06/01/16   Are You Managing Risk, Or Is It Managing You?

Editor’s Corner

Ron Rowland

Once upon a time, in a pension portfolio not so far away, achieving target returns of 7.5% did not require taking on much risk. Today, it is not such a simple task and requires assuming 186% additional risk than was necessary 20 years ago. Callan Associates Inc. recently released a research report illustrating the differences in constructing “buy-and-hold” portfolios with expected returns of 7.5% in the years 1995, 2005, and 2015.

Back in 1995, such a portfolio could be built entirely with investment-grade bonds. This was by no means an exciting portfolio, but that was also one of its endearing features. Investment-grade bonds are one of the least volatile asset classes on the planet, and this asset class could deliver a 7.5% annual return with a 6.0% standard deviation. Standard deviation is the mathematical expression of the variability of returns, and in the investment world, it is the default method of quantifying risk and volatility.

Although standard deviation is the industry standard for risk measurement, it is far from perfect. If does not adequately capture default risk, interest-rate risk, drawdown risk, asset-class risk, single-company risk, and a host of others. In fact, one could make the argument that such a 1995 portfolio consisting entirely of investment-grade bonds was riskier than its 6.0% standard deviation would imply. However, since standard deviation is calculated from the actual return stream, it accurately reflects what occurred historically and provides a good starting point.

Callan then constructed a 2005 portfolio with an expected return of 7.5% by combining various asset classes that achieved the goal with the lowest standard deviation (risk). This 2005 portfolio had just a 52% allocation to investment-grade bonds, and while they helped reduce the risk, they fell short of the desired 7.5% return. To overcome the shortfall, 25% of the portfolio was placed in domestic stocks, 14% in foreign stocks, 5% in real estate, and 4% in private equity. This portfolio has a standard deviation of 8.9%, which is 48% riskier than the 1995 version. It also has the added benefit of asset-class diversification, but it comes at the cost of a much higher potential drawdown.

Fast-forward another 10 years to 2015. Constructing a buy-and-hold portfolio with a 7.5% expected return and the lowest possible standard deviation becomes more complex. The expected return of investment-grade bonds is so low that they now only occupy 12% of the portfolio. The remaining 88% of the portfolio is forced to hold riskier assets, including 41% in domestic stocks, 22% foreign stocks, 13% real estate, and 12% private equity. Even though these allocations were determined by the combination that produced the lowest volatility, the standard deviation of 17.2% is nearly double the 2005 level and more than 2.8 times the 1995 level. With 75% of the portfolio in equities, the drawdown risk has probably increased at an even steeper rate.

This is a classic case of letting risk manage the portfolio. By specifying a desired return and requiring a buy-and-hold approach, these portfolios are not managing risk—they are surrendering to risk. It seems like a funny way to run a pension fund, but this is often the standard approach. Additionally, it is easy to brush off risk concerns when positive trends have been in place for years. When sitting on top of the hill, it is easy to look back and say the risk was worth it. However, during that long positive trend, it was only potential risk—real risk never materialized.

What happens when the trend changes and the risk becomes real? It doesn’t matter how much risk you think you are willing to assume; during the down years you will not make your desired 7.5% return. Additionally, your realized risk will shoot higher at the same time. Given that your return will drop at the same time your risk increases, wouldn’t it make more sense to manage risk rather than letting it be the uncontrolled variable?

There are numerous ways to manage risk, but they all begin with abandoning the self-imposed buy-and-hold restriction. Asset-class diversification will only take you so far. The Callan research shows that even with historically optimized asset allocations, the risk level has substantially increased over the years. Additionally, if you know anything about historical optimization, then you also know it will not be the optimum mix going forward.

By making risk a controlled variable, you are taking charge of the most dangerous aspect of your portfolio. Managing risk within a range that you are comfortable with, means having to be tactical with your asset allocations or with the securities and strategies inside those allocations. It seems like a simple trade-off, and one that makes sense to me.

Investor Heat Map 6/1/16

Sectors

Technology was the week’s big mover, surging from eighth to fourth after being on the bottom just two weeks ago. This is Technology’s highest ranking since December and could signal a turnaround. Health Care and Consumer Discretionary were the only other sectors improving their relative strength, with both moving a notch higher. Market strength still resides with Energy and Materials, which have been the dominant forces for the past eight weeks. Financials held on to its third-place spot, although Technology is now a threat. Utilities, Industrials, Real Estate, and Consumer Staples managed to gain momentum for the week, but it wasn’t enough as all of them slipped in the rankings. The market is moving toward a more aggressive stance, with the defensive sectors starting to lag. Consumer Discretionary successfully pulled itself out of the red and out of the basement. Consumer Staples was on top back in December and is now on the bottom.

Styles

Value and small-capitalization characteristics are starting to define the style rankings. The three Value categories were at the top a week ago, and while Large-Cap Value slipped two spots to fifth, there is still a clear Value bias in the rankings. Small-capitalization categories were the upside movers for the week, with Small-Cap Blend climbing two spots to third, Micro-Cap edging a notch higher, and Small-Cap Growth surging from 10th to fourth. This places the four smallest-capitalization categories in the top six slots along with the three Value segments. Given this backdrop, it is not surprising that the opposite corner of the style box underwent relative strength declines. Mid-Cap Blend fell three spots, large-Cap Blend slipped two, and Mid-Cap Growth gave up two positions. Large-Cap Growth could not fall any further, as it is already in the basement.

Global

Canada is at the top for a third consecutive week, and it has not been ranked any lower than second place for 17 weeks. The upper portion of the global rankings had little change over the past week. The U.S. and U.K. swapped places, with the U.S. gaining the upper hand. Meanwhile, World Equity, EFEA, Japan, and Pacific ex-Japan all held steady. Three global categories made the transition from red to green. China was the biggest mover of this bunch, climbing three places off the bottom while shedding its negative momentum score. The Eurozone and Emerging Markets were the other two categories to resume their positive trends. Latin America is now the only category in the red, and its two-place drop in the rankings leaves it in last place after being on the top just three weeks ago.

 

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


“ Stocks are just ownership, and they can go to zero. Private equity can also go to zero.
The perverse result is that you need more of that to get the extra oomph.”

Jay Kloepfer, head of capital-markets research at Callan Associates Inc.


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