Are Wealth Managers Clinging to Old, Ineffective Investment Models?

Wealth managers, as a group, have not grasped the extent to which the financial markets have fundamentally changed in the wake of the 2008-2009 downturn, according to a survey of 130 wealth managers.

“[A] segment of wealth managers appear to live in denial, clinging to investment methodologies that have patently failed twice over the past decade and are likely to fall short again,” the authors of a white paper accompanying the survey results wrote.

The survey was conducted by Risk 3.0 Asset Management, a Morristown, N.J., and New York CIty-based RIA that manages separate accounts and plans to launch a hedge fund Jan. 1, using its own investment approach. The authors are the firm’s Chief Executive Officer Mitchell Eichen and its Senior Vice President John Longo. The pair plan to release a second white paper in the first quarter of the new year further detailing their strategy.

In sum, that strategy uses options to buy puts and calls “to create a desired return pattern” and “bend the risk-reward curve of an index,” according to Eichen.

“We do all this in a completely transparent, completely liquid manner with no credit risk,” he said. “It’s not magic. It’s just math.”

The firm currently manages $450 million in assets and $375 million in this strategy, according to Eichen.

The firm’s name refers to the new era of risk management that its founders believe the financial services industry has entered. Risk 1.0 was based on modern portfolio theory and its use of highly diversified assets, while Risk 2.0 refers to the use of hedge funds to control risk, according to Eichen.

Risk 3.0, by contrast, will require entirely new thinking, he says, that doesn’t rely on predictive reasoning based on the analysis of past market performance.

If the credit crisis provided one lesson, Eichen said, it was that asset class correlations often converge to nearly one in times of severe economic stress.  While asset class diversification will remain a staple of portfolio management, he believes that, by itself, it is clearly no longer an adequate guarantee of downside protection.