Thursday, August 26, 2010

Abbink, Alternative Assets & Strategic Allocation

Don’t judge a book by its title. John B. Abbink’s Alternative Assets and Strategic Allocation: Rethinking the Institutional Approach (Wiley, 2010) is a fascinating work. It’s packed with well-reasoned insights about a range of markets and strategies and written with clarity, precision, and wit. Anyone who trades for his own account, runs a fund, or manages an institutional portfolio should put aside a day to read this book. It will be a day well spent.

Abbink contends that there are just three investment strategies that underlie all approaches to investing: directional strategies, cash flow strategies, and arbitrage strategies. They can be pursued individually or, more frequently, in combination. Returns from these three strategies can be enhanced through the techniques of leverage, hedging, tactical allocation, investor activism, accepting liquidity risk, or trading volatility.

Abbink analyzes a range of investment styles: long/short equity, direct lending, merger arbitrage, high-frequency trading, holding private assets for their cash flows, fixed-income arbitrage, and event-driven investment. He then moves on to position management and portfolio construction.

That’s the book in bald outline. Since I obviously cannot condense over 500 pages into a few paragraphs, I’m going to let Abbink speak on his own behalf. To begin, here are two passages, the first dealing with hedging and the second with opportunity cost.

“Hedging has become a portmanteau term—a concept that has gradually been made to carry so much freight that it has become very difficult to unpack. A hedge is a position that is put on to offset the volatility of another. This can lead to equivocation over which is the position and which is the hedge. Human nature being what it is, managers sometimes claim that the successful legs of hedged trades were invariably the investment positions, reflecting their sagacity, while the losses on the other legs of the trades ‘just reflected unavoidable hedging costs.’“ (p. 41)

Opportunity cost, Abbink writes, is “a fundamental concept that pervades all investment activity.” It results from “the necessary specificity of our actions… [W]e cannot choose to invest in general but must always select this or that particular investment.” Naturally, we can’t know in advance which will be a high-flyer and which a dud, so we reduce opportunity cost through diversification. “Although the return of the best-performing asset will unquestionably be diluted through diversification, there is a compensating reduction in the aggregate volatility of the portfolio if the less promising assets are carefully chosen.” Abbink views opportunity cost as a pervasive investment risk. “However, opportunity cost is different from all the other pervasive risks in one important respect. While operational or credit risks relate to things that may go wrong, but against which we can take preventative measures, opportunity risk is an ironclad promise that something will turn out other than as desired. Opportunity cost embodies the relationship between risk and return in its purest form: as the Devil’s Dictionary defines it, an opportunity is unavoidably “a favorable occasion for grasping a disappointment.” (pp. 413-15)

Lest my readers think that Abbink’s book is a series of quips, let me quote a paragraph from his chapter on fixed-income arbitrage which describes an option strategy. “Consider a butterfly trade around a yield-curve discontinuity…. In this instance the trading strategy would be implemented by taking a long position at B and shorting positions at A and C that have a combined value equivalent to that of the long position. The trade is productive whether the yield at B drops into line with the yield curve or the curve rises to bring itself into line with B’s yield: the returns are symmetrical and thus the trade is directionally hedged, as any true arbitrage must be, by definition.” (p. 203)

Abbink’s book brings a fresh perspective to topics often relegated to academic papers, making them accessible to investors, both individual and institutional. It’s one of the most thought-provoking books I’ve read in quite a while.

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