This year’s commentaries review some of the surprising ways in which scientific-seeming or rule-based approaches to investing, which are now the norm and implemented via exchange-traded funds (ETFs) and index-based mutual funds, are foiled in practice by the social science reality of the fluid marketplace. A formulaic approach can work for a while, until a sufficient number of additional investors apply it. Their aggregate actions impact the supply/demand balance, valuations change, and the formula can no longer work. In reviewing some popular building blocks of the asset allocation model of investing, we have, hopefully, demonstrated:
- That an emerging markets index probably does not contain much in the way of emerging markets exposure, so much as exposure to large, relatively mature companies, many of which are exporters that, economically, are really global companies, not local. That the historical excess returns recorded by emerging markets indexes are probably not a reliable set of figures. That a non-indexed approach, or a different form of index, could better capture the local-economy potential of emerging markets.
- That private equity index returns are probably not as uncorrelated with the stock market as the historical results suggest. That a semantic correction from the common-use term "private equity" to the more financially accurate term "leveraged equity" might better capture the pricing risk inherent in private equity investing. Looking forward, private equity investors, providing the small slice of equity collateral that backs the substantial borrowing in these acquisitions, are essentially leveraged backers of low quality debt (or debt that can rapidly become lower quality) during a period of historic low interest rates. What might happen in several years if interest rates for those private equity companies are meaningfully higher? The private equity limited partner is taking on serious refinancing or duration risk, something that bond investors are now loath to do.
In the asset allocation framework of investing, investors who buy short-maturity bonds in order to avoid duration risk may also be purchasing private equity in the belief that they are diversifying their portfolios away from interest rate risk.
In this quarter’s commentary, we continue to explore the question of whether one actually achieves, though a typical asset allocation approach, meaningful diversification at all.
Continue reading here.
