The creation of wealth, or alpha, is limited if your strategy is the traditional allocation between asset classes, instead investors need to embrace idiosyncratic risk to achieve wealth generation, which is at odds with modern portfolio theory’s ambition. Chief investment officer of the Institute for Advanced Study, Ashvin Chhabra (pictured), explores this in his latest article.
Speaking at the CFA Institute asset and risk allocation conference in Chicago, Ashvin Chhabra, chief investment officer, Institute for Advanced Study, says a good investment process rests with identifying what an investor’s objectives are, as this separates what you can and can’t control.
“What are the objectives of your process, what risk, return and drawdown do you need, then your process is the execution of how to get those objectives. The quality of managers, and things like the amount of leverage, costs, all help in shaping a realistic risk management,” he says. “You can’t control market returns and volatility. The risks you don’t know about are incredibly important. People associate risk with volatility, the variability of returns, but if you control variability then it’s not a risk anymore. But risks are not just volatility, they are what you don’t know about.”
Chhabra has developed a framework for investing over the past 10 years, and it is how he manages the endowment at the Institute for the Advanced Study. The essence of his philosophy is to separate the portfolio into different pools, which reflect the return objectives, and while have very different risk profiles.
Chhabra says that as an endowment manager, his key objective is to be able to write a cheque when the institute wants it, not to be in an arms race with other endowments for returns, or to achieve the “best” quarterly returns.
“The market over the long term will give you a pretty good return, create a basic safety net, but it doesn’t know your particular situation,” he says.
Chhabra observed that whenever there was a bubble investors were sucked into the thinking there was serious money to be made, and so he decided to explore the exact result of what an aggressive movement in asset allocation does to wealth.
His paper, co-authored by Ravindra Koneru and Lex Zaharoff, is to be published in the summer edition of the Journal of Wealth Management.
Entitled “Modern Portfolio Theory’s Third Rail: Achieving Wealth Mobility through idiosyncratic risk”, it uses quantitative arguments to explore the idea of how to achieve a change in an investor’s relative wealth position in a society.
The authors conclude if an investment portfolio were limited to well-diversified portfolios lying along the efficient frontier, it would take close to a century to materially change the investor’s relative position.
This was analysed by looking at the data of different socio-economic groups in the US, their asset allocation and how long, and what extreme alterations, it would take to move a family into a different percentile band.
Families in the US were broken into percentiles of wealth.
“There is a long tail of being extremely wealth in the US, most people are worth nothing,” he says.
“We looked at the asset allocation of a 75th percentile family and a 90th percentile family, and it would take about 100 years for them to catch up. Wealth mobility doesn’t come from an aggressive asset allocation. It only comes from strategies.”
Further he concludes that the strategies to wealth mobility are: business owners (reinvesting in companies), finance, marriage and inheritance, and real estate.
The common features of all of these strategies are idiosyncratic risk and leverage, he says.
“Trying to create wealth, or in the case of institutions alpha, by deciding whether to put more in private equity or equities etc through asset allocation is a waste of time,” he says.
Instead he says investors should divide the management of their assets into three distinct buckets, and the dynamics of each are very different.
1. The safety net, which holds the riskless assets
2. The market portfolio, with risky assets
3. The aspirational portfolio for wealth mobility, which contains idiosyncratic assets
“In the three-bucket framework the first is a safety net (which expects a zero return) such as asset liability matching, the diversified bucket is your normal diversified portfolio and then there is an aspirational bucket, which is wealth generation,” Chhabra says. “You can’t have this last bucket without leverage and idiosyncratic risk. If you don’t have leverage, forget about making wealth. This is not just risk allocation, survival just comes from number one bucket, short-term risk management, the number two market portfolio is not about meeting short-term cash flow, but equivalent to market rate of return or keeping up with your peer group. And number three is about true wealth creation.”
In the paper’s conclusion, it says modern portfolio theory points to the futility of idiosyncratic risk. Investors searching for above-market returns are directed to leverage the well-diversified market portfolio. However in the real world, leveraging the entire market portfolio is a risky and “often fool hardy strategy”.
Instead investors in the search of excess returns often become more aggressive during bull markets only to take on excessive losses as the market turns.
It says the authors have shown ‘the futility of a more aggressive asset allocation with regard to true wealth generation”.
And because wealth mobility is bi-directional investors would do better to create a strong safety net and a market portfolio, with a risk tolerance in turn with their life goals.
And the bi-directional aspect of wealth mobility also suggests that an individual or institution may be better off separating out the allocation to wealth creation from the rest of the portfolio, and explicitly recognising the risk of catastrophic capital loss associated with such a strategy.
In his presentation at the CFA Institute in Chicago he said it was important to structure this “third bucket’ properly as it involves a lot of leverage
“Because of idiosyncratic risk you must have an advantage otherwise you’re just market timing but your tactical asset allocation weights are not what’s going to make you wealthy,” he says.