Three finance professors have ruffled the feathers of one of Wall Street’s most vocal hedge fund managers with a new paper. “Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice” estimates that “Americans could realize trillions of dollars in welfare gains” by adopting an “all-equity strategy” for their retirement savings.
It’s a serious challenge to some bedrock principles of modern investing, particularly the idea that diversifying across asset classes, i.e. stocks and bonds, is the most logical choice for long-term investors. The paper’s authors, professors Aizhan Anarkulova of Emory University, Scott Cederburg of the University of Arizona, and Michael S. O’Doherty of the University of Missouri, came around to an all-stock investment strategy after reviewing the history of 38 developed markets between 1890 and 2019.
But Clifford Asness, the billionaire co-founder and chief investment officer of the world’s third-largest hedge fund, AQR Capital Management, isn’t buying it.
“Simply looking at historical results and urging investors to ‘buy the thing that’s gone up the most over the long term’ is not financial analysis, it is finger painting,” the Wall Street veteran, who definitely isn’t known for pulling his punches, argued in a Monday article titled “Why Not 100% Equities.”
Asness had a few specific critiques of “Beyond the Status Quo”—but they aren’t really new. In fact, the hedge funder, known for his quant value strategies, has been battling arguments for 100% equity portfolios with “alacrity and panache” (his own words) since the ’90s. He even used the same title, “Why Not 100% Equities,” in 1996 to refute the findings of a paper that “presented strong evidence documenting the historical superiority of investing in 100% equities.”
According to Asness, the idea that investors should put all their financial eggs into one basket doesn’t account for a critical feature of financial markets: risk. “We (academics, practitioners, anyone who’s taken a cursory look at modern finance) prefer a diversified portfolio because we believe it has a higher return for the risk taken, not a higher expected return,” he explained.
The debate over risk-adjusted returns—and why leverage matters
That brings us to what the leading portfolio strategy of our era, modern portfolio theory (MPT), sometimes calls “risk-adjusted returns.” When the Nobel Prize-winning economist Harry Markowitz first described the theory that spawned MPT in a paper called “Portfolio Selection” in the Journal of Finance in 1952, he argued that proper portfolio construction requires investors to analyze both return and risk. The theory gained a lot of traction, and today investors will often measure the return of their portfolio only after considering how much risk was taken to earn it.
This idea is used as the justification for diversifying into different asset classes with different risk profiles, and it has helped support the now-common belief that a portfolio allocated to 60% stocks and 40% bonds is the most logical option for most long-term investors.
But there’s a caveat to MPT’s central tenet, which holds that risk-adjusted returns are superior to expected returns that don’t account for risk: Getting the best return often requires the use of leverage, and most retirement savers aren’t leveraging their portfolios.
Even Asness explained: “If the best return-for-risk portfolio doesn’t have enough expected return for you, then you lever it (within reason). If it has too much risk for you, you de-lever it with cash. Remarkably this has been shown to work.”
He’s right that this tactic has been shown to work, but can it really be used by the average American? In a statement to Fortune, Anarkulova, Cederburg, and O’Doherty noted that their study focused on retirement savers and the “vast majority” of these investors are not allowed or not able to use leverage.
“It is possible that some other portfolio could be levered up and be better than the all-equity strategy for hypothetical investors who are able to use leverage for their retirement savings,” they explained in written comments, adding that they will “examine these cases in the next version of the paper.”
But overall, the professors said that their analysis suggests “that any such portfolio will remain dominated by stocks and will not include much (if anything) in bonds for reasonable leverage levels.”
But don’t take the idea that leverage is necessary for MPT from the professors—take it from two principals at Asness’ own firm, AQR. In 2014, AQR’s Andrea Frazzini and Lasse Heje Pedersen explained in a paper that “many investors, such as individuals, pension funds, and mutual funds, are constrained in the leverage that they can take, and they therefore overweight risky securities instead of using leverage.” In other words, in order to get the gains you want using a portfolio designed for risk-adjusted returns, you might have to use leverage; and if you don’t, the lure of “risky” stocks with higher absolute returns is always there. That lure may be more of a siren song (Asness would likely argue so) but that’s up for debate.
Trillions in welfare gains?
So the disagreement over the use of diversified portfolios that maximize risk-adjusted returns may come down to leverage, something that is more commonly used by professional investors rather than your average Joe. But Asness also had a few other points of contention with this new paper worth addressing.
The most important of these is the paper’s claim that by switching to 100% equity portfolios, U.S. retirees could get “trillions in welfare gains.”
Asness argued that there’s a flaw in the logic behind this idea. The claim that trillions of dollars are “being left on the table is really just non-economic hype” based on the incorrect assumption that there are “sidelines” in the investing world, he explained. Asness noted that stocks are always 100% owned, and in the world of finance, there are no sidelines, just investors holding different types of assets.
“If some investors read this ‘new’ paper and decide to buy more equities, they have to buy those equities from other investors. This can force the price up, and the expected future return down, but everyone can’t suddenly have double the normal amount of equity dollar return out of thin air,” he explained.
In response, the professors said that they “don’t disagree” that if all retirement savers switched to 100% stocks, “the additional demand for stocks would raise prices and lower expected returns,” which could alter the “optimal” portfolio to something other than 100% equities.
However, they also offered a couple explanations for their idea (I’ll let you judge their validity on your own). First, they claimed that retirement savers with 100% equity portfolios would be able to save more income annually than their peers with traditional diversified retirement portfolios (14% vs. 10%) due to increased market returns. That could offer a serious economic benefit of over $200 billion a year, they said.
Second, they argued that if most investors do not shift to the all-equity strategy, which is likely, then “those who do will get their portion of the benefit and overall stock prices aren’t likely to move too much so all-equity would remain a good strategy.”
Still, the professors admitted that they plan to remove the “trillions of dollars” line from their next draft of this paper. They concluded by saying: “it’s at least tough to argue with our simple point that the economic magnitudes of differences in strategy performance are large.” Make of that what you will.
Sampling issues?
Finally, Asness mentioned sampling bias as a potential issue with the “Beyond the Status Quo” paper. He claimed that rising valuations during the measured period have created an “overestimation” of the future performance of stocks. But the professors pushed back on this one, noting that they used data from 38 developed countries, a sample period of over 100 years, and U.S. stocks only made up 5% of the data.
“We aren’t sure what to make of this criticism,” they wrote. “We carefully constructed our sample to mitigate the sort of lookahead bias that seems to be referred to in the comment…Our sample contains a very large amount of information about stock and bond performance with a variety of market conditions across countries and time, so we believe it provides investors with a balanced and comprehensive view of potential outcomes.”
Sampling issues aside, the debate over modern portfolio theory, as well as the validity of risk-adjusted returns and diversification, isn’t going anywhere soon. Asness argues that challenges to this conventional wisdom are a feature of periods of stock market outperformance.
“The bottom line is diversification works, theory works (eventually), owning one asset is suboptimal, extrapolating the winning country over a period of valuation increases is dangerous, finance 101 is actually helpful – and we’ll likely have to do this again after the next bull market,” he concluded.
Is he right? Well, I’ll leave that one up to you.