Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Harmony between treasuries and equities in money, the musical
Investors will have to retune expectations in line with changing market harmonics, global consultancy firm Oliver Wyman notes in part three of a five-paper opus delivered earlier this year.
Based on data covering a 150-year period, the Oliver Wyman series concludes that investors must turn to more sophisticated tools to appreciate the complex tones of modern markets.
The 133-page report questions long-held assumptions about economic cycles, stock valuations, the equity risk premium (ERP), bond risks and the capital asset pricing model (CAPM).
“We have found that the music of the market is much richer in the post-World War II era: What started as a string quartet is now a full symphony orchestra,” the paper says. “The machinery used to study the market up to now isn’t designed to pay attention to the music.”
For instance, the Oliver Wyman research defines a ‘real truly risk rate’ (RTRR), or an after-tax version of US Treasury Inflation-Protected Securities (TIPS), that serves as a baseline measure.
“We have uncovered the natural harmony between equities and long-term nominal Treasuries,” the report says. “The two risk assets share a common root, the RTRR.”
The finding extends the CAPM methodology – the standard equity valuation technique – to the bond market in an advance that Oliver Wyman says “is of marked value to all fixed-income professionals, as well as to Fed and Treasury officials”.
“Ultimately, asset prices are set by mass investor behavior and there is always a balance between what is innate and what is learned. In the case of equities, the history of the last 150 years suggests that the behavior of equities is largely innate because it has been remarkably stable over the period,” the paper says.
“In contrast, the behavior of Treasuries has exhibited multiple polarity switches… In other words, many of the risk factors in the TRP are chameleons that adapt to the conditions of the day.”
Among a raft of other observations, the study refutes arguments that share markets have been in a bubble of late.
“The answer to the question of whether we have been in a bubble is a resounding No, as long as one defines a bubble accurately rather than retrofitting the definition to support a pre-determined agenda,” the report says. “Equity prices have been highly elevated because corporate margins have been strong (they are currently at a 100-year high), and the RTRR has been at an all-time low, not because the equity premium has been unsustainably compressed.”
But the Oliver Wyman report, authored by chief transformation officer, Jacques César (photo at top), says the almost certain prospect that the RTRR cannot repeat another 30-year down-trend has more dangerous implications for investors.
“While this is a very serious concern, it is not an immediate one,” the paper says with no signs yet of an RTRR reversal.
And “when the turns come, history shows that they will do so relatively slowly, giving astute investors sufficient time to react” before the music stops.
