Correlating Risky Assets

Asset allocation is tough, because the correlations are not stable.  Here’s an example: in the 90s, at many conferences that I went to, I was told that one of the smartest moves you could make was to invest heavily in every new class of Asset Backed Security [ABS] created, because they all tighten in yield spread terms after issuance, leading to price gains.

I didn’t believe it then, and that was a good thing, because the most exotic of ABS classes got whacked in the financial crisis.  As it was was, I had already seen debacles in Franchise Loan ABS (spit, spit), and Manufactured Housing (post-1997 vintage).  At a conference for Life Insurance, I was a skunk at the party in 2006, as one ignorant presenter suggested that AAA structured assets never went bad.  History already taught us better, and as I tried to say to the then-CEO of Principal Financial as he was exiting the conference, he needed to look at the mezzanine and subordinated structured product in his company.  Free consulting, but but worth more than the consensus.  As far as I can tell, he didn’t listen.  For many reasons the stock price is lower today.

I have many other tales where in fixed income (bonds), everyone “followed the leader,” which worked in the short run, but failed in the long run.  The point is that investor behavior correlates asset classes.  There may be underlying economic differences, such as owning a natural gas producer and utility that uses natural gas, but most of those differences get erased as most investors seek portfolios immune from factors of secular change.

So as new asset or sub-asset classes are introduced, in the short-run they are uncorrelated, and likely rally, because few own them.  But after the rally, many now own it, and the future correlations are high because so many own it.  The correlations ultimately depend on two things: the underlying economics, and investor behavior.  Investor behavior is the dominant aspect of pricing.

I don’t think there is a lot of diversification in most risky asset classes from an economic standpoint.  Does it matter whether a business is public or private?   I think the answer is no.

What that means in the present environment is that there is a gap between business risk, and those that finance business risk.  In other words, there is a difference between investment grade bonds, and risk assets.  That’s the negative correlation in this market.  Do you want diversification?  Buy some ETFs that invest in long high investment grade debt.  You will not get any effective diversification out of buying different classes of risky assets.  Those are already owned by those that compete with you.

Promises to pay from sound entities that can be relied upon in the future behave very differently than risky assets.  In your asset allocation, to the degree that you need real diversification, look at that as the critical distinction.  All other distinctions are secondary at best.

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About David Merkel 144 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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