Stock picking and portfolio allocation are very different, if related, skills. The former involves identifying unrecognized value and the potential for price change. The latter involves identifying potential risks and rewards, and weighing a portfolio accordingly. These are similar but different abilities, and investors ultimately need to develop both if they want to outperform the market.
Stock picking involves identifying value, trends, and market momentum. Portfolio allocation, however, is about identifying conviction. Which stock picks are you most confident in, and why? Which sectors are prone to get more exposure and interest from investors? How long is your time horizon, and how will your stocks perform during that time? These are questions that portfolio managers dwell on constantly, and institutional investors of all sizes develop their own proprietary models for allocating portfolios to different stocks, sectors, and funds. They develop these systems most often by identifying the stock’s beta, its market cap, and other indicators of risk and reward, as well as more qualitative factors such as the company’s growth potential, ability to attract growing market share, grow revenue and earnings, and so on.
These allocations aren’t set in stone, and it’s the portfolio manager’s job to decide when the portfolio allocations are working and when they are not. For hedge funds, whose job is to limit risk while seeking greater returns than the market average, this can mean not only reallocating between bonds and stocks, but also deciding if some companies should go from the long book to the short book or vice versa. In other words, they need to decide if their bets that a stock will go up or down has changed for some reason.
The problem here is that there is a temptation to reallocate the portfolio when the market is going down, especially if the fund has gone down greater than the market as a whole. If this is done incorrectly or timed poorly, it can amplify losses while limiting returns. When bull markets turn bearish, highly controversial momentum stocks like Herbalife (HLF) and NQ Mobile (NQ), will frequently go down faster than the market itself, even if the growth story behind the bullish case for these stocks is intact. The reverse is true as well; when bear markets go bullish, the downward trend for a momentum stock is postponed by the market movement, but not forever, assuming the story behind the stock doesn’t change.
So when portfolio managers look to reallocate their portfolios, especially in the case of a hedged portfolio using long and short books to outperform the market, keeping a close eye on each name and the rationale behind the allocation is essential. Changing a portfolio allocation in reaction to a market can all too easily turn into a panic, especially in a bear market. This will inevitably hinder returns and amplify losses.
Bronte Capital has published an interested and detailed post on this very topic, and it’s worth reading in its entirety. The process of changing a portfolio strategy involves understanding the cause of the underperformance, if there is one, and acknowledging that a strategy has suddenly stopped working. But the process must be done with care, and should involve tracking portfolio returns to the market index. If there is underperformance, is it being caused by one particular position? If so, what is causing that name to drag down returns? If not, is there a cluster in a particular sector that is underperforming the market? Or is there a fundamental change in the macroeconomic environment that is causing the hedge to no longer be a hedge?
That latter question is particularly important in the brave new world of the post-2008 Federal Reserve. For instance, 2013 showed a clear divergence in the historic norm when it came to gold and bonds. Crudely put, bonds go up with low inflation and deflation, while gold goes up with high inflation. 2013’s inflation rate was far below the historic norm and the Fed Reserve’s goal, so gold’s decline makes sense—but the decline in bonds is unexpected. A macro fund that plays on these two asset classes would have massively underperformed the S&P 500 (SPY) because the macro environment has changed.
In 2014, the macro environment has changed again. Capital is fleeing emerging markets and the Federal Reserve is paring back its bond buying program. Now investors need to understand what that means for the market as a whole and their own portfolio, and reallocate accordingly. Plus, they need to understand if other market disruptions— ecommerce, 3-d printing, genetic research, fracking — are also changing the potential performance of their portfolios.