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Decade of decay: Eight investment strategies set to fall apart

A host of things investors have benefitted from in recent decades are likely to turn on a multi-year view. Even the much vaunted alternatives will find it harder to generate alpha.

Entropy always wins in the end according to science. As encapsulated in the depressing second law of thermodynamics, the entropy (or disorder) of any ‘closed system’ cannot decrease.

Website Thoughtco.com notes that one scientific school of thought has it that entropical trends will ultimately degrade the universe to an unemployable expanse of thermal energy where it “would be said to have died of heat death”.

Too bad for the universe but the second law of thermodynamics might also apply to investment markets, a new paper from the research arm of hedge fund giant, Man Group, suggests.

“In investing, the equivalent might be that the game is never getting any easier,” the Man Institute analysis says. “Now more than ever. A host of things investors have benefitted from in recent decades is likely to turn on a multi-year view, we think.”

Authors Teun Draaisma and Henry Neville – both Man Solutions portfolio managers – lay out eight universal investment assumptions about to be questioned as the previous decades-long market order frays.

First-up, the pair call time on high-return expectations for traditional stock and bond assets.

“Starting valuations have eased but are still well above average,” the Man report says. “For example, the current Shiller PE of 28.9x is 67 per cent above its long-term average of 17.3, and nominal rates are still well below nominal trend growth. In addition, we know that traditional assets perform badly in times of high and rising inflation. What is more, investors are still heavily invested in a portfolio of traditional assets.”

Draaisma and Neville also suggest other assumed features of traditional assets including the diversification power of bonds – or the famous ‘free lunch’ of blended shares/fixed income portfolios (as measured by attractive Sharpe ratios) – will falter as background financial conditions change.

“Occasional monster rallies notwithstanding, a static portfolio of traditional assets will deliver more volatility and less performance,” the analysis says.

And despite representing an alternative asset investment house, Draaisma and Neville note hedge fund managers will find it harder to deliver outperformance – or alpha – compared to previous chaotic periods.

“We speculate that… the strongest driver has been the move to passive: as the market share of passive investment has gone up, the weaker active investors have been squeezed out, thus leaving the remaining investors with stronger competition and a harder job to come out winning in the zero-sum game that is pure alpha.”

The study also says other market heuristics will be tested including: a supposed link between a weak Australian currency and market corrections, a negative correlation between the US dollar and oil, plus the expectation that all emerging market equities will weaken as the US currency strengthens.

Of course, Draaisma and Neville present one potential version of the investment future rather than a certain outcome, and even Thoughtco.com leaves the window open a little for the universe.

“Other scientists dispute the theory of heat death,” the website says. “Some say the universe as a system moves further away from entropy even as areas within it increase in entropy. Others consider the universe as part of a larger system. Still others say the possible states do not have equal likelihood, so ordinary equations to calculate entropy do not hold valid.”

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