Investing in up and Down Markets

Investing In Up and Down Markets

By Dr Phoon Kok Fai

School of Business

SIM University

The turbulence in financial markets over the past decade has shaken our faith in the basic tenets of investment theory. A key finding in Modern Portfolio Theory (MPT) is that investors by investing in diverse assets can obtain a better risk-return tradeoff compared with investing in a less diversified portfolio of assets. The Efficient Market Hypothesis (EMH) developed by Eugene Fama that new information is instantaneously reflected by asset price is claimed by many to be clearly refuted by recent evidence. In this short article, I will argue that it is not MPT and the concept of diversification that failed us, but the failure is in its application. I will also argue that EMH remains an important concept for our understanding of the benefits and costs of active investing and in developing investment strategies.

Investing in a portfolio of stocks and bonds can provide significant diversification in environments of high economic growth. However, stock and bond prices move very much in the same direction during periods of heightened inflation and economic risk. These are the same conditions when investor would like the most downside protection. As a portfolio of only stocks and bonds only provided limited diversification, investors sought to invest into more asset classes that include real estate, hedge funds, private equity and commodities. However, these new allocations only partially addressed the problem as was painfully clear during the Global Financial Crisis (GFC). Virtually all asset classes, other than high quality sovereign debt suffered significant losses. We have come to realize that many asset classes have the same drivers embedded in them making them vulnerable during stressful periods. An example from the GFC is when 14 of the 18 hedge fund styles suffered their worst losses, despite them investing in different asset classes and pursuing seemingly diverse strategies. The recent developments show that diversification in and of itself is not a failed concept. However, the key to its benefits is to understand the key drivers of asset class returns and the commonality and co-movement of these drivers under different market conditions.

The EMH remains a useful concept and helps us to decide on the potential benefits of active versus passive investing. Many investment managers have adopted a core-satellite strategy for their portfolios. In a core-satellite approach to allocate among asset classes, an investor builds a core consisting mostly of passively managed assets and adds to this core a set of satellites consisting of actively managed assets. The idea is that investors should not spend valuable resources seeking excess returns in efficient markets where it does not exist or is too small to make a difference. Evidence indicate that it does not pay to waste time, money and effort in finding top managers in the area of traditional equity and fixed income investments where even if an investor find an very “good” manager, he/she fails to outperform other managers by a significant amount.

Now, if an investor has decided on the allocation to his core portfolio that is based on his returns requirements and risk tolerance; the choice of satellite assets is the next key consideration. Satellite assets can play a very significant and complementary role in the investor’s total portfolio. The selection process must consider carefully the co-movement of their returns with those of the core assets. Having learnt our lesson from the decline in most asset classes during the GFC, we must also ask how such co-movements behave under different market conditions.

To develop an appropriate selection process for satellite assets, we specify that investors possess sophisticated preferences. Specifically, investors like downside protection, whilst looking for yield enhancement. Moreover,