Listening to David Swenson on youtube, and he claimed there are 3 ways to achieve returns: asset allocation, market timing, and security selection. He mentioned research (Ibbotson I think) suggests that asset allocation makes up the vast majority of the return across the market given that market timing and security selection are zero-sum games (he actually claims that they might be negative-sum games).
But why is asset allocation not zero-sum? I think Swenson is pointing to the diversification "free-lunch" idea from MPT as the answer, but not sure I understand why that is a sufficient explanation. Wouldn't the returns achieved from "optimally" balancing a portfolio be earned in part due to the "sub-optimal" asset allocation of others?
I guess it might have something to do with markets/economies growing over time - but don't understand how that wouldn't impact market timing or security selection in the same way.
Typically speaking, endowments such as Yale use a top down approach to asset allocation, meaning that they take in consideration of market environments and macro factors. When one allocates capital across various types of assets, they look at the overall performance of one asset class relative to other asset classes and their respective risk characteristics. Therefore, asset allocation in a sense, is optimizing beta. Consequently, I think this is what David Swenson means when he argues that asset allocation isn’t a zero sum game (aka doesn’t produce alpha).
In order to produce alpha, one could choose securities that outperform their respective markets. As for market timing, traders create pnl through volatility/price fluctuations in the market. In both cases, when an investor gains alpha and outperforms the market, other investors under perform the market. In the first case, beta is the aggregate average of the market and some securities have returns below the average while some have returns above. In the second case, every trade has a winner and loser, which produces alpha.
This is just my rudimentary understanding of the market but hope that helps.
Thanks for the reply. Based on my understanding of MPT (which is pretty basic as well) I think I agree with your response. Asset allocation is optimizing beta while trading/security selection is alpha focused. I get Swenson's argument as well that picking asset classes is a much more important place to focus for an endowment since this is such a "coarse" decision that can diversify and dramatically change risk/return.That said, zooming out and taking a step back from the MPT framework, isn't selecting/weighting asset classes a very similar type of decision to selecting/weighting individual securities within an asset class? It's just picking groups vs picking objects within that group. Not sure why the former would not be "zero-sum" but the latter would be. You could imagine a country where investors only have the ability to buy market index funds in different asset classes. Wouldn't their return come from doing a better job of picking asset classes than the other investors (their win is still someone else's loss)?
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Alpha is just the excess or lack of returns compared to a benchmark that usually represents an entire market. So asset allocation does not generate alpha since it is purely an allocation to various markets.
Subsequently, multi asset portfolios tend to have very low correlations and volatility due to its diversification into various markets. Now, the problem for multi asset portfolios is to choose assets that thrive in the existing or emerging macro environment, which leads to the idea of smart beta. Of course, different types of financial markets are sometimes mis-priced relative to each other, which leads to hedge funds utilizing short to medium term relative value strategies to arbitrage and generate alpha. But generally speaking, allocating assets into various baskets are purely beta plays in the long term as one is investing in the general performance of each asset class and optimizing the risk to return based on general expectations of how economic factors will drive the general market (beta).
In a sense, it’s not alpha that is being generated, but rather the theoretical separation of negative beta from positive beta through top down research and readjusting the portfolio to maximize positive beta and minimize negative beta.
In general, for asset allocation, you are not winning while someone else is losing. It’s more like everyone wins but you lose less when everyone else loses due to your low exposure.
Thanks, this is helpful for understanding within the MPT framework why asset allocation is a beta play. Still not sure I agree/understand the last paragraph tho, but prob just me at this point lol
My two cents
I think a simpler way to put it is that if you are a firm believer of an efficient market, it would essentially be a zero sum game. And that gave birth tot her index funds, while everything else (sector allocation, smart beta, and top down approach, etc) is just market timing in other forms.
I read through margin of safety and Seth Klarman does claim it is not a losers game because, as he believes, the market produces a lot of inefficiencies and deviations from the validation models. (So that one can find arbitrage opportunities and generate alpha).
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