The Fall Of The Great Bull

Coupled with an extended bull market, the enactment of ERISA had the effect of codifying modern portfolio theory (MPT) in the eyes of the majority of investors and investment managers. (In a nutshell, MPT emphasizes that risk is an inherent part of higher reward, and that investors can construct portfolios in order to optimize risk for expected returns.) For fiduciaries, the concept of controlled risk through diverse asset allocation is certainly appealing. When markets are “behaving” (as they were for nearly two bullish decades) the return, risk, and correlation assumptions used to generate asset allocation analyses tend to sync relatively well with market activity; a trend is predictable as long as it continues. In this environment, modern portfolio theory became the comfortable thread that held the financial markets’ complex patchwork quilt together. Within this model, asset managers that performed well on a relative basis within a single, easily identifiable style could consistently raise assets. Once they stepped away from their advertised style, however, their opportunities became limited.

An unfortunate result of this phenomenon was that this narrow, restrictive environment tended to limit the growth of asset managers’ skill base. It’s difficult to understand how talented, competitive individuals allowed themselves to remain locked into one specific management style for so long, especially when that style had clearly fallen out of favor. I saw managers literally go out of business rather than change their investment approach.

As the great bull began to show signs of strain and the equity markets began to behave with far less certainty (no longer trending up). It became apparent that the relativistic, MPT-driven business model embraced by traditional asset managers—one in which money was managed on a relative basis, track records were marketed based on relative performance, and performance was measured in relative terms—was plagued by significant weaknesses.

Alexander M. Ineichen of Union Bank of Switzerland (UBS) estimated that total global equity peaked at a little over $31 trillion at the top of the bull market, falling to approximately $18 trillion at the 2002 low—a decline of approximately 42 percent. As during the 1974 period, the investment community reluctantly began to embrace change in order to cope with the divide that opened between the objectives of traditional money managers and the needs of their clients.

One of the prime causes for this divide was that MPT depends on “reasonable” assumptions for each asset class. Implicitly, this requires a very long-term view; investors must plan on holding their investments for a long time in order to reap the desired rewards. Unfortunately, when markets failed to cooperate toward the end of the bull market, it became evident that most individuals and institutions have a vastly different perspective of what “long-term” means, especially when short-term performance is on the line. During times of market stress, the correlations between asset classes often fall apart, which often results in unexpectedly poor performance.
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