In 1998, my firm visited with a prominent money manager in New York City. At the time, we were trying to raise money to invest in less-than-investment-grade corporate debt. We attended the meeting and, to put it politely, we were given the brush off. That was no big deal—it happened all the time. But what that money manager said struck us as very odd. “Why should I give you guys money?” he asked. “You can’t make me one point a month like my friend Bernie.” We knew who Bernie was, and responded, “It’s not a ‘point-a-month’ world.”

Several years later, in 2005, we were sitting in front of another group that said it was interested in raising money for us. The talks proceeded to the point where we were invited to meet with the company’s founder and his top lieutenants. These gentlemen explained they were looking for another product to add to the offering of their largest existing manager (whose identity was treated like a national security secret) who was producing consistent monthly returns in the 80 to 100 basis point range. They stressed repeatedly that they could not consider a strategy that experienced losses of as much as 2 percent a month. We told them that it would be impossible to guarantee that there would not be monthly losses. Needless to say, the talks went nowhere.

The money manager we met in 1998 was Ezra Merkin, whose funds lost a reported $2.4 billion with Bernard Madoff. The money management firm we met in 2005 was Fairfield Greenwich Group, whose clients reportedly lost more than $7 billion in the Madoff fraud. Madoff, of course, was the top secret manager whose identity they refused to disclose. The firm’s now disgraced founder Walter Noel attended that meeting but let his minions do most of the talking.

Satan in the Garden

Bernard Madoff Investment Securities offered investors what they think they are supposed to seek in all of their investments: steady returns and minimal risk. This is the mantra of fiduciary thought. Unfortunately, when the curtain was pulled back on that particular wizard, what was discovered was a virtual checklist of the worst imaginable investment practices that knowledgeable investors such as Merkin and Fairfield Greenwich were paid obscene amounts of money to sniff out and avoid. These practices included: a total lack of transparency; financial statements prepared by a hole-in-the-wall accounting firm; and an investment strategy that could not possibly be carried out in any markets on the planet Earth (the so-called “split strike conversion strategy”). Yet fiduciaries such as Merkin and Fairfield Greenwich, as well as a laundry list of other respected investment institutions such as Tremont Group Holdings (owned by MassMutual), Banco Santander of Spain, the Swiss fund-of-funds firm EIM, and many other prominent investors were lured by the promise of month-after-month of consistently positive (but not too positive, which was an essential part of the scam) returns. The knowledge that such returns are virtually unattainable and that their purveyor refused to reveal how he produced them was apparently insufficient to dampen investors’ hunger for them, suggesting just how rare and valuable such a return profile would be if it were truly achievable in the real world.

Madoff’s scheme had a deeply pernicious effect on the investment management business long before it was revealed to be a complete fraud. In addition to casting a cloud of suspicion on other money management firms, particularly independent firms that are not part of large institutions, Madoff’s scheme distorted investors’ perceptions about the kind of returns they can reasonably expect. This aspect of the Madoff affair has been insufficiently acknowledged and is an essential part of the reason why capital continues to be so poorly managed by the professional investment class.

The essence of Madoff’s scheme was the proffer of consistent returns with low risk. To some people, this may seem like a reasonable proposition, but experienced and knowledgeable market participants should know better. This should particularly have been the case with respect to Madoff’s track record, which purported to show consecutive years of positive monthly returns with few if any negative months and no correlation to what was occurring in the financial markets. As we told Mr. Merkin in 1998, it is not a “point-a-month” world; it is a world of fat tails and, in the term that Nassim Nicholas Taleb made famous a few years later, Black Swans. Yet Madoff’s return pattern captured the imagination of the professional investment class and led it down the road to ruin. It also led to many imitators as institutional investors came to demand that other managers offer the same impossible model. This is one of the ways that the road to investment hell became littered with fiduciary intentions.

Reverse Black Swans

It is hardly a coincidence that the explosion of so-called alternative investments in the hedge fund industry coincided with the growth of investment strategies that offered consistent low-risk returns. By the end of 2006, the cusp of the financial crisis, Hedge Fund Research, Inc., estimated that the global hedge fund industry held $1.43 trillion in assets. These assets were spread among 11,000 different funds of which approximately one-third were funds-of-funds, according to the European Central Bank. This was a huge jump from 1990, when hedge funds held less than $400 billion in assets, and even from 2005, when the $1 trillion mark was passed.

Since the financial crisis, hedge fund assets more than doubled again to $3.118 trillion as of June 2015 according to eVestment.¹ This growth paralleled the growth of private equity assets and related strategies that invest increasing amounts of capital in nonpublic securities that can only be valued by their managers rather than by reference to any objective market standard that is independently verifiable. The two concepts—alternative investments and consistent positive returns—were joined at the hip in a symbiotic relationship that turned into a dance of death during the financial crisis. With some exceptions, the hedge fund model became one in which managers offered investors the prospect of consistent, uncorrelated positive returns in exchange for exorbitant fees.

As we saw with private equity returns, when we pull back the kimono on hedge fund returns from a risk-adjusted basis (that is, adjusted for liquidity, leverage, concentration risks and fees), many of them turn out to be far less attractive than advertised. This is particularly true with respect to credit strategies that invest predominately in nonpublic securities, most of which lost enormous amounts of money in 2008. There were profound structural flaws in the investment strategies of credit hedge funds that were responsible for many of them ending up on the wrong side—and same side—of the market in 2008. These flaws included the following:

• They owned a lot of illiquid assets.
• They used too much leverage.
• Their positions were correlated.
• They took a lot of fat tail risk.
• They financed themselves with unstable capital on both the equity and debt sides of their balance sheets.
• They carried assets at book value (misrepresenting actual values).
• They extrapolated the past into the future and ignored statistically or historically improbable events.

As a result, hedge funds—especially those that reported years of strong performance during the bull market in less liquid asset classes that involved the trading of corporate bonds, loans and credit derivatives— were susceptible to blowing up. They did not disappoint in 2008.

What these funds did was effectively adopt a reverse-Black Swan investment model in which they offered the illusion of steady high returns with low risk. In his book The Black Swan: The Impact of the Highly Improbable, best-selling author Nassim Nicholas Taleb described the Black Swan investment strategy, which is characterized by trades that yield small losses over time but can generate extraordinary returns if the market or individual stocks make extreme downward moves. Many hedge funds marketing low volatility strategies inadvertently flipped this strategy on its head and tried to create a series of small but steady returns against the small possibility of large losses due to expectations that market volatility would remain within historical limits. Some funds did this using highly liquid securities and high degrees of leverage, such as credit arbitrage funds, and others invested in non-public debt and equity securities in the credit space, like the many highly leveraged credit-oriented hedge funds that blew up in 2008. These funds collected a lot of illiquid investments and ended up retaining the least valuable ones through a process of adverse selection when forced to sell. Many of these funds either blocked redemptions (i.e., “gated” their funds) or offered to return assets “in-kind” to investors (which from an investor’s standpoint is the equivalent of winning the booby prize). Realistically, there is nothing else these funds could do with these investments; they certainly couldn’t sell their illiquid assets to anybody at the bottom of the market.

In order to deliver steady streams of positive returns, however, hedge fund managers claimed they were following strategies that were uncorrelated with the financial markets. What does uncorrelated mean? We all know what it is supposed to mean—returns that are not correlated with the movements of other risk assets such as stocks. What uncorrelated really came to mean was something else entirely: Madoff-type returns, which were simply fraudulent, or private-market-type returns, which were based on nonpublic market valuations that could not be confirmed by liquidity events except on a sporadic basis. The latter type of investments included private equity, direct lending to small and mid-size companies, structured products, and similar investment strategies. Some of the largest hedge funds in the world managed by firms such as Cerberus Capital Management, LLC, GoldenTree Asset Management, L.P., and Highland Capital Management, L.P. engaged in these strategies and grew to enormous sizes before running aground in 2008. Their losses called into question their reported returns in earlier years to the extent those returns included unrealized gains that were later reversed by losses. But in order to compete to manage the money of institutions that believed in the prospect of low-volatility/high returns, firms that wanted to grow had little choice but to follow these strategies.

This approach worked out just fine as long as the markets were rising, or at least when they weren’t experiencing extreme volatility. As long as global liquidity was robust and markets were stable, these strategies looked successful on the surface. Funds could continue to borrow to bid up the prices of financial assets, and managers could continue to convince investors that their investments were worth more each year. But when credit markets seized up, these strategies were swamped by three simultaneous tsunamis. First, the value of their leveraged assets started to decline precipitously. Second, their lenders became nervous and demanded more collateral to support their positions. And third, these firms could no longer convince investors to keep feeding them money and in many cases were faced with requests to return capital. When the markets sold off, many investors wanted their money back. The problem was that these investments were completely illiquid and investor capital could only be returned in kind or not at all. Returning cash to investors was out of the question because capital had died. This was how Madoff’s Ponzi scheme came apart: It relied on a continual stream of new money to pay interest on investor capital and to handle the return of capital to investors who requested their money back. But when such requests grew increasingly large (reportedly to $5 or $6 billion by late 2008), there simply wasn’t enough new money coming in for Madoff to honor them and the scheme fell apart.

Many legitimate hedge funds (that unlike Madoff’s actually engaged in real investing and trading strategies) suffered the same fate and were forced to suspend redemptions, return capital in kind, or close shop. This was not only another example (like the banking industry’s SIVs) of a flawed financial strategy that confused long-term solvency with short-term liquidity by borrowing short to lend long, but also emblematic of the fact that institutional investors were seeking an impossible Holy Grail of consistently high positive returns with low risk. One has to wonder how differently things might have turned out had Madoff’s fraud been discovered much earlier and the investment community come to an earlier understanding that markets don’t serve free lunches.

The real question that should be asked is how so many investors could be led to believe that such strategies were prudent (or even possible). After all, the prudent man rule is the basis on which most fiduciaries base their conduct. How could an entire generation of investors be duped into believing in concepts that are so blatantly false? Like many of the other intellectually corrupting influences discussed in this book, investors were given a mighty helping hand by the political and academic authorities. In particular, the U.S. legal system adopted a doctrine of fiduciary duty that narrowed the focus of those charged with investing other peoples’ money to the single goal of economic gain. Other societal interests such as the rights of labor, the environment, and the distinction between productive and speculative investment, were pushed aside.

Moreover, an entire industry of consultants and academics developed the intellectual scaffolding to dress up this mandate in pseudoscientific language. Concepts like “Sharpe ratio” and “R-squared” and the infamous Greek chorus of “alpha” and “beta” were used to justify investment strategies that could theoretically deliver steady returns with low volatility and low correlation with the stock market. These arcana dressed the consultants in the garb of a secret ministry holding the keys to the kingdom of gold. The only problem is that when one pulls back the curtain, one finds that that there is no wizard and that the magic formula is malarkey. There is a perfectly good reason many of the strategies recommended by the consultant community and other investment advisers don’t correlate with financial markets: They are not marked-to-market or even capable of being marked-to-market in any meaningful manner. Accordingly, the entire industry is operating under an illusion from which it would be extremely painful to break free.

It should be noted that there are absolute return strategies that are uncorrelated with the market that can generate consistent high returns without employing high leverage or investing in illiquid assets. I know because I manage one such strategy in The Third Friday Total Return Fund, L.P., which is discussed further in Chapter 11. This strategy was developed over two decades and has been tested successfully through several market cycles. But such strategies are rare.

Birth of the Prudent Man

There are two aspects of modern fiduciary doctrine that are deeply troubling. First, how did the prudent man rule become warped into a blind pursuit of financial profit at the expense of the other, arguably equally important economic and societal values? And second, how did substantive thinking about investing devolve into thinking that the Madoff model of consistent monthly returns is realistic?

The prudent man rule dates back to the 1830 Massachusetts court case Harvard College v. Amory, 26 Mass (9 Pick.) 446 (1830). That court held that “all that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.” Most important, the case held that “trustees are not to be made chargeable but for gross neglect and willful mismanagement,” standards of conduct that still apply today.

Like many legal standards, this one is extremely broad and leaves many of the details to be filled in by legislators, practitioners, and judges as specific situations arise. There have been a number of landmark advances in the thinking governing this rule over the years. In 1942, the Model Prudent Man Statute was adopted that codified this rule and influenced the passage of many state statutes. In 1972, the Uniform Management of Institutional Funds Act was issued as a model law designed to guide institutional investors to adopt total return strategies for their investment portfolios. This was followed in 1974 by the Employee Retirement Income Security Act (ERISA), a comprehensive federal pension law that codified the prudent man standard of care. ERISA 29 USC § 1104(a) states that

[A] fiduciary shall discharge his duties with respect to a [retirement] plan solely in the interest of the participants and beneficiaries and—

1. for the exclusive purpose of:
   1. providing benefits to participants and their beneficiaries; and
   2. defraying reasonable expenses of administering the plan;
2. with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims;
3. by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so;...

But ERISA did more than simply codify the prudent man rule—it added a duty of diversification. This requirement was an endorsement of the modern portfolio theory developed by Harry Markowitz in one of the most famous papers in modern finance, “Portfolio Selection.”

Markowitz’s article appeared in the March 1952 issue of the Journal of Finance and was written when the author was only 25 years old. Markowitz followed this article with a more detailed discussion in a book entitled Portfolio Selection: Diversification of Investment, which was published seven years later in 1959. In the key passage in the article, Markowitz argued, “[i]t is necessary to avoid investing in securities with high covariances among themselves. We should diversify across industries because firms in different industries, especially industries with different economic characteristics, have lower covariances than firms within an industry.”²

This means that securities in the same industry, for example, will not provide sufficient diversification because they tend to react to the same types of business and economic risk factors in the same way. A portfolio composed of an undue concentration of companies in a single industry would be too vulnerable to the risks facing that industry. “A portfolio with sixty different railway securities,” Markowitz wrote, “would not be as well diversified as the same size portfolio with some railroad, some public utility, mining, various sorts of manufacturing, etc. The reason is that it is generally more likely for firms within the same industry to do poorly at the same time than for firms in dissimilar industries.”³ Markowitz’s paper was considered revolutionary at the time because it introduced the concept of risk-adjusted returns. Previously, the concept of diversification had not been considered essential to portfolio management. Instead, investors were primarily focused on maximizing their returns without regard to the risks involved. Markowitz introduced the important concept that returns are related to the amount of risk associated with an investment. As noted previously with respect to the discussion of private equity returns, this is an essential insight that is too often overlooked even today.

In constructing portfolios that were sufficiently diversified to protect against risk, Markowitz added the mathematical concept of mean variance optimization, which in layman’s terms means “efficiency.” In mathematical terms, efficiency means maximizing output for a given input, or minimizing input for a given output. In portfolio terms, this means maximizing the anticipated return for the amount of risk taken, or minimizing risk for the amount of return achieved. In Peter Bernstein’s words, an efficient portfolio “offers the highest expected return for any given degree of risk, or that has the lowest degree of risk for any given expected return.”⁴ This concept still guides much of the money management industry today. Unfortunately, it has done little to help the industry avoid repeating the same mistakes over and over again.

The other theory that has exercised enormous (and undue) influence on fiduciaries is the wholly discredited efficient market theory, which was set forth in a 1965 article by economist Eugene F. Fama. An efficient market is defined as one in which:

There are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any given moment in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.⁵

Although this is clearly a definition that only someone completely lacking in market experience could actually accept as a reflection of reality, it has exercised an undue influence on fiduciary thought.

In fact, the efficient market theory was endorsed in the Restatement Third of Trusts (1992), where the Reporter’s General Note on Restatement Section 227 reads:

Economic evidence shows that, from a typical investment perspective, the major capital markets of this country are highly efficient, in the sense that available information is rapidly digested and reflected in the market prices of securities. As a result, fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to “beat the market” in these publicly traded securities ordinarily promises little or no payoff, or even a negative payoff after taking account of research and transaction costs. Empirical research supporting the theory of efficient markets reveals that in such markets skilled professionals have rarely been able to identify underpriced securities (that is, to outguess the market with respect to future return) with any regularity.⁶

The introduction to the Restatement and the prefatory note to the Uniform Prudent Investor Act passed two years later stressed the influence of modern portfolio theory, of which Markowitz was one of the founding fathers. In fact, this landmark restatement of the law of trusts was primarily intended to incorporate modern portfolio theory into the rules governing fiduciaries. Among the principles laid out in the Restatement was that both passive and active investment strategies would be deemed prudent, but that active strategies would be required to meet a higher standard in justifying that they were adding value (which came to be known as “alpha,” one of the Greek gods of current investment argot). The Restatement outlined five principles of prudence for fiduciaries to follow: diversification; a reasonable relationship between risk and reward; minimizing unnecessary and unreasonable fees; balancing preservation of capital and production of current income; and giving trustees the duty and authority to delegate investment decisions to others. With the exception of the bald assertion of the necessity of diversification, this is a reasonable list.

It is little wonder that typical fiduciaries at large institutions tend to stumble into one investment trap after another; they invest as though they actually believe that the markets are efficient and that diversification really pays off. They might as well believe that the earth is flat or the moon is made of green cheese, two propositions for which there is just as much empirical proof as there is for the efficient market theory and Harry Markowitz’s “Portfolio Selection.” This is the type of thinking that leads institutions into the private equity trap, the distressed debt trap, and other illiquid strategies that they are told do not correlate with public equity and debt markets when, in fact, they correlate strongly with such markets with the added handicap of enjoying limited liquidity, employing greater leverage, incurring higher fees, and producing lower risk-adjusted returns. These theories completely overlook market realities. The efficient market theory ignores not only the wisdom of thinkers like Smith, Marx, Keynes, and Minsky that markets are highly inefficient because they are driven primarily by human emotion, but the reams of data that illustrate beyond a shadow of a doubt that market prices are imprecise measures of underlying valuation metrics that are themselves unstable indicia of value. The Portfolio Selection thesis overlooks the fact that the concept of correlation has changed dramatically since the time that Markowitz wrote his paper. Investors treat the concept of correlation like a law of nature rather than a human construct, and therefore engage in profound intellectual error. In fact, it is ironic that when Markowitz wrote the paper in 1955, it was difficult to test his thesis because of limited computer power, while today the advanced computer power that permits every conceivable type of financial instrument to be deconstructed into 1s and 0s renders the very concept of diversification obsolete.

The Fallacy of Diversification

In Chapter 3, we discussed the role that the prudent or reasonable man played in the work of Adam Smith as he tried to design a just society based on commercial exchange. We saw the flaws in that approach as it cedes power to groupthink and the madness of crowds. Add that to an almost religious belief in diversification and efficient markets and one can begin to understand how the evolution of fiduciary law created the conditions for most shepherds of capital to consistently produce sub-optimal returns.

Diversification came to be taken for granted as the gravamen of prudent investment management. But the world changed, and diversification in the early twenty-first century no longer means what it did half a century ago before derivatives and Ponzi finance came to dominate the financial landscape. So while the concept of diversification had a great deal to recommend it in the investment world of the 1950s, it has turned out to be a trap for investors in the twenty-first century. Today, asset classes that are not ostensibly covariant (to invoke Markowitz’s terminology), such as equities and debt, have been rendered covariant by new financial technology. The ability to deconstruct all types of securities and financial instruments into their constituent parts (1s and 0s) has erased the differences between asset classes, nullifying the boundaries between different types of securities in ways that render the concept of diversification completely outmoded. During the financial crisis, investors discovered, much to their distress, that while they thought their portfolios were invested in different types of risks, they were, in fact, largely exposed to the same risks. The most significant risk was the enormous amount of leverage embedded in all asset classes. Another way of saying this, in the terminology of Hyman Minsky, is that they were at greater risk than they realized that the Ponzi finance structure of the U.S. and global economy would come apart. The economy became populated by so many economic actors—individual homeowners, corporations—that were so highly leveraged that virtually their entire capital structures (equity and debt) effectively consisted of borrowed money. As a result, both the equity and debt components of their capital structures were equally vulnerable not only to changes in individual debtors’ financial situations but also to deterioration in the financial markets. What once was uncorrelated suddenly turned out to be highly correlated because all asset classes were vulnerable to the risk of a credit crisis.

Perhaps the grossest abuse of the concept of diversification was committed by the U.S. credit rating agencies, Moody’s Investors Service and Standard & Poor’s, in their ratings of structured products. The intellectual poverty of the agencies’ approach to modeling correlation is writ large in the fact that the agencies subsequently found themselves compelled to reject their earlier ratings and admit that the models on which the entire trillion dollar edifice of structured finance was constructed was deeply flawed. Aided and abetted by large Wall Street underwriters of CDOs, these oligopolists concocted so-called black box models that were intended to measure the correlations among individual mortgages, bonds, or loans. In the case of mortgages, as noted earlier in Chapter 4, they simply ignored the fact that the borrower data (FICO scores) they were using had never been tested in an economic downturn. In the case of corporate bonds and loans, they applied grossly understated corporate default and recovery assumptions (ones that predated the 2001–2002 period in which corporate defaults exceeded 10 percent for two consecutive years) and then categorically restated their assumptions in 2009 after the worst of the crisis had passed with little rationale and without distinguishing among different securities. Their actions effectively forced stable collateralized loan obligations into slow motion liquidations at the nadir of the financial crisis that rendered them incapable of purchasing additional bank loans and further damaged the market. The fact that hundreds of billions of dollars of transactions were premised on default assumptions that were unilaterally altered (at a time, by the way, when the default outlook was improving due to companies enjoying better access to capital that enabled them to refinance their debt) was apparently of no account to these self-appointed doyens of credit that had demonstrated beyond a shadow of a doubt that they know nothing about credit. With banks having exited this market, this unilateral and ill-considered post hoc action further shrunk the sources of capital available to fund less-than-investment-grade companies in the United States and Europe.

The only positive sign that the credit agencies were going to be held accountable for their fecklessness was the fact that New York Federal Court Judge Shira Scheindlin rejected their argument that their intellectually vacuous credit opinions were protected by the First Amendment. Judge Scheindlin held that First Amendment protection does not apply “where a credit rating agency has disseminated their ratings to a select group of investors rather than to the public at large.” I would simply add that when rating agencies are paid large amounts of money for their opinions, the First Amendment veneer of free speech should not protect them from their mistakes.

The high-yield bond area has been a Petri dish for misapplied financial theories and assumptions for years. As noted earlier, high yield bonds are properly understood as hybrid securities that possess the characteristics of both debt and equity. Yet most investors in this asset class focus on the “spread” at which a bond trades. The spread is the number of basis points (1/100s of a percentage point) above a benchmark yield at which a bond trades. In the case of high yield bonds, Treasury bonds are considered the benchmark on the basis that they are riskless securities (an assumption that itself is questionable in view of the United States’ increasingly precarious fiscal posture). Spread represents the risk premium that investors demand for owning a security that is riskier than a Treasury bond.

There are two problems with this approach. First, conceding for the sake of argument that Treasury securities are riskless in the sense that their repayment in nominal terms by the U.S. government is assured, their interest rates have been kept artificially low since the early 1990s by pro-cyclical Federal Reserve policy. This phenomenon intensified after the Fed lowered the Federal Funds rate to zero during the financial crisis and kept it there for seven years while also engaging in several rounds of quantitative easing, policies that distorted interest rates beyond recognition. These low rates are signs that all is not well in the economy, a condition that adds further risk to high yield bond investments that are generally highly sensitive to economic conditions. In periods when interest rates are extremely low, these low rates are indicative of economic weakness, not strength. Accordingly, high yield bond investors are being grossly underpaid for the risks they are assuming.

Second, spread is a fixed income measurement and high yield bonds are not simple fixed income instruments; they contain a significant component of equity risk (that far too many investors have swallowed firsthand, to their dismay). The market is applying a tool designed to measure fixed income risk to what is in large part an equity security. This is particularly true with respect to lower rated bonds (bonds rated Ba/B or lower by Standard & Poor’s and Moody’s). Lower rated bonds are extremely risky and are really not fixed income instruments at all; they are best described as “equities in disguise” or “equities with a coupon.” In fact, these bonds always end up trading at equity-like yields (which translates into much lower prices and very high yields) when the market recognizes their subordinated, equity-like character.

Combining the wrong benchmark with the wrong tool to measure risk virtually assures investors of a bad outcome. The primary reason spread is used to value high yield bonds is because it appeals to the quantitative side of the investment universe. Unfortunately, it is an extremely poor tool that continues to be used by investors to their detriment.

Another bogus assumption in the high yield bond market that led to billions of dollars of investor losses in the 2001–2002 credit collapse was the set of default expectations underlying a now mercifully extinct product, the collateralized bond obligation (CBO). CBOs were a form of collateralized debt obligation whose collateral was comprised primarily of high yield bonds. CBOs were underwritten by the largest and most respected financial institutions in the world using the basic assumptions that only two percent of the bonds in a diversified portfolio would default each year and that the recovery rate on these bonds would be 40 percent. These assumptions had little basis in reality, as the bond market collapses of 1990–1991, 1998, 2001–2002 and 2007–2008 demonstrated. Yet for some reason, the major credit rating agencies continued to issue investment grade ratings on the various tranches of CBOs based on these erroneous assumptions. Even worse, highly respected investment firms continued to hawk these products based on these same assumptions, and large institutional investors continued to purchase securities while believing them.

Interestingly enough, Harry Markowitz would be very open to suggestions that investment mantras like diversification should be subject to question in view of changing conditions. In 1995, Markowitz wrote a fascinating paper for the Financial Analysts Journal entitled “Market Efficiency: A Theoretical Distinction and So What?” in which he subjected William Sharpe’s Capital Asset Pricing Model (CAPM) to some revisionary thinking. The CAPM is among the most influential theories in the recent history of investment management despite the fact that it depends on wholly unrealistic assumptions about the way in which markets and investors operate in the real world.⁷ Among the assumptions of the CAPM that do not jive with the real world of investment are first, the assumption that taxes, transaction costs, and other friction costs can be ignored, and second, that investors share the same predictions for expected returns, volatilities, and correlations of securities. Both of these assumptions are obviously false. Moreover, the predictive record of this model is notoriously poor. As Eugene F. Fama and Kenneth R. French wrote in 2004: “(t)he empirical record of the model is poor—poor enough to invalidate the way it is used in applications.... The CAPM, like Markowitz’s … portfolio model on which it is built, is nevertheless a theoretical tour de force. We continue to teach the CAPM as an introduction to the fundamentals of portfolio theory and asset pricing.... But we also warn students that, despite its seductive simplicity, the CAPM’s empirical problems probably invalidate its use in applications.”⁸ Despite these flaws—it is based on bogus assumptions and has poor predictive power—the CAPM has exercised an enormous influence on the thinking of investment professionals. There are valuable lessons to be learned from this model. But it is also a lesson that the investment management business—and on a broader basis, human knowledge—is built on error. The trick is learning from those errors and building on them to come to a deeper understanding of the truth—not repeating them.

Peter Bernstein argued powerfully in his final book, Capital Ideas Evolving, that “investors have learned from CAPM that they must recognize the fundamental distinction between investing in an asset class and selecting individual securities on which they hope to earn an extra return. The choice of asset classes—for example, stocks, bonds, emerging market equities, real estate, or subdivisions of those markets—is in essence the choice of beta risks, or the volatility of entire markets rather than their individual components.”⁹ This may be true but does not help solve the conundrum facing investors when all asset classes correlate because they have been reduced to 1s and 0s. Theory has yet to catch up to practice and fiduciaries need to understand the new reality if they are to properly fulfill their obligation to first do no harm before worrying about how to generate attractive risk-adjusted returns for their flocks.

Market dislocations like those that occurred in 1998 and 2008 demonstrated that allegedly non-covariant asset classes like debt and equity can (and likely will) collapse at precisely the same time, and that stocks in different industries are far more interconnected than Markowitz’s theory contended. True diversification turns out to require a far more radical approach than that proposed by Markowitz’s model and legislated by ERISA and other codifiers of fiduciary standards in the mid-to-late twentieth century, as market events have demonstrated. Fiduciary law, like much of the thinking governing financial markets as they barely escaped the 2008 financial crisis and appeared headed toward another one a decade later, has been left in the dust.