Investors’ current affinity with asset liability benchmarks has a very strong resemblance to investors hugging asset benchmarks towards the end of the prolonged equity bull market at the end of the 1990s. The period of disinflation of the 1980s and mainly the 1990s together with some other factors gave rise to the cult of equities. Reforms and a changed perception allowed some investors larger allocations to equities, essentially to take more risk. The common wisdom prior and at the peak was that “equities are for the long term” and that they outperform bonds in the long run. As a long-term investor, one could therefore have a large equity allocation because one could sit through large drawdowns. Many continental European institutional investors, for example, started to move away from their traditional bond-heavy portfolios and piled into equities close to the peak. So when we hear more and more institutional investors claiming that asset liability management, ALM for short, is the pinnacle of institutional investors’ wisdom, it somehow has a déjà vu ring to it. We’ve seen an institutional infatuation with benchmarks before.
Let’s assume for a moment that wealth or capital preservation is one of the key aspects of the whole asset management profession, potentially elucidated by the following two pieces of financial wisdom:
“Diversification should be the cornerstone of any investment programme.”
—Sir John Templeton
“The first rule of investment is don’t lose. And the second rule of investment is don’t forget the first rule. And that’s all the rules there are.”
—Warren Buffett quoting Benjamin Graham 
The diversification idea is based on the premise that we don’t know the future. If we knew that wind farms would yield the best 10-year point return, there would be no need for caring about risk or diversification. Diversification is for those who know what they don’t know. All other investors either don’t know what they don’t know or caught some dogma bug from which the only cure is substantial losses. “Learning by doing” is an important adage in risk management and experience a cruel and expensive teacher.
The idea of diversification is very old. Supposedly, it’s the only free lunch. The idea has entered the English language as “don’t put all your eggs in one basket.” It has entered investment management orthodoxy via Harry Markowitz and modern portfolio theory (MPT). The idea of spreading risk by diversifying risk is much older than MPT though. The Oxford English Dictionary traces the “eggs in the basket” idea to 1710, referencing an Italian source of proverbs from 1662. The idea of diversifying risk can be traced even further. The Talmud suggests:
Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve. 
This makes it somewhat difficult to date the origin of the idea of diversification by spreading the risks. Suffice to say, the idea of diversifying risk could be thousands of years old, potentially as old as civilisation itself; or if not, at least as old as men going about their business affairs. The funny thing about the Talmud quote above is that it suggests both a “margin of safety” as well as equal weighting. Equal weighting is not yet a trend in investment management but it has been discussed in some journals for a while. The main argument for equal weighting is that we just know far too little about future returns, future volatilities, and future correlations for mean-variance optimisation to have any value. Furthermore, the assumptions behind MPT are onerous and impractical; onerous because the input variables for many viable investments are not available; impractical because most of the assumptions behind MPT have turned out to be false, misleading, or dangerous, or a combination thereof.
In the model-world of MPT, combining equities and bonds makes perfect sense because the correlation coefficient is less than one. (Except when it really matters of course; in a major panic and sell-off, for example.) However, strong beliefs in a model can be dangerous, as various blow-ups as well as the most recent banking crises have demonstrated. Long-only investments in equities and bonds (and bills or cash) can move more or less in tandem over extended periods of time. More precisely, in times of inflation equities and bonds decline in tandem while in times of disinflation equities and bonds rise in tandem. It is wiser, we believe, to seek additional alternatives and/or operate in an “asymmetric returns” fashion . This means allocations should be a function of the opportunity set, rather than a combination of statistical variables entered into a faulty econometric supposed-optimiser.
In the institutionalisation of the equity market there were pioneers, early adaptors, and late-comers. The pioneers are typically a small group. For reasons that are beyond the scope of this article, it was the English-speaking economies that developed an equity culture of some sort very early on. In the US the idea of investing 60% of assets into equities while 40% into bonds held for many years, decades even. In inflation-prone UK the equivalent allocations were closer to 70% and 30%. A high equity allocation was the right choice, as cheap credit expanded and the authorities were pursuing continuous competitiveness boosts via currency weakness. An institutional equity culture in continental Europe developed in the 1990s whereas equity allocations – generally speaking – never reached the “English-speaking” levels of 60% or 70%. Some (governmental or government-sponsored) entities literally started allocating to equities within a couple of months from the 2000 peak.
The institutionalisation of hedge funds, for example, was similar. The institutional pioneers invested in the 1990s; early adaptors around 2000-2002; and then the institutionalisation of the hedge fund industry took off. The institutionalisation of hedge funds took place during a time where nearly any diversified portfolio of hedge funds had outperformed equities or a 60/40 equity/bond mix on a rolling five-year basis. The main selling points were “absolute returns”, or “alpha”, or the hedge-funds-can-make-money-in-all-market-conditions argument. Investing in hedge funds had become a fashionable consensus. Since the end of 2012, any combination of equities and bonds outperformed hedge funds thanks to various asset inflation-friendly interventions by the various central planning authorities around the world. Whether the artificial, international orchestrated wealth effect will last forever, thereby making risk management and hedge funds obsolete, is doubtful.
There are institutional investors who are not diversified. The belief is that they don’t need to. The belief is that bonds, long-term bonds in particular, are the perfect match for their liabilities. These investors are in synch with the current regulatory regime but not with what Sir John Templeton thinks is the cornerstone of every investment programme. Potentially there is a gap opening with regards to doing what is rightful and what is right.
When risk is managed relative to a benchmark, there is an implicit indifference to absolute losses. If a benchmark falls by, say, 20% and assets fall in unison, from the perspective of the tracking risk manager, nothing is lost. The current infatuation with ALM and liability benchmarking and the subsequent high bond allocations potentially mean that some investors are out of synch with the two “rules” on diversification and capital preservation mentioned above. There is an indifference to potential losses. When interest rises and bonds fall, the liabilities will fall too. The risk management department, therefore, is managing tracking risk, like in equities 10+ years ago. There is a reality kick out there. There are two statements that we occasionally hear from institutional investors that we interpret as warnings signs that history is just about to repeat. 1. An institutional investor stating after explaining his approach that he never would manage his own money in that fashion. 2. The idea of holding a bond to maturity in the case of sharp declines in bond prices, thereby ignoring rising default probability.
At the peak perceptions are different than at the trough. Calling an active mandate in equities with a tracking error constraint of 1-2% against the benchmark was perfectly normal at the peak of the equities bull market. Managing risk from an absolute returns perspective was not even a thought among many long-only asset managers and their consultants and clients. However, this changed as share prices started to fall. The assumed indifference to absolute losses slowly but steadily turned out to be ill-advised. It is this reality kick that put hedge funds on the agenda of many institutional investors. (Note that the pioneers and early adaptors invested prior to equities falling. It is therefore interesting to observe that some institutional investors, mainly in North America, have already started to diversify their bond exposures).
Related to ALM, this reality kick has not yet materialised. The reason is that the ALM crowd has actually done rather well up until a couple of months ago. So when they argue that they are indifferent to absolute losses, it actually makes perfect sense to them. After all, when interest rates rise in earnest and bonds fall, so do liabilities. Assets and liabilities are in synch. Risk is defined as tracking risk, i.e., risk is perceived as asset moving out of synch with their liabilities. This is of course the same as the tracking risk dogma in equities 12 years ago. There is the perception that there is no need for diversification or capital preservation. Some investors might have turned into administrators by allocating their time to ticking boxes and abiding to guidelines rather than thinking about attractive long-term investments.
Bonds have been in a 30-year bull market and one bond expert after another is now calling its end. Bonds are expensive. Fig.1 shows pricing of equities, bonds and cash for the US as a proxy for the industrialised economies. Equities valuation is based on the trailing earnings yield (reverse of the PE ratio), bonds on the 10-year Treasury yield and cash on the Fed’s fund rate. The first six groups of bars show the valuation metric in January of the decade while the bars on the right show the most recent valuation. The higher the yield, the cheaper the asset class. (With a yield of 10% it takes only a decade to get one’s money back, with a yield of 1% it takes a century. This is a tricky concept, of course. It assumes there are no taxes and expropriation. A yield of 1% in Switzerland (strong currency, low taxes, lean government, and history of sound private property rights) is potentially cheaper than a 2.5% yield in France (weak currency, high taxes, big government, and history of nationalising private assets).
Bonds, represented here by yield of the US 10-year Treasury, have become expensive since the early 1980s, yields falling from double digits in the 1980s to below 1% in 2012. Equities went the other way, being expensive at 3.4%, trailing earnings yield, to being cheap compared to government as well as corporate bonds. With the short end of the yield curve being very low or negative in real terms, cash is very expensive as financial repression is essentially a wealth transfer from the risk-averse saver or rentier to debtor; or governmental theft, depending on one’s propensity to articulate economic phenomena.
An additional aspect is related to committee-based investment decision-making. Most institutional investment committees are comprised of individuals with different backgrounds. Not all of them are familiar with finance and economics in general and the history of stock and bond markets in particular. Those with knowledge dominate the investment process, especially when all goes well. Those with less knowledge have nothing much to add other than agree and nod approvingly with the bellwether. Any criticism is easily put down by referring to favourable past performance. However, when equities started to fall in the early 2000s the investment committee dynamics started to change. Suddenly the equities-outperform-bonds-in-the-long-term mantra had a different feel to it. The equity-defending bellwethers in the committee had their wings clipped. The laypeople in the committee started to question the logic of having such a high allocation to equities. Doubting equities was nearly impossible when they were rising, but was made easier when falling. Was tracking risk really all that mattered? Real absolute losses changed the game. Committee meetings turned less jovial when faced with losses. Suddenly underfunding and fund solvency were agenda items. The investment committee dynamics were different when share prices were free-falling than when they were rising with irrational exuberance.
The practical relevance is that history rhymes. This time it is not an infatuation with equities but with long-term bonds, including government bonds. The regulator and accounting ruling boards are partly to blame. Next to politics and central banking, they play an increasingly dominant role in the current environment. It is they who apply current dogma in finance unquestioned and set the guidelines. The ALM phenomenon is essentially, or partly, a function of the general legal and regulatory framework; hence the perception of rationality on the part of the asset liability benchmarker.
One aspect beyond the scope of this article is an ethical one: rational decision-making under uncertainty and asset allocation is one thing. Another is whether the Prudent Person Rule supports financing political profligacy, supports the participation in a government-sponsored pyramid scheme (certain aspects of health care and social security), and – some might argue – unprecedented maladministration, misgovernment, and mismanagement of public funds.
Alexander Ineichen is founder of Ineichen Research and Management AG, a research firm founded in October 2009 focusing on risk management, absolute returns and thematic investing. Ineichen is the author of the two books on absolute returns investing. He is on the board of directors of the CAIA Association and is a member of the AIMA Research Committee.
1. It is unclear whether origin is from Ben Graham. Buffett in “The Forbes Four Hundred Billionaires,” 27 October 1986: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”
2. Swedroe, Larry E., and Jared Kizer (2008) “The Only Guide To Alternative Investments You’ll Ever Need,” New York: Bloomberg Press.
3. See Ineichen (2007) or earlier work.
Swedroe, Larry E., and Jared Kizer (2008) “The Only Guide To Alternative Investments You’ll Ever Need,” New York: Bloomberg Press.
Ineichen, Alexander (2007) “Asymmetric Returns—The Future of Active Asset Management,” New York: John Wiley & Sons.