There are trust funds and endowments blowing up all over the country in this market event.  Ok, it is unexpected but an asset allocation should be robust enough to with stand an event of this magnitude.  So why have so many failed?

Having witnessed a trust not of my management suffer a massive loss on a portfolio that was designed not to exceed a four percent loss in any one year, within two sigma.  The account has annual required cash flows of two to four percent.  If you saw the asset allocation, you would probably scratching your head, but if you look at the statistics, they tell a different story, a story of risk adjusted balance. 

Sadly, the assumptions on hedge funds, namely their high return, low risk, and non-correlation to other asset classes makes it a favorite choice of the Markowitz model.  It was in explaining what uncorrelated means to this very upset board that I realized the model malfunction – garbage in garbage out. 

If I was a trustee of a fund, I would be on the phone with my advisor or consultant and ask them to model the portfolio without hedge funds and instruct them to migrate to that asset allocation and damn soon too.  When you look at the whole portfolio in terms of risk, what happens when hedge funds perform exactly like the rest of your very risky assets?  That is right you blow up and die. 

The moral of the story:

1.      Uncorrelated means that what happens in the stock market gives you no information on how the asset class in question will perform.

2.      You should ask a few more questions on just how much risk your portfolio is taking.

3.      In all models garbage in garbage out, so understand the assumptions that go into your Markowitz Optimization model.

Nobel prizes can be sent to me in Alaska