SEC guidelines for target date funds and disclosure miss the critical problem with these very popular products. They don't do what consumers THINK they do. Target date funds make investing easy for long term investors in 401k and other DC pension schemes by promising to make systematic asset allocation changes that reduce the equity exposure of the portfolio as retirement, or the target date approaches. As a result, 80% of all new and redirected assets into U.S.-based DC plans are flowing into these funds. 77% of assets in these products are controlled by three manufacturers, Fidelity, Vanguard, and T. Rowe Price who must bear much of the responsibility for the misdirection.
By suggesting that equity exposure is being reduced over the life of the investment, investors think RISK is being reduced. If this were true, there would be no problem. But equity exposure does not equal risk exposure and risk changes over time. Think in terms of two relatively recent example. The RISK of the S&P 500 pre-Tech Bubble with less that 10% technology exposure and in 2000 with technology representing over 30% the risk in the market, as represented by a 252 day moving average of S&P 500 SD, spiked to over 15% during the period. The recent financial crisis saw an even more dramatic shift in the risk of stocks and bonds as corporate spreads over treasuries ballooned in late 2008 early 2009 and the SD of the S&P 500 spiked to a mind blowing 60%! So for target date funds to imply that they are systematically reducing RISK exposure is misleading at best.
The remedy is Target Date Funds 3.0, an approach that maintains a consistent approach towards portfolio RISK. It is a systems solution as much as an investment solution but most importantly in the debate about full disclosure to clients, it provides an honest relationship between what investors understand they are getting and the marketing hype of the industry. For more information www.purinvesting.com
Showing posts with label risk management. Show all posts
Showing posts with label risk management. Show all posts
Thursday, December 9, 2010
Tuesday, October 19, 2010
Risk is a Ten Letter Word
Investors over the recent past not only know about volatility, they likely have the scars to prove it!
Exchange-traded funds (ETFs) are well known for their low cost, tax efficiency and diversified exposure to markets, asset classes, sectors, commodities and industries. Less well known is that ETFs provide neat packets of stable risk that can not only be used to construct tailored portfolios but also to control risk easily and more effectively than ever before.
Case for more volatility
Capital market volatility threatens the adequacy of RRSPs, the solvency of defined benefit pension plans, the patience of clients and the sanity of advisors. Systemic risk from deregulation, interconnected global financial and banking structures exacerbated by an explosion in derivatives use, high frequency trading, and advances in information technology suggests that “returns are likely to remain highly heteroskedastic, showing periods of consistently high and low volatility,” says Ioulia Tretiakova, Manager of Quantitative Strategies, PŮR Investing Inc.. Nothing in currently proposed banking reform legislation suggests otherwise. The problem is that capital markets dislike uncertainty most of all.
Even if you believe that the credit crisis was a “once-in-a-lifetime” aberration, advisors have a duty to clients to protect them from it.
Managing volatility
Diversification theory suggests selecting assets that don’t move in the same direction at the same time (uncorrelated). This is smart because if one asset class is zigging (i.e. Canadian equities) while another is zagging (i.e. gold) the volatility of the combined portfolio will be dampened. But very much like a balance sheet, these relationships are more like a snapshot than the dynamic of an income or cash flow statement that show changes between periods. Two important things to remember:
• correlation between asset classes can and does change over time;
• market volatility can over-ride correlations.
I mention these caveats because they are too often ignored or forgotten by investment professionals and retail investors alike. The table below shows the correlations between several asset classes represented by ETFs. Because they are already individually diversified, ETFs provide reliable risk that can be assembled into effective portfolios. Low and negative correlations are the best combinations for diversification.
Diversification failed to protect portfolios during the market meltdown. There is little protection against crises of confidence and lack of liquidity.
This chart illustrates the development of the U.S. credit crisis as represented by the interest rate spread between U.S. Treasury bonds and corporate bonds. As confidence deteriorates, lenders demand higher yields to hold any debt instrument other than Treasuries, so the spread opens up. The shaded area shows the volatility of the S&P 500 – 126 day moving average. Volatility remained stable until mid-2007 before spiking in 2008-2009.
Market volatility is a big challenge for investors and their advisors. Let’s assume a 60% stock 40% bond portfolio is considered appropriate for an investor in 2005. As the stock market rose in 2006 and 2007, the portfolio sells stocks and buys bonds to rebalance to the 60:40 fixed asset mix. This seems reasonable because we’re supposed to “sell high” and “buy low”, right? But is the “risk” of the portfolio the same in 2008-2009 as it was in 2005? Clearly it is not.
A better solution would be to maintain the “risk” represented by the 60:40 asset mix consistently through periods of market volatility. The risk of a portfolio should represent the risk tolerance of the investor that doesn’t change in good or bad markets. If “12” represents the risk of a 60:40 mix in 2005, the “risk” of the portfolio would have spiked to over 30 in 2008-2009! To keep this portfolio at 12, equities would be 20% and bonds 80% in mid 2008. An alternative less disruptive to the mix would have been to buy the iPath S&P 500 VIX Short Term Futures ETN (VXX). Either approach would have saved serious money for investors.
Sophisticated
The idea of managing to a consistent risk is a sophisticated institutional approach on two levels. Firstly, the idea of budgeting risk is a concept used only by the largest pension funds and institutional pools of capital. No mutual fund in Canada uses this strategy as far as I know. Secondly, managing volatility is a cutting edge idea. The availability of volatility ETFs like VXX and VXZ (the mid-term version of VXX) makes these tactics available to individual investors. Hedging long positions with short or inverse ETFs is also a tactical option, but that is a subject for another time.
Summary
ETFs offer the potential to bend and shape risk in ways previously available only to institutional portfolio managers with hundreds of millions under management. This capability comes with the responsibility for advisors to “up” their game, but the payoff will benefit their clients and their practices.
Exchange-traded funds (ETFs) are well known for their low cost, tax efficiency and diversified exposure to markets, asset classes, sectors, commodities and industries. Less well known is that ETFs provide neat packets of stable risk that can not only be used to construct tailored portfolios but also to control risk easily and more effectively than ever before.
Case for more volatility
Capital market volatility threatens the adequacy of RRSPs, the solvency of defined benefit pension plans, the patience of clients and the sanity of advisors. Systemic risk from deregulation, interconnected global financial and banking structures exacerbated by an explosion in derivatives use, high frequency trading, and advances in information technology suggests that “returns are likely to remain highly heteroskedastic, showing periods of consistently high and low volatility,” says Ioulia Tretiakova, Manager of Quantitative Strategies, PŮR Investing Inc.. Nothing in currently proposed banking reform legislation suggests otherwise. The problem is that capital markets dislike uncertainty most of all.
Even if you believe that the credit crisis was a “once-in-a-lifetime” aberration, advisors have a duty to clients to protect them from it.
Managing volatility
Diversification theory suggests selecting assets that don’t move in the same direction at the same time (uncorrelated). This is smart because if one asset class is zigging (i.e. Canadian equities) while another is zagging (i.e. gold) the volatility of the combined portfolio will be dampened. But very much like a balance sheet, these relationships are more like a snapshot than the dynamic of an income or cash flow statement that show changes between periods. Two important things to remember:
• correlation between asset classes can and does change over time;
• market volatility can over-ride correlations.
I mention these caveats because they are too often ignored or forgotten by investment professionals and retail investors alike. The table below shows the correlations between several asset classes represented by ETFs. Because they are already individually diversified, ETFs provide reliable risk that can be assembled into effective portfolios. Low and negative correlations are the best combinations for diversification.
Diversification failed to protect portfolios during the market meltdown. There is little protection against crises of confidence and lack of liquidity.
This chart illustrates the development of the U.S. credit crisis as represented by the interest rate spread between U.S. Treasury bonds and corporate bonds. As confidence deteriorates, lenders demand higher yields to hold any debt instrument other than Treasuries, so the spread opens up. The shaded area shows the volatility of the S&P 500 – 126 day moving average. Volatility remained stable until mid-2007 before spiking in 2008-2009.
Market volatility is a big challenge for investors and their advisors. Let’s assume a 60% stock 40% bond portfolio is considered appropriate for an investor in 2005. As the stock market rose in 2006 and 2007, the portfolio sells stocks and buys bonds to rebalance to the 60:40 fixed asset mix. This seems reasonable because we’re supposed to “sell high” and “buy low”, right? But is the “risk” of the portfolio the same in 2008-2009 as it was in 2005? Clearly it is not.
A better solution would be to maintain the “risk” represented by the 60:40 asset mix consistently through periods of market volatility. The risk of a portfolio should represent the risk tolerance of the investor that doesn’t change in good or bad markets. If “12” represents the risk of a 60:40 mix in 2005, the “risk” of the portfolio would have spiked to over 30 in 2008-2009! To keep this portfolio at 12, equities would be 20% and bonds 80% in mid 2008. An alternative less disruptive to the mix would have been to buy the iPath S&P 500 VIX Short Term Futures ETN (VXX). Either approach would have saved serious money for investors.
Sophisticated
The idea of managing to a consistent risk is a sophisticated institutional approach on two levels. Firstly, the idea of budgeting risk is a concept used only by the largest pension funds and institutional pools of capital. No mutual fund in Canada uses this strategy as far as I know. Secondly, managing volatility is a cutting edge idea. The availability of volatility ETFs like VXX and VXZ (the mid-term version of VXX) makes these tactics available to individual investors. Hedging long positions with short or inverse ETFs is also a tactical option, but that is a subject for another time.
Summary
ETFs offer the potential to bend and shape risk in ways previously available only to institutional portfolio managers with hundreds of millions under management. This capability comes with the responsibility for advisors to “up” their game, but the payoff will benefit their clients and their practices.
Thursday, April 15, 2010
Bird-brained stock picking
Less guesswork with exchange-traded funds
Every week at home, as a keen young portfolio manager, I would pour over the charts of all the stocks traded on the New York and American Stock Exchanges that were included in a binder with 12 charts to the page, 24 in total when open.
My pet cockatiel, named Dow Jones, would fly around the room as I worked. One day, he landed on my shoulder and walked down my arm onto the chart book. He shuffled around and pecked showed his displeasure in a unique bird-like way on one of the charts. The next day that stock went down sharply! A humorous coincidence!
He did it the next week and the next. Each stock that received a “deposit” went down in price. Still a humorous coincidence, but I realized it represented a random key to how many people make investment decisions.
People are notoriously random when it comes to making investment decisions. They base them on conversations overheard in the office bathroom, or relatives who’ve seen big returns on their investments, or the sound bites of investment journalists. And then they pray. People do what they think worked for them in the past regardless of the method’s randomness. Sometimes their lottery ticket selection strategy is more systematic. No wonder so many investors end up with a portfolio of random securities with no plan or purpose.
But when it comes to exchange-traded funds, there is no guesswork. There is less guesswork with exchange-traded funds (ETFs). These securities track an broad indicies, a commodities, currencies, sectors and industries and allow investors to take leveraged long and short positions. a grouping of assets like an index fund, or a trade like a stock on an exchange. They offer diversification, and the ability to sell short, buy on margin, and purchase as little as one share and trade like a stock during regular exchange hours.
There are only three basic ways to build portfolios with them, all others are variations. Over the next three issues, I will examine each of these.
Here is a brief overview of how ETFs portfolio construction works:
Fundamental approaches
The fundamental approaches use some form of “top down” or “bottom up” analysis. Assessing views of global, regional and local economies and their impact on sectors, industries and companies, ETFs lend themselves nicely to these strategies because they make country, regional, sector and industry investing simple.
Institutional managers can use ETFs to establish broad exposure before making specific securities investments and they can hedge existing exposure by shorting the relevant ETF. Portfolios for individual investors can similarly benefit from diversified exposure to elements identified by the portfolio manager.
“Bottom up” managers, or stock pickers who screen for superior growth, value a combination of both or other factors, have style ETFs as well as large, mid-cap, and small capitalization alternatives in different regions and sectors to choose from.
Many large portfolios and pension schemes employ “core” plus “satellite” or “tactical” approaches. They create a passive core cheaply and select active alpha-seeking strategies around that core.
ETFs offer flexibility and choice at a low cost so these traditional approaches can be applied to private client portfolios effectively. The tax efficiency of separately managed accounts combines nicely with ETFs so many firms will be encouraged to transition pooled and mutual fund assets to this format. Indeed, low costs contribute to better performance, so complacent product vendors should pay attention.
Market timing
Today, there are 1,000 ETFs available worldwide, with another 500 or so in registration, a fact attractive to many. Include currency; commodity; leveraged or enhanced; long and short; so-called “fundamental” and even Chinese real estate ETFs; and the possibilities grow.
Traders feed on volatility. So it’s good news that the dampened relative volatility of groups of securities, which counters traders’ need for action, is offset by better liquidity from the ETF structure.
Leveraged ETFs that offer the holder two times the daily price movement of an index are available; inverse versions go up two times the daily fall in price of an index. This is the type of action that traders want. But leveraged ETFs are not just for traders.
Trading has done much to democratize capital markets for individual investors; specialized education in financial analysis is not required. Technical analysis, the trader’s discipline, doesn’t care about companies, products, margins or market share. All that matters is price movement.
Within the movement of prices (and sometimes trading volume) lies all the necessary information needed to make buy and sell decisions. Anybody can apply these methods to the price of anything. This is pure market timing.
SIDEBAR
Risk management
The low cost and tax efficiency of ETFs are what individual investors should exploit. However, there are many other perks to using ETF products:
1. A free lunch: Lowering risk by using levered ETFs : If achieved, investors benefit from the higher return potential from leverage without assuming additional risk.
2. Risk budgeting through sophisticated portfolio construction: Only the most sophisticated institutions use this approach that optimizes diversification by assigning weights by risk.
3. Constant volatility: Consistent risk exposure for individuals can help avoid sharp market declines.
ETFs are neat little packages of diversified risk that make effective building blocks for many kinds of portfolios. Next month: ETFs in greater detail.
Every week at home, as a keen young portfolio manager, I would pour over the charts of all the stocks traded on the New York and American Stock Exchanges that were included in a binder with 12 charts to the page, 24 in total when open.
My pet cockatiel, named Dow Jones, would fly around the room as I worked. One day, he landed on my shoulder and walked down my arm onto the chart book. He shuffled around and pecked showed his displeasure in a unique bird-like way on one of the charts. The next day that stock went down sharply! A humorous coincidence!
He did it the next week and the next. Each stock that received a “deposit” went down in price. Still a humorous coincidence, but I realized it represented a random key to how many people make investment decisions.
People are notoriously random when it comes to making investment decisions. They base them on conversations overheard in the office bathroom, or relatives who’ve seen big returns on their investments, or the sound bites of investment journalists. And then they pray. People do what they think worked for them in the past regardless of the method’s randomness. Sometimes their lottery ticket selection strategy is more systematic. No wonder so many investors end up with a portfolio of random securities with no plan or purpose.
But when it comes to exchange-traded funds, there is no guesswork. There is less guesswork with exchange-traded funds (ETFs). These securities track an broad indicies, a commodities, currencies, sectors and industries and allow investors to take leveraged long and short positions. a grouping of assets like an index fund, or a trade like a stock on an exchange. They offer diversification, and the ability to sell short, buy on margin, and purchase as little as one share and trade like a stock during regular exchange hours.
There are only three basic ways to build portfolios with them, all others are variations. Over the next three issues, I will examine each of these.
Here is a brief overview of how ETFs portfolio construction works:
Fundamental approaches
The fundamental approaches use some form of “top down” or “bottom up” analysis. Assessing views of global, regional and local economies and their impact on sectors, industries and companies, ETFs lend themselves nicely to these strategies because they make country, regional, sector and industry investing simple.
Institutional managers can use ETFs to establish broad exposure before making specific securities investments and they can hedge existing exposure by shorting the relevant ETF. Portfolios for individual investors can similarly benefit from diversified exposure to elements identified by the portfolio manager.
“Bottom up” managers, or stock pickers who screen for superior growth, value a combination of both or other factors, have style ETFs as well as large, mid-cap, and small capitalization alternatives in different regions and sectors to choose from.
Many large portfolios and pension schemes employ “core” plus “satellite” or “tactical” approaches. They create a passive core cheaply and select active alpha-seeking strategies around that core.
ETFs offer flexibility and choice at a low cost so these traditional approaches can be applied to private client portfolios effectively. The tax efficiency of separately managed accounts combines nicely with ETFs so many firms will be encouraged to transition pooled and mutual fund assets to this format. Indeed, low costs contribute to better performance, so complacent product vendors should pay attention.
Market timing
Today, there are 1,000 ETFs available worldwide, with another 500 or so in registration, a fact attractive to many. Include currency; commodity; leveraged or enhanced; long and short; so-called “fundamental” and even Chinese real estate ETFs; and the possibilities grow.
Traders feed on volatility. So it’s good news that the dampened relative volatility of groups of securities, which counters traders’ need for action, is offset by better liquidity from the ETF structure.
Leveraged ETFs that offer the holder two times the daily price movement of an index are available; inverse versions go up two times the daily fall in price of an index. This is the type of action that traders want. But leveraged ETFs are not just for traders.
Trading has done much to democratize capital markets for individual investors; specialized education in financial analysis is not required. Technical analysis, the trader’s discipline, doesn’t care about companies, products, margins or market share. All that matters is price movement.
Within the movement of prices (and sometimes trading volume) lies all the necessary information needed to make buy and sell decisions. Anybody can apply these methods to the price of anything. This is pure market timing.
SIDEBAR
Risk management
The low cost and tax efficiency of ETFs are what individual investors should exploit. However, there are many other perks to using ETF products:
1. A free lunch: Lowering risk by using levered ETFs : If achieved, investors benefit from the higher return potential from leverage without assuming additional risk.
2. Risk budgeting through sophisticated portfolio construction: Only the most sophisticated institutions use this approach that optimizes diversification by assigning weights by risk.
3. Constant volatility: Consistent risk exposure for individuals can help avoid sharp market declines.
ETFs are neat little packages of diversified risk that make effective building blocks for many kinds of portfolios. Next month: ETFs in greater detail.
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