One of the reasons we formed RBA in 2009 was we thought the US was entering one of the biggest bull markets of our careers. US corporate fundamentals, although poor on an absolute basis, were demonstrably improving, central banks were engineering an immense liquidity injection into the global economy, and investors were extraordinarily wary of US public equity. The makings of a major bull market seemed evident to us.
Investors were hesitant to invest with us given our bullishness, and due diligence meetings often centered on how defensive RBA’s strategies could become if there was another bear market. Protecting against a bear market was clearly more important to investors than was taking advantage of the opportunities.
Our marketing presentations accordingly mentioned “fire extinguishers” or strategies to be used “in case of emergency”. We weren’t employing such defensive strategies, but wanted to make it very clear to potential investors what RBA was likely to do if investment risk increased.
Today’s fundamentals are markedly different from those of ten years ago. Corporate fundamentals have been deteriorating all year, but remain healthy on an absolute basis. Global yield curves have begun to suggest that liquidity is starting to dry up. Investors are not necessarily euphoric regarding public equity but, as we’ve pointed out before, investment flows into private equity and venture capital have surpassed the Technology Bubble’s flows into US equity funds.
Investors seem to be following the historical precedent and are becoming increasingly bullish despite a deterioration in underlying fundamentals. With that in mind, it seems prudent to dust off the fire extinguishers.
Testing the fire extinguisher?
Real fire extinguishers get checked and tested regularly, but financial fire extinguishers often get rusty or ineffective because the financial markets change through time. Investors often assume their portfolios are diversified, however, asset classes that might provide significant portfolio diversification in one period might be quite ineffective in another. Investors tend to rely
too much on marketing literature rather than unbiased statistical analyses to determine effective fire extinguishing asset classes.
Correlation among asset classes and not the number of asset classes ultimately determines the level of diversification within a portfolio.
Traditional portfolio construction includes numerous asset and sub-asset classes, but one could have a very well-diversified portfolio with only two assets if those two assets are very uncorrelated.