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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
As shown in Chart 38, this 60% US equities/40% US bonds
portfolio has aligned nearly perfectly to the MPT and CAPM
expectations. Calculating an efficient frontier using data from
1950 to 2009 for stocks and bonds, the model 60/40 portfolio
would have returned slightly under 10% while assuming
10% risk. Obviously to achieve these model risk and return
results over the past 60 years investors would have needed to
periodically rebalance their portfolios to maintain the 60/40
allocation. Such rebalancing would need to be accomplished
even during periods of market correction. This is more
easily said than done as investors would have to periodically
reallocate capital away from performing assets and allocate
to underperforming assets with the hope that the 60/40
model was optimal for them to achieve their long-term return
targets. The reality was that what began as a 60/40 allocation
would oftentimes drift from that point.
Investors Move From a One-Factor to a
Three-Factor Portfolio Model
In addition to gauging the success of their portfolio and
underlying managers by their risk-adjusted returns,
investors also compared the performance of their
portfolio to the total market return. Mean-variance
optimization of managers’ returns and diversification across
managers were major drivers of institutional investors’
portfolio construction process.
Historically, institutional portfolios were administered as a
single large pool of money that was divided up across a set of
active money managers to achieve diversification. Investors
measured a manager’s outperformance against the market
based on total market returns and broad-based market
indices. The market returns portion of the portfolio was
considered beta and the “excess” returns or positive tracking
error generated by the manager was considered alpha. This
performance analysis was conducted for both equity and
bond managers.
In the mid-1990s, Eugene Fama from the University of
Chicago & Kenneth French from Yale University published a
new financial theory that resulted in a major shift in portfolio
configurations by the early 2000s. Fama’s and French’s
research noted that a manager’s return was only one factor
that should be monitored to determine performance. They
expanded the factors for consideration to a 3-factor model for
equities and a 2-factor model for bonds.
For equities, they determined that in addition to risk-adjusted
return, if an investor considered the capitalization of the
stocks in a portfolio and if the value of the stocks was also
considered in terms of whether the stocks traded on a high
or a low book to market value, it would result in more discrete
portfolio groupings and like-for-like comparisons. This is
illustrated in Chart 39. For bonds, they determined that in
addition to risk-adjusted returns, an investor also needed to
consider the likelihood of the issuer’s likely default and the
term of the bond itself.
Dividing their large pool of equities and bonds up into these
discrete groupings (which became known as style boxes over
time), investors would be able to determine whether their
managers were simply equaling the market performance
for the segment of the market they invested in—thus only
producing beta—or whether they were producing excess
returns or alpha.
“ People are comfortable with “a set it and forget it” portfolio
approach and tend not to be dynamic,”
– US Corporate Pension
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Risk% (Standard Deviation)
Return %
60% Equities /
40% Bonds
100% Bonds
100% Equities
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Chart 2
Chart 38: Risk-Return profile for 60/40 Vs 100%
Equities or Bonds. 1950-2009