Markowitz attacks hedge fund
Author: Kris Devasabai
Source: Risk magazine | 26 Feb 2014
Nobel prize winner Harry Markowitz says alternative investments may not deliver the diversification benefits sought by investors
Harry Markowitz, one of the pioneers of modern portfolio theory and 1990 Nobel prize winner, has claimed alternative investments such as hedge funds rarely offer the diversification benefits sought by their investors. "The people selling these products claim they have higher expected returns and lower correlations and volatilities than traditional investments. But if you dig deeper, you'll find that isn't really true in most cases," says Markowitz, professor of finance at the University of California in San Diego. Markowitz's comments came after a BNY Mellon study found nearly 80% of institutional investors have an allocation to alternative investments, compared to 40% in 2009. Investors also expect to raise their allocations to virtually every category of alternative investment over the next five years. Asked why they were allocating to alternatives, 69% of respondents cited the diversification benefits.
"Investors clearly believe alternatives can enhance diversification. They expect to achieve a good return, but the real reason for investing in alternatives is to increase portfolio diversification, so that if there is another market event – which everyone is convinced there will be – they will be better protected on the downside," says Debra Baker, head of BNY Mellon's global risk solutions group.
The idea behind modern portfolio theory is to combine assets with low correlations to reduce the variance, or riskiness, of a portfolio. Alternative investments are thought of as effective diversifiers of risk because of their low correlations to traditional assets. But that benefit is offset by the higher average volatility of alternatives, according to Markowitz. "The fact is alternatives tend to be more volatile investments, which makes them poor diversifiers," he says.
Correlation and volatility are equally important metrics of portfolio risk. Modern portfolio theory relies on covariance – the combination of the volatilities of two assets and the correlation between them – to measure the diversification properties of assets. Combining investments with low covariance to each other reduces the riskiness of the portfolio.
"An investment may have low correlations, but if its volatility is higher than average, then it's not going to diversify the portfolio," says Markowitz. The fear of interest rate rises – which survey respondents identified as the most critical market risk they face – is a factor in pushing investors towards alternatives. "Investors are searching for sources of return that are not correlated to equities or interest rates. Alternative investments claim to provide this, but it's up to investors to determine if they really can," says Markowitz. Many alternative fixed-income strategies use leverage to magnify returns after stripping out interest rate risk, and are prone to fail during periods of market turbulence, he says.
Markowitz is also sceptical of risk parity investing – which has been popularised by hedge funds such as Bridgewater Associates and AQR. Risk parity strategies distribute risk equally across asset classes to achieve optimal portfolio diversification. In practice, this means bond investments are leveraged to match the volatility of stocks.
"I could never understand how a portfolio that is heavily overweight fixedincome assets, which have low expected returns, could be leveraged to achieve an excess return. It's like the merchant that loses three dollars on every sale and makes it up on volume. But when I looked at these portfolios, I realised they were applying leverage to a lot of low-quality fixed-income investments. So I'm in the anti-risk-parity camp," he says.
Supporters of risk parity investing often describe it as a pure application of...
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