The First Question: Security selection or asset allocation


Key takeaways:

Nobody is bigger than the market: The market you’re invested in far more important than the securities you select within that market.
  • Paul Samuelson’s Dictum: Markets are microefficient but macro inefficient
    • At an individual security level, market agents are able to keep prices at approximately or close to general equilibrium but there are large structural barriers to arbitrage that keep markets from finding equilibrium at the macro ie asset class level.
    • You can’t “stock select” your way out of a bad market environment. For example, they cite that a 5th percentile US equity fund crushed the 95th percentile emerging market fund from roughly 2013 to 2018. The implication is that these markets as of 2013 must have been inefficiently priced compared to each other. That’s a macro inefficiency
    • Original BHB study and the wave of studies which followed showed that nearly all of the variability of a portfolio comes from asset allocation. The benchmarks for the allocation sleeves explain most of the return.
Reasons why the market is micro but not macro efficient
  • 99% of cognitive and computational capacity is devoted to security selection. Why?
    • Large investment committees direct the largest pools of capital and decide the asset allocation mix that they believe can help them achieve their goals ie match their liabilities.
    • Within the buckets underneath that decisions (equities, bonds, private investments, etc) are silos that focus on security and manager selection within the bucket.
    • Much more effort is applied within the silos, than at the investment committee level.
    • Since the large allocators devote effort to finding alpha in the silos they create demand for active managers within asset types but do not create demand for broader asset allocation managers.
    • The primary barrier to macro arbitrage comes down to:
      • Mandate inflexibility (this is also driven by regulation)
      • Lack of portfolio agility because of liquidity constraints/costs
    • Private retail wealth faces the same issue from a behavioral point of view. There isn’t much deviation from standard stock/bond splits because there is little patience for weird portfolios with high tracking error.