60/40 Is Dead: Why the Traditional Optimized Portfolio Became Risk Additive
- Is “60/40,” the fundamental “optimized portfolio model,” the wrong model for 2023 and the years to come?
- Dave Dredge, chief investment officer of Singapore-based Convex Strategies, thinks 60/40 is part and parcel of “Sharpe World” — his tongue-in-cheek name for the prevailing financial wisdom: mathematical models espoused by the U.S. Federal Reserve and national banks the world over.
- Dave discusses how “Sharpe World” benefits the fiduciary industry and why it is insufficient for risk management today.
Convex Strategies CIO Dave Dredge has long maintained that the basic optimized portfolio model (aka “60/40”) is dead — or at least dead wrong.
“The 40 is holding capital out of the things that participate in the market — not providing sufficient, and eventually not providing any, protection to the portfolio,” he says.
Risk management is the cornerstone of Convex Strategies, an “alternative investment manager” based in Singapore. Correlation risk across diversified portfolios is “hard to measure and misunderstood,” according to the firm’s website. That’s partly because the prevailing wisdom of economists and the fiduciary industry is flawed. Dave’s tongue-in-cheek name for this fuzzy math is “Sharpe World” — “the whole Bachelier ‘Random Walk,’ Gaussian normal distribution, efficient-market hypothesis, modern portfolio theory, capital asset pricing market model, Sharpe ratio, value-at-risk fraud.”
Dave writes a monthly “Risk Update” column on Convex Strategies’ blog that centers on why his firm’s approach differs from traditional “Sharpe Mathematics”-influenced investment strategies.
Dave returned to Top Traders Unplugged for a conversation with me and co-host Cem Karsan about his nuanced view of risk and fragility in a system that’s driven by Sharpe World. We talked about why the folly of 60/40 is the reason why big pension funds suffered major losses in recent years, the pointlessness of forecasting, what the future of volatility will look like as we move forward — and much more. Read on for his “Sharpe”-tongued thoughts on economics in 2023.
Thanks, Alan (Greenspan)
The premise of the “40” in 60/40 “was artificially generated from the ‘Greenspan Put’ Era onwards,” says Dave. This artificial ratio created a “negative correlation between bonds and stocks” when asset prices fell and central banks reacted by cutting interest rates.
“That created this sort of multi-decade faux benefit of holding those two things together,” he adds, “and, in essence, reducing the capital requirement of your portfolio by both a Kelly Criterion reduction of exposure mindset and a positive-carry correlation benefit.”
But interest rates at zero percent (or in negative territory), aren’t risk-mitigating. They’re risk-additive.
“Then we [or the Fed, rather] did a whole bunch of QE [quantitative easing] and made it even worse,” Dave notes.
So why do so many “smart investors” — the ones who run big pension funds and other massive portfolios — insist on the 60/40 split? Why is it so difficult for them to see this risk?
Portfolio (conspiracy) theory
Times are hard. (That’s the understatement of the year.) Big portfolios are in big trouble.
Take ATP, the largest pension fund in my native Denmark. Its September update, for the first three quarters of the year (2022), published (if I’m not mistaken) a loss of 47% of its strategic reserve capital. That loss was incurred in just nine months. Yikes.
Interest rates have risen quite a bit, but not to the levels they could go if we have a resurgence of inflation in 2023. It seems to me that simple math would dictate this isn’t a great portfolio structure anymore. I asked Dave why he thinks this happens.
He thinks the financial fiduciary industry and the Sharpe World “conspired” to enrich themselves at the expense of previous compounding for end-capital owners and allow virtually every major world government “to blow through 100% debt-to-GDP numbers.”
That meant “the only way you could get savers to hold this stuff is to dupe them into it through their pension funds,” he says.
“Insurance companies and banks bought this stuff on a Sharpe World mathematic, risk-regulatory, accounting-reporting, annual-return incentive structure that loaded everybody in the financial fiduciary world with this debt — to the disbenefit of the end-capital holders.”
In a “Sharpe World” risk update post from September 2022, Dave writes:
We think of Sharpe World as a metaverse fantasy land where fiduciary wealth managers dreams all come true.
In Sharpe World, historical volatilities and correlations always remain constant. Geometric compounding paths are irrelevant. Tails are never fat. Leverage is not risk. Frequency matters more than magnitude. Ensemble averages dominate time averages. Hens lay soft-boiled eggs.
Given Dave’s opinions on Sharpe World, Cem asks him how he views the concept of fragility, specifically in the context of the Fed’s decisions that affect inflation, globalization, inequality and corporate versus labor power.
As a professional advisor and investor, Dave is used to these kinds of questions. When someone asks him what the biggest risks are in the investment ecosystem, he answers: “Interest rates going up, obviously.”
Often, the next question he’s asked is something like: Why would they let that happen?
His reply? “I assume because they decided to.”
He thinks that’s the best way to describe the Fed’s action: It wasn’t magic; it was a decision, based on the recognition that “the negative externality of foregone price stability was more costly than their ongoing desire to forever prop it up,” says Dave.
Fragility: A ‘triple-A’ hangover
In his August 2022 blog post, Dave made the analogy between Fed Chair Jay Powell’s response to inflation and President Biden’s withdrawal from Afghanistan.
“Why did the U.S. military decide to let the Taliban take over all of Afghanistan?” he asks. “They could have prevented it forever, but that came with a cost they were unwilling to bear. So they left. It happened in a weekend.”
Similarly, we investors often think of fragility in terms of uncapitalized tails in the system — the same system that’s driven by the Sharpe World fiduciary participants and financial institutions.
In 2008, the banking system, as well as the failings and flaws of Sharpe World’s regulatory structure, allowed the powers that be “to tranche and construct — through derivative innovation — AAA subprime CDOs (collateralized debt obligation) and call them zero RWAs (risk-weighted assets) and lever them infinitely.”
Back then (before it all blew up), many investors “were trading as though [subprime CDOs] were the closest thing in the world to U.S. treasuries, the least risky thing in the world,” he says.
Those CDOs were priced attractively “because of the infinite layers of leverage applied to them,” Dave adds. “They were the biggest uncapitalized tail risk in the world.”
The industry implied that only a “very small change in the correlation of house prices” created such a tranche of AAA subprime loans that it “wiped out all of the capital in the global banking system,” he explains. “That’s the way we think of fragility.”
The ‘immaculate recession’
Dave argues that uncapitalized risk lies “in the lack of capital supporting the 40%.”
Contemporary versions of 60/40 liability-driven investment (LDI) risk parity deem the “40” to be “risk-reducing.” But instead, “it actually reduced the amount of capital you held against the 60 in its various versions — and much less holding capital for the 40,” he says.
Arguably, the Fed is the de facto king of the world of central bankers. The other central banks simply hope they “can coattail-ride on the Fed’s soon-to-arrive ‘immaculate recession.’”
That means those central banks can pray, so to speak, that a “beautiful recession” will save the world by preventing interest rates from rising.
Now, “they’ve got to walk this tightrope where they can’t raise rates so much that they blow up this leverage in the fixed-income fiduciary savings pool, but they need to raise rates enough that they restore price stability,” Dave explains. “Otherwise, that’s going to blow up the back end of all the fixed-income markets in the world.”
That’s a tough tightrope to walk. The Fed and its fellow central banks are “playing the usual mythology games of neo-Keynesian economists, saying, ‘Oh, we have to protect jobs.’” Those are the same moves Arthur Burns made in the 1970s and later admitted were mistakes.
“They’re making all the same mistakes today and trying to soft-step and be very asymmetric,” Dave notes. “When they need to slash rates to zero and jack up QE (quantitative easing) [by] $7 trillion, the asymmetry around their measures of inflation being 20 basis points below their target is a hell of a lot different than when it’s 800 basis points above their target.”
All in all, he thinks it’s a massive “game,” one in which the U.S. is currently way behind. But he does think some of the Fed’s leadership has been positive.
“The further you’re behind, the more you subsequently have to do,” Dave says.
“Jay Powell is the only one that has shown any understanding of this problem. I will argue the Fed, through all of its post-repo crisis in September 2019, and bailing out the fixed-income markets in March 2020, is the one that was most cognizant of the amount of leverage in the fixed-income markets, and has done the best job of keeping the yield curve as inverted as possible to protect the back end of fixed income markets.”
Let’s hope that this game is more Life than Monopoly — and that Sharpe World strategies are tempered with 21st-century risk management.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.
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