneral,allsecuritiescanbetracedbacktotherootsofequityorliabilitybasedsources.ThedifferentwaysofhowtoaccessthosesourcesincreasedsigniWicantlyduringthesecondhalfofthe20thcentury.Bynow,assetclassesconsistofaheterogeneoussetoffragmentedstrategies,structuresandgeographies.FollowingMarkowitz´ideaofnotputtingallofoureggsinonebasket,itwasassumedtobesufWicientduring2GENtodiversifyinmanydifferentassetclasses.EmpiricalevidencehasproventhisideaofsimpleassetclassdiversiWicationwrong.OneexamplewasprovidedbySebastienPagefromPIMCO(Page,2011)whoworkedouttheweaknessofmulti-assetportfoliosthatrelyonthebeliefofheadlinediversiWication.

Theideaoffactorinvestingisfarfromnew.ItcanbebackdatedtoWilliamSharpe´sCAPM,whichpredictsthattheonlydeterminantofanasset´sexpectedreturnishowstronglyitsreturnsmovewiththemarket(Beta).Thisfactorhasbeenprovenwronginthe1970s(Ross,1976),butresearchersstartedthesearchformoredeterminingfactors.Aprominentexampleofthesearchwaspublishedin1993byEugeneFamaandKennethFrench(Fama&French,1993).Theyintroducedthethree-factor-modeltodescribestockreturns,namelybeta,smallcapandvalue.Carhartadded„momentum“asfourthfactorin1997(Carhart,1997).



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FactorinvestinghasbeenresearchedforthelastWiftyyearsbasedonthefollowingassumption:riskisasaquantitative,vola-related(SD,Variance,MaxD,Beta,etc.)factor,whichhastopayapremiuminexchangeforaninvestorsexposure.

Under3GEN,ariskfactorisdeWinedmorecomprehensively:it´sameasurable,quantitativeorqualitativefactorofinWluenceonanasset.

Anin-depthanalysisofstate-of-the-artriskfactordiversiWicationcanbefoundinthepublication„DiversiAikationvonRisikofaktoren.EineEinführung.“(Schuller,Kula,2013)ofGökhanKula(MYRACapital)andMarkusSchuller(PantheraSolutions).

Fundamentally,inrecentyears,factorbasedinvestingbecameincreasinglypopularduetothesuccessofpassiveinvesting.ValueorSizefactorsarenowaccessibleevenforretailinvestorsviaETFs.ThoseSmartBeta(orasdescendantsAlternativeBeta)productssimplyrepresentanewwayofstructuringriskfactorsthatfollowthetraditionaldeWinition.

WhenstartingtheAssetAllocationprocesswithbuildingblockIbyreplicatingtheaggregatevalueaddedofglobaltransformationprocessesinaportfolio,a3GENriskfactorframeworkachievesdiversiWicationthroughmanagingquantitativeandqualitativefactorsacrossthreemainlevels,whichareasfollows(Schuller,Kula,2013):

v  Macrolevel:globalriskfactorsv  Mesolevel:transformationprocessriskfactorsv  Microlevel:Winancialinstrumentriskfactors5.33GENBuildingBlockIIIAppliedBehavioralFinance

Asearlyasinthe1960s,BenoitMandelbrot(Mandelbrot,2006),fatheroffractalsandcreatorofChaosTheory,criticizedtheMPTbyexplainingwhythesimplifyingassumptionsaregettingthemoutofrelevancetotherealworld.Backthen,themind-setwasbiasedtowardsadeterministicimageofhumanity(„homooeconomicus“).ItwasthetimewhenMiltonFriedmanpublishedhisCapitalismandFreedom(Friedman,1962),layingthefoundationforaschoolofthought(Chicagoschoolofeconomics)thatdominatedmostofthesecondhalfofthe20thcentury.Itshouldnotsurprisethatthismind-setfounditswayinto

Winance.TheEfWicientMarketHypothesis–EMH(Fama,1970)actsassignalexample.Itshouldbeequallyunsurprisingwhywarningvoicesbackthenwentunheard.Theywereagainstthezeitgeist.

Today,wecanrelyontheinsightsofbehaviouralWinancepioneerslikeDanielKahneman(Kahneman,2011),AndrewLo(Lo,2004)andRobertShiller(Shiller,2009).ExchangingtheimageofhumanityinourunderstandingofmarketsfromamathematicaltoabiologicalrigorleadstosigniWicantlydifferentconclusionsforarule-basedinvestmentprocess.

Theprocess,evenwhenbeingimplementedautomatically,isdeWinedandmanagedbypeople.Nottakingthehumanfactorintoconsiderationduringitsimplementationwouldunderestimatetheimpactofmorethan90cognitivebiasesacademiahasdeWined.Havingsaidthat,deWiningdecision-making,believesandbehaviouralbiasesaswellasknowingthemisnotsufWicient.Theactionmakesthedifference.AsBenjaminFranklinusedtosay:“Welldoneisbetterthanwellsaid.“HowtoapplybehaviouralWinanceinaninvestmentteam/process?

This3GENbuildingblockIIIshouldoperatealongthefollowingimperative:

MinimizeblindspotsOurperceptionisourreality.ThecognitiveinabilitytoexperienceontologicaltruthisknownatleastsincePlato'sallegoryofthecave.Humanbeings,asnon-trivialmachines(vonFörster,2006)intheirongoingautopoiesis(Maturana,Varela,1992)arelimitedtoepistemologicalperceptionsofreality.Itresultsinustryingtoanalyzeothermarketparticipantsasmovingnon-trivialsubjectswhilebeinginmotionourselves.Evenifhightechnicalcompetence,highethicalstandardsandastrongwillforimplementationisassumed,thisrepresentsahighlycomplextask.Allwecandoistryingtominimizeasmanyblindspotsinourperceptionaspossiblethroughmanagingourcognitivebiases.Thisleadstoarelativeandtemporarycompetitiveadvantagetoothermarketparticipants.LikehowBenoitMandelbrothasdescribedit(Mandelbrot,2006):“TheprimemoverinAinancialmarketsisnotvalueorprice,butpricedifferences;notaveraging,butarbitraging(betweenplacesand/ortimes).”



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Conclusively,theadvantageofamarketparticipantisnotsourcedfromWindingontologicaltruth,likeanabsolutealgorithm–quasiaworldformulaofinvesting-butinbeingabletointerprettheepistemologicallandscapebetterthanothers.Thisimpliestheneedofaninvestmentprocessthatrespondsdynamicallytochangesintheperceptionofthelandscape.

DonaldRumsfeld(Rumsfeld,2002),forexample,managedtoguideusatleastinstructuringthisprocessofminimizingblindspots:

„[T]hereareknownknowns;theyarethingsweknowweknow(category1).Wealsoknowthereareknownunknowns(category2);thatistosayweknowtherearesomethingswedonotknow.Buttherearealsounknownunknowns(category3)–therearethingswedonotknowwedon'tknow.“

NassimTalebnamesthemdifferently,butcomestothesameconclusionwhencategorizingriskfactorsasfollows:

§  WhiteSwans(=knownknowns/category1)§  GreySwans(=knownunknowns/category2)§  BlackSwans(=unknownunknowns/category3)

ThepsychoanalyticalphilosopherSlavojŽižekextrapolateda4thcategoryoutoftheWirstthree:“unknownknowns”(Žižek,2006).ThoserefusetoacknowledgeepistemologicalrealitiesandpretendnottoknowthemlikeUSmortgagelendingpracticesduringthelastcycle.

WhenimplementingbuildingblockII–thediversiWicationofriskfactors–weactuallytrytomaximizethequantityofcategory1factors,togetherwithanestimateontheirimpactprobabilityandlikelihoodofoccurrenceonamacro,mesoandmicrolevel.Implicitlywetrytominimizethenumberoffactorsincategory2-4.

Whatisrequiredforaninvestmentteamtodowellinminimizingblindspots?1.  Individualqualitiesofinvestmentteam

membersliketechnicalskills,criticalthinking,ethicsandintrinsicmotivationtosearch,Windandminimizeblindspots.Ongoingmentalhygieneachievedthroughsingleand/orteamsupervisionwillfacilitatecontinuousdevelopmentofthoseindividualqualities.

1.  x

2.  Ateamculturethatencouragesthewillingnesstoconstructivelychallengeoneselfandeachotherinsearchforblindspots,inordertoreachbetterexplanationnothigherrankrulesinadebate.Consequentiallycreatingwisdomwillsupersedecareerrisk.Giventhat,teamswillconsiderit´normal´tosecond-guesstraditionalnormsintheinvestmentindustryonacontinuousbasis,withtheabilitytogenerateinnovativeideastoovercomethem.

3.  Anincentivesystemthatdemandsfromindividualstohaveskinintheinvestmentgame.

4.  AtransparentgovernancestructurewithclearlydeWinedroles,strategies,decision-makingprocessparticipationandprinciplesforexecution.Theinvestmentdecision-makingprocessitselfrequiresascientiWic,evidencedrivenframework,utilizingboththeartandexperienceofprofessionalinvesting.

5.  AdiversesetofquantiWiableriskmeasuresthatsupporttheinvestmentteamtomonitortheblindspotminimization

RayDaliocanbenamedaspositiveexampleofhowtocreateanorganizationthatisdeterminedtominimizeblindspots.Inhis“Principles”(Dalio,2011),hedescribeshisinterpretationforthe5requirementsfromabove.5.43GENBuildingBlockIVVehicle&JurisdictionAgnosticism

AreCTAspartofthehedgefundpocket?ShouldwecategorizeanAlternativeUCITSproductofanoffshorehedgefundmanagerasmutualfund?CananactivelymanagedETFinaUCITSstructurestillbecalledpassiveinvestmentorisitaplainvanillamutualfundlikethevehiclesuggests?WhenenteringabroadEmergingMarketETFareweactuallybuyingexposuretoemergingmarketsoronlyareciprocalhomebiasvialarge,exportorientedindexmembers?

AsshowninbuildingblockII,thedaysofsimpleheadlinediversiWicationviaassetclassesareover.Weneedtobreakdowneachassetclassinitsriskfactors.Thebreak-downneedstobeguidedbythedeconstructionofgeneralizingmyths,likemutualfundsgeneratingalphaorhedgefundsaddingnon-correlationtoaportfolio.



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Exemplaryimplicationsofvehicle&jurisdictionagnosticism:

v  Thedistinctionbetweentraditionalandalternativeinvestmentsisobsolete.Anincreasing“mutualfundization”effectinAIemerginghasbeenseen.Consequentially,assetclasscorrelationsremainhigh.

v  Applythesamedetailedquantitativeandqualitativeduediligenceprocessforonshoreoroffshore,retailorinstitutional,hedgefundormutualfund,andactiveorpassiveproducts.

v  TheInvestmentCompanyInstitute(ICI,2015)counts79669mutualfundsworldwide.About80%ofthemapplyclassiclong-onlyequity,bondorbalancedportfoliostrategies.Avoidthem!

v  Eachselectedproductneedstoofferexposuretoatleastonetransformationprocess(buildingblockI)andmanagesatleastoneriskfactor(buildingblockII).

v  Minimizecostsviapassivebias.Onlyenterinactivelymanagedproductsifnicheisattractiveenoughtoofferatemporaryalphaopportunity.

5.53GENBuildingBlockVEvidence-driven,rule-basedDSAAProcess

SinceMarkowitz´modelmarkedamilestoneinprofessionalizingtheassetallocationprocessintheformofarepeatable,standardizedprocess,thetrendinassetallocationwenttowards“optimizationthroughautomation”.Itallowedtorunlargerportfolioswithalowerhead-countandalsoenabledthemanagertooutsourceresponsibilitiesoftheWinalallocationdecisiontoamathematicalformula.Careerriskminimized,missionaccomplished.

Outsourcingresponsibilitiestoamathematicalformula,thusanalgorithm,isnotonlyethicallywrong,butalsoepistemologicallyWlawed–seebuildingblockIII.Itsuffersfromthe“garbagein,garbageout”syndrome.NassimTaleb(Taleb,2012)pointsonthedangerofoutsourcingthisresponsibilityincaseofarareevent:“BlackSwanshijackourbrains,makingusfeelwe»sortof«or»almost«predictedthem,becausetheyareretrospectivelyexplainable.[...]AnannoyingaspectoftheBlackSwanproblem–infactthecentral,andlargelymissed,point,isthattheoddsofrateeventsaresimplynotcomputable.“

Whenturningawayfromquantitativeoptimizationmodels,therule-basedprocessoffersafeasiblealternativetorandomdiscretion.Runningportfoliosaccordingtorule-basedprocessesisnothingnew.Evensomeplainvanillalong-onlyequitymutualfundsclaimtoapplythistechnique.Aruleitselfisneutralfactorwithanormativeintention.Itnowdependsonthequalityofruleandthecontextitisembeddedin.

Howcananevidence-driven,rule-based3GENframeworkcombinethedifferentbuildingblocksinonecoherenceassetallocationprocess?

Step1DeWineAssetAllocationPrinciplesAssetallocationprincipleshelptoconvertthegeneralideaof3GENbuildingblocks1-5intoactionableworkpackages,bydeWiningadurablesetofrules.

(BB:buildingblock)

ExampleI PrincipleOnGeneralSetting(BBI)

“Eachprinciplehastobeevidence-driven.“

ExampleII PrincipleOnTeamCulture(BBIII)

“Eachteammembermeetsquarterlyforasupervision.”

ExampleIII PrincipleOnStrategy(BBI)“Eachselectedtransformationprocessneedstoqualifyintwomaincriteria:a)itcanbequantiAiedandb)asufAicientlydiversesetofAinancialinstrumentsisavailabletocoveritfromdifferentangles.”

ExampleIV PrincipleonProductSelection(BBIV)

“Investasclosetothevaluegeneratingsourceofanopportunityaspossible.”

ExampleV PrincipleonProductSelection(BBIV)

“Foreachproductselected,a´productjournal´hastobeAilledintoreasonthechoice.”

ExampleVI PrincipleOnRebalancing(BBV)

“RebalancequarterlyontheAirsttradingdayofanewquarter.”



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Step2DeWineOperationalProcessFormtheassetallocationprinciplestoworkpackageswhichshouldbearrangedinaWlat-hierarchy-basedworkWlow.Step3ManageOperationalProcessRunningtheoperationalprocessrepresentsamanagerialtask,comparabletothoseinotherindustries.Best-practicemethodslikeManagement-by-ExceptionandBalancedScorecardswillhelpmanagerstoruntheirorganizations.Both,principlesandprocessshouldbereviewedperiodicallyinatransparentandparticipativeway.6.  12AssetAllocationImperativesforUHNWI

1.  Stopmarkettiming,starttransformationprocessreplication

2.  Stoppredictingassetpricechangesandeconomicturningpoints,investforecast-free

3.  StopassetclassdiversiWication,startriskfactordiversiWication

4.  Rebalancefrequently5.  OnlyadjustyourDSAAwhenriskfactors

change

6.  Bevehicleagnostic7.  Bejurisdictionagnostic8.  Createamissiondrivenculturethat

facilitatesopendebatesandrewardsthebestreasoning

9.  Developalong-terminvestmentmindset10.  DeWineAAprinciplesasgeneralguidancefor

anevidencedriven,rule-basedasset

allocationprocess11.  Combineyourmissiondrivencultureand

yourrule-basedassetallocationprocessto

achieveanti-cyclicalinvestmentrhythms12.  ComplementyourexperiencewithascientiWic

decisionmakingframeworktoutilizeboth

yourexperienceandtalentpractically.

7.SpecialAssetAllocationTopics7.1EthicsandAssetAllocationComplyingwithregulatorynormsasaqualiWied/sophisticated/professionalinvestorleftaside,wenowwanttodigressandtalkaboutprofessionassuch.ThetermcomesfromtheLatinprofessioandsigniWiesapubliccommitmenttoatrade,anoccupation.

TalcottParsonsarguesthatprofessionsconsistofandemergefromavalueconsensusthatisspeciWictotherelevantprofessionalactivity.Itensuresthat,instrivingtosolvecertainproblems,membersofthetradegainhighapprovalfromsociety.ParsonidentiWiestheriskoffailinginthisparticularactivityasanotherpremiseforthisprofession.

Fromasystems-theoryperspective,anindividual’soccupation,beingagainfulactivitythatwastaughtanddevelopedovertime,isasubsetofthenotion‘profession‘.Kurtzviewstheprofessionasanautopoieticsubsystemthatischaracterisedbya‘speciWictrainingforaparticularWieldofactivity‘.Assuch,italwayshastoWindwaysofadministeringknowledge.

SowhichqualitiescanweexpectaprofessionalWinancialmarketparticipanttohave:§  Willingnesstoacquireknowledge§  Willingnesstoapplysaidknowledgeinspiteofariskoffailure

§  Willingnesstocreateanaddedvalueforthecustomerinapplyingone‘sknowledge

UnethicalactionsofaprofessionalWinancialmarketparticipantcanthereforebeattributedtothefollowing:

§  Lackofwillingnesstoacquireknowledge–Result:Ignorance

§  Ignoranceinspiteofwillingnesstoacquireknowledge–Result:Ignorance

§  Lackofwillingnesstoapplytheacquiredknowledge–Result:Actingagainstone’sbetterjudgement

PretenceItstartswithpretending.

PretencecanbelistedasanestablishedformofunethicalbehaviourofprofessionalWinancialmarketparticipants.Itcanbeattributedtobothignorance(1.and2.)andactingagainstone’s



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betterjudgement(3.).MoneyasanabstractmediumofcommunicationofpowerbetweenindividualshasbeengivenanexchangeplatformonWinancialmarkets.Inlegitimisinggreed(asevidencedbytheBerkeleystudies),thismediumencouragespretence.Thehubris:ProfessionalWinancialmarketparticipantsareintelligent,well-educatedandwealthy–theycanthusrightfullybecalledsuperior.Pretenceprovidesaneleganttooltoturnthishubrisintoaliveableformofself-perceptionforeachindividualparticipant.7.2UnethicalAssetAllocationMethod–ExampleIndex-huggingmutualfundsThelifelineofanytraditionalmutualfund(Long-Equity/LongFixedIncome/BalancedPortfolio)istheprospectofoutperformingitsrespectivebenchmark.Thisiswhatisknownas‘generatingalpha‘.ThegrossoutperformanceinrelationtotheindexhastobesigniWicantenoughtogeneratealphaintheinvestor’sportfolioevenafterthedeductionofoperativemanagementcosts,transactioncosts,structuralcostsanddistributioncosts.Thisistheassumption.

Howgoodistheindustryatsupportingitsownclaim?Well,notverygood.Studieshaverepeatedlyandconsistentlyproventhattraditionalmutualfundsunderperform.Herearesomeexamples:

Edelen,RichardEvans(2007):“ScaleEffectsinMutualFundPerformance–TheRoleOfTradingCosts”|ChristopherPhilips,FrancisKinnery(2010):“MutualFundRatingsandFuturePerformance”|MarlenaLee(2009):“Isthereskillamongactivebondmanagers?”|LarrySwedroe(2011):“TheQuestforAlpha”|RogerBurtonMalkiel(1996):“ARandomWalkDownWallStreet”|MarkCarhard(1997):“OnPersistenceinMutualFundPerformance,”|MarkCarhart,JenniferCarpenter(2002):“MutualFundSurvivorship”.

Manymorecouldbeaddedtothislist.Beitonalong-termorshort-termbasis,equityorbondfunds,experiencedoremergingmanagers:SincemutualfundsturnedintoasuccessstoryafterWWII,initiallybasedonsingle-period,singlefactormodels,thepatternoftheirchronicalunderperformancecanbeconsideredstable.

Thosearguingthattheindustryhasbeentryingforsometimetoimproveitsperformancethroughinnovations–130/130fonds,absolute/total-returnmutualfundsoralternativeUCITSbasedontraditionalassetclasses–canbereferredtothisstatistic:Accordingtothe2011ICIfactbook,equityfunds(includingrespectivemutations)held95.2%inlongequitiesand3.5%incashorequivalents.Alternativevariationsintheguiseofmutualfundsrepresentedagrowing,butstillmarginalminority.

ToxicFormula:Fees+Index-hugging

In2013,ProfessorAmihud(NYUSternUniversity)co-publishedastudyinvestigatingwhethertraditionalmutualfundsareworththeirfees.ThestudyfoundthatthemedianmutualfundhadanR-squaredof93%inrelationtoitsindex.HereishowhecommentedtheseWindings:“Theytellyoutheyareactivefundsandtakeyourmoneybutdosomethingclosetotheindex.“ThereisareasonthatanoldWinancesayinggoes:“MutualFundsaresold,ETFsarebought.“Itreferstothefactthatdistributionchannelsofmutualfundsinitiatorsstillworkverywelldespitetheirmodestperformance.Atthebeginningofthe21stcentury,ameasureestablisheditselfthatshouldhelpsortoutthemultitudeofindex-huggingmutualfundsbyintroducinganindicator:ActiveShare.

Youcanreaduponitin:Wermers(2003)“IsMoneyReallySmart?NewEvidenceontheRelationBetweenMutualFundFlows,ManagerBehaviorandPerformancePersistence“/Brands,Brown&Gallagher(2005):“PortfolioConcentrationandInvestmentManagerPerformance“/Kacperczyk,Siam&Zheng(2005):“UnobservedActionsofMutualFunds“/Cohen,Polk&Silli(2010):“BestIdeas“.Astudythathasfrequentlybeencitedis“HowActiveIsYourFundManager?“(2007)byCremers(OxfordUniversity)andPetajisto(YaleUniversity).

Majorinvestmentmanagementgroupsinthemutualfundssector,suchasFidelity,weren’tgoingtotakethislyingdown.Intheirrebuttal(“ActiveShare:AMisunderstoodMeasureinManagerSelection“),whichwasreleasedinearly2014,theyattemptedtodiscreditthisindicatorbydisprovingtheunderlyingconcept.Shortlythereafter,JohnAuthers,oneofthemostdistinguishedjournalistsoftheFinancialTimes,evisceratedFidelity’spaperinhisarticle“Activefundmanagersareclosetindexhuggers“.



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Rightlyso.Fidelitypublishedanobviouslycommissionedwork.Aregularoccurenceinourindustry.Managingandsellingtraditionalindex-huggingmutualfundsisunethical.Thepeopletakingpartinthisactivitycouldandshouldknowbetter.Theyliketoclaimthatitisinthecustomer’sbestinterestwhenitisnothingmorethananotherformoftheaforementioneddeception.Inactuality,thisisaclassicalcaseofthe‘greaterfool‘game.Accordingtothe“GreaterFoolTheory“,oneoffersastupidproduct,hopingthatsomebodyevenmorestupidwillbuyit.Thisisnotaboutthevexedquestionofactivevspassiveinvestments.InvestinginactivelymanagedportfoliosthathavearealisticchanceofoutperformingtheirbenchmarkindexisentirelyjustiWied.Ifamanageroperatesinanichewherehecollectsandinterpretsinformationthathelpshimoutpacehiscompetitorsduetoabetterunderstandingofcausalfactorscurrentlydrivingtheniche,theinvestorhasarealisticchanceofobtainingalpha.Thisdoesn’trequireaforecast.Suchcases,however,arecurrentlytheexception.Ontheotherhand,makingacustomerbelievethatafundcangeneratealphaalthoughitconsistentlyunderperformsinrelationtobetaduetoitsverystructuralconceptionisnotonlyinadvisable,butalsounethical.Insteadofinvestinginindex-huggingmutualfunds,institutionalandprivateinvestorswouldbebetteroffallocatingfundstotrackerfundsorETPs.Theydon’tclaimtogeneratealphaandaresigniWicantlycheaper.7.3AlternativeRiskMeasuresinAssetAllocationAsoutlinedabove,risk-managementpracticeshavebecomeacentraltopicsincetherecentWinancialcrisis.Riskmanagementisnolongeracomplianceissue.Organisations/investorsshouldidentifyandpreparefornon-preventablerisksthatariseinternallyandexternallytotheirinvestmentstrategy–seepreviouscategory1-4riskssegmentation.

Inimplementation,riskisoftenunder-measured.Forexample,manyinvestmentinstitutionsuserisk-distortingfactorslikestandarddeviationorSharperatioasameasureofrisk,duetoitseaseofuseandtheavailabilityoftheunderlyingdata.However,manyresearchersprovideanalysisofriskmeasuresthatgobeyondstandarddeviation,suchasPWlug(2006),Balbas,BalbasandMayoral(2009)andRockafellar,UryasevandZabarankin(2006):OtheralternativeapproachesincreatingaframeworkofriskmanagementmeasuresincludeTobin´sQ(Tobin,1968),MinskyMoments(Minsky,1992)andIneichen´s“FEI–FinancialExplosivityIndex”(Ineichen,2012).

v  PWlug(2006)researchesmeasuresofriskintwocategories:riskcapitalmeasures(whichservetodeterminethenecessaryamountofriskcapitalinordertoavoiddamageiftheoutcomesofaneconomicactivityareuncertain,andtheirnegativevaluesmaybeinterpretedas:acceptabilitymeasures,safetymeasures,andpureriskmeasures)andriskdeviationmeasures(whicharenaturalgeneralisationsofthestandarddeviation).

v  Rockafellar,UryasevandZabarankin(2006)systematicallystudygeneraldeviationmeasuresfortheirpotentialapplicationstoriskmeasurementinareassuchasportfoliooptimisationandengineering.

v  Balbas,BalbasandMayoral(2009)emphasisethatmodernriskanalysismustfacetwomajordrawbacksaffectingmostoftheavailablesecuritiesandmanyinvestmentstrategies;namely:asymmetricreturnsandfattails.



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Thismaterialisforyourinformationonlyandisnotintendedtobeusedbyanyoneotherthanyou.Itisdirectedatprofessionalclientsandeligiblecounterpartiesonlyandisnotintendedforretailclients.TheinformationcontainedhereinshouldnotberegardedasanoffertosellorasasolicitationofanoffertobuyanyWinancialproducts,includinganinterestinafund,oranofWicialconWirmationofanytransaction.AnysuchofferorsolicitationwillbemadetoqualiWiedinvestorsonlybymeansofanofferingmemorandum.ThematerialisintendedonlytofacilitateyourdiscussionswithPantheraSolutionsastotheopportunitiesavailabletoourclients.Thegivenmaterialissubjecttochangeand,althoughbaseduponinformationwhichweconsiderreliable,itisnotguaranteedastoaccuracyorcompletenessanditshouldnotberelieduponassuch.Thematerialisnotintendedtobeusedasageneralguidetoinvesting,orasasourceofanyspeciWicinvestmentrecommendations.Pastperformanceisnotaguidetofutureperformance.Futurereturnsarenotguaranteedandalossofprincipalmoneymayoccur.©2015PantheraSolutions.Allrightsreserved.

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