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Nov 07

My day at the Portfolio Construction Academy

Last Friday I attended a day long program with around 80 researchers, financial advisers, and other financial professionals as part of a 5 day portfolio construction program run by Graham Rich over a 12 month period. Friday’s program was divided into three parts…

  1. Investment Fables
  2. Asset Allocation using Scenario Modelling
  3. Greece

Each part went for around two and a half hours each and was mostly a fairly robust discussion or debate across each topic within small groups of 6 people or the forum as a whole.

Investment Fables was a completely appropriate introduction and reminded us all how vulnerable we all can be to a good investment story. This session was hosted by Professor Jack Gray, a self confessed ‘value’ investor with an enormous amount of experience who I could spend days on end listening to…a wonderful thinker and someone everyone could learn from. We explored many investment fables (or should I say myths) across asset classes as well as economics and investing itself. A couple of examples include, “buying stocks with low PE win out”, and “stocks always outperform in the long run”.

My main take-out from this session was how fallible we all are to the investment story and of course we all know that when it comes to investing you can always find a counter-example to the investment story…. If you are a ‘value’ investor there have always been long periods when ‘value’ investing has underperformed and same goes for the belief that ‘stocks always outperform’…personally I always look to Japan as a counter-example for many stock-related myths. Pretty obvious stuff but nonetheless an excellent reminder for perspective.

Next topic was Scenario modelling and this was hosted by the Asset Allocator, Tim Farrelly and Paul Scully. Scenario Modelling is a technique that on its surface is a relatively simple and logical approach to developing an asset allocation that reflects one’s belief. The main risk I see with it is, like with any mathematical model, garbage-in means garbage-out.

I believe one of the main users of this approach is Dr Susan Gosling of MLC. The approach basically involves the design of a number of economic scenarios that the future may bring and apply ideal asset allocations to each scenario followed by the application of probabilities of each scenario occurring. For example, we may believe one scenario for the future is that the Greece debacle may explode, the Euro experiment finishes, contagion results in the default of not just Greece, but Portugal, Ireland, Italy and Spain and a collapse of the global financial system as well as a severe global depression. The ideal asset allocation one may apply to this scenario is one that primarily consists of government bonds (Australian and US???), very few equities and perhaps a reasonable amount of cash (assuming the local banks don’t collapse also). A probability associated with this scenario may be 10%. Scenario 2 is developed, it may be early recovery which entails a high equities allocation and not much in the way of bonds, and the probability assigned may be 15% etc. The final asset allocation is the sum of the probabilities by the asset allocation for each scenario.

Whilst I don’t mind this approach for the institutional investor or even personal investor, I see a difficult application in the retail financial advisory world. This approach requires constant updating as new information enters the market, and would create quite a moving feast for the asset allocation, let alone the time required for the ongoing application. Whilst I do believe scenario modelling is much more likely to yield better results than a static asset allocation, the complexity of implementation across many advisers and their clients means the risks associated with it from an AFSL perspective may outweigh the benefits. I get the impression most of the delegates were mostly concerned with implementation in a retail setting.

The final topic of the day was Greece. Graham Rich brought along two guest speakers from European Banks, Barclays and UBS, to provide the audience with their perspectives on what the future holds for the European economies and markets. Their virtual blind faith (well, a slight exaggeration) in trusting the solution with the current politicians and bureaucrats was a little too optimistic for me. Despite that, the widely agreed expectations were that equity markets will continue to be volatile, Greece will ultimately default, and that markets may get worse before they get better.

The most poignant comment of the day was early on when Graham Rich mentioned that he could not recall a time that politicians have played a bigger part in the outcome of financial markets than they do today. Lets face it, it is up to politicians, with their various agendas, to solve the European Sovereign Crisis and it is up to the politicians to implement fiscal policy to generate more jobs in the US given Monetary policy is out of ammunition. Given this situation it is very difficult for any investor to happily embrace the risk of the equity markets so for most the best decision will be to sit on the sidelines until there is light at the end of the tunnel. We all know that this means significant upside in the market will be missed but that is an opportunity cost I believe many are prepared to make.

Anyway, overall it was a worthy day with some excellent debate and comment. I will be attending their markets summit and Day 2 of the Academy in February when the debate will centre on whether Cash is still King!

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