Private View Blog: How three global crises ended investors’ free lunches
“Summertime and the living is easy;
Fish are jumpin' and the cotton is high.”
George Gershwin, Porgy and Bess, 1935
In managing investments over the last 20 years we have left the “summertime” when real and nominal interest rates were high and nicely compounding wealth, and when diversification and rebalancing were easier than today for reducing portfolio risk. The trilogy of global crises — the implosion of the dotcom bubble, the global financial crisis, and the Covid pandemic — and their aftermaths have taken large bites out of these three “free lunches” that were as old as investing itself. To meet this daunting challenge, investors are forced to pursue adaptative strategies to manage complexity, but that does leave room for innovative solutions.
Disappearing risk-free rate compounding
Gone are the benefits of easy compounding interest, which Albert Einstein described as the “eighth wonder of the world”. Forced to preserve wealth and stability in the financial system, central banks have deflated official nominal and real yields deep into negative territory, eroding the power of capitalising by reinvesting in government bonds. A multi-decade fall of inflation and a permanent need for safe assets have also contributed to this situation.
Investors are now fleeing income destruction, forced to take credit and liquidity risks or venture further into equity markets, facing new risks. The recent burst of unexpected inflation post-Covid has entailed even deeper negative real yields and has hastened exodus towards risky assets away from the now-distant comfort zone of a high, risk-free rate.
Shadows over diversification
Diversification is now facing a paradox: it remains effective when you don’t need it, when the risk, uncertainty and asset correlations are low; but not so effective when you most need it, in times of heavy market drawdowns affecting all assets. Just as economies, financial liquidity, data, and the capacity to trade on such data became truly global, so did crisis moments, encouraging herding in unidirectional financial flows and market swings.
The promise of diversification for the long term was poor consolation. The future is to achieve such diversification with a broader range of assets than the standard 60/40 equity/bond allocation, with help of sophisticated solutions to address this uniformity risk in times of crisis. Thus diversification becomes more than ever a “no pain, no gain” game.
Rebalancing with more risk
The trilogy of global crises has profoundly changed the circumstances for successful portfolio rebalancing from expensive to cheaper assets as a general principle. First, financial repression since the global financial crisis has led to a “forced rebalancing” out of government bonds.
Massive bond purchase programmes saw the highest-quality bonds placed on central bank books, while average quality of private client bond holdings has deteriorated. Further, the global crises left scars, with lasting risk sensitivity for investors, despite their reluctant migration towards greater equity exposure.
The response of the finance industry was to offer “ready-made” systematic risk-rebalancing tools, such as capital guarantee products or risk-targeted rebalancing programmes. But these had many disadvantages, such as reducing risks for the downside but offering little (or even no) exposure to the upside.
Finally, the trilogy of crises has originated deep changes in the economic fabric, such as the change in the financial sector during the global financial crisis or the rise of work-from-home companies during the recent pandemic. Systematic rebalancing is led by price action, blind to fundamental changes that last longer than a short rebalancing period. There is an implicit behavioural bias of selling winners and keeping losers. Portfolio managers have learned that rebalancing needs to be conducted with care and judgement.
With underperformance an opportunity cost, Milton Friedman has reappeared with a vengeance, given that it was he who coined the term: “There is no such thing as a free lunch.”
Strategies for the future
Diversification is not, however, totally doomed. Passive strategies on top of optimising costs can still produce decent international diversification, and the Morgan Stanley Capital World Index remains a stiff benchmark to beat.
Risk-premia investing with a strong risk management backbone can reproduce the miracle of compounded returns. New possibilities have emerged with dedicated managers harvesting multiple sources of alpha with Commodity Trader Advisers (CTA) programmes and in the hedge fund space, exploiting anomalies, market drawdowns and reversals. These complex strategies are sought after in markets largely dominated by computers and AI trading.
By adding non-listed equities, investors are acting as entrepreneurs interested in the future cash flows of underlying businesses, though the excursion into illiquid assets requires new skills and redesigned governance in family offices. Managing the future is more demanding, requiring investigation capabilities, trust in partners, and independence of mind.
But this will increase the chances that “Then you'll spread your wings, and you'll take to the sky,” as Porgy wished Bess.
Didier Duret is non-executive Chairman on the board of directors of Omega Wealth Management SA, and member of the investment committee at Halkin Investments LLP. He holds several independent advisory positions at private family offices and foundations.
