We can finally fulfill MPT's risk-management promise.
In most aspects of our lives, risk is something to
be avoided. As has often been observed, we live in a highly risk-averse
society surrounded with an ever-increasing array of laws and
regulations designed to protect us against the hazards of daily life.
It is, in many ways, as if we seek to make risk itself disappear.
There is one important area of our lives, however,
where risk is something to be managed, not avoided; where the exposure
to risk is unavoidable and, in fact, desirable. When we invest money in
a portfolio of financial assets, we are seeking to expose ourselves to
risk in a way that helps us achieve our financial goals. This, as we
all know, is due to the fact that the relationship between risk and
reward (expected return) is one of the only inviolate relationships in
the financial markets. If one assumes more risk, the potential for
reward should be proportionately higher. Thus, in the world of
investing, risk is most definitely not a four-letter word.
But what is risk? It is widely accepted that the
definition of risk is the variability of returns over time. This
definition carries with it the assumption that, for each investor,
there is a level of risk that is both tolerable from a psychological
standpoint and appropriate given one's investment horizon and wealth
level, as well as a host of other considerations.
Most investment strategies seek to manage that key
variable-risk. This is due to the fact that return is considered to be
the dependent variable. That is, control the level of portfolio risk
and an expected level of return will be realized based upon the
historical relationship between the two. This linkage ultimately gave
rise to the concept of risk-adjusted returns. The basic idea is that
the absolute return of any given asset carries little informational
value. What is really important is the amount of return per unit of
risk. Risk-adjusted return attempts to answer the question, "Did the
investor assume too much risk for the amount of return that was
realized?"
In fact, an entire industry has grown up around the
idea that this relationship can be quantified with increasing levels of
precision. Measures such as Standard Deviation, Sharpe Ratios,
Information Ratios, Treynor Ratios, Value at Risk (VAR), Down Market
Capture and Tracking Error are all designed to identify the amount of
risk in a portfolio of assets either in absolute terms, relative to a
specific benchmark or in relation to actual returns.
A risk-based approach to portfolio management makes
sense for a couple of reasons. The first is that an investor's risk
tolerance evolves over time. As investors approach the end of their
investment horizon, the ability to withstand substantial declines in
portfolio valuations (risk) decreases as the need to access portfolio
assets approaches.
This hard reality is compounded by the fact that
risk is asymmetric; a 50% decline in the value of an asset requires a
100% gain to return to the initial value. Thus, from a long-term
investor's standpoint, the ability to avoid substantial portfolio
losses outweighs the rewards associated with outsized gains. In other
words, risk needs to be managed.
How? By not putting all of one's eggs in a single
basket. It is not an overstatement to say that the blending of
financial assets with differing risk characteristics is the cornerstone
of modern financial theory. The central tenet of Modern Portfolio
Theory (MPT), developed by Harry Markowitz in 1952, was that given a
pool of risky assets, overall risk can be reduced by combining assets
that exhibit low correlations of returns. Thus, from a risk management
standpoint, the correlation between various assets, not their actual
volatility, is the critical factor.
According to MPT, diversification is the key. But is
this enough? The answer from our standpoint is both yes and no. Yes, in
the sense that combining financial assets with low correlations is the
key to controlling portfolio risk. No, in the sense of how
diversification has been implemented in practice.
The standard industry definition of a diversified
portfolio is one that includes allocations to U.S. stocks,
international stocks, bonds and money market instruments. Within those
broad allocations, equity assets can be further divided by market
capitalization (large, mid-sized and small) and by investment style
(growth, blend and value). Additional allocations are often made to
international equities (developed and emerging markets), and
fixed-income exposure is often diversified across maturity and credit
quality.
How effective is this approach? Clearly, using fixed
income and equities to diversify portfolio risk is an effective
technique. Looking at historical correlations between the Standard and
Poor's 500 Index and the Citigroup/Salomon Bros. U.S. Broad Investment
Grade Bond Index, correlations over the last 25 years have been low
and, at times, negative.
There are however, periods when correlations between
stocks and bonds "spike" and the diversification benefit is reduced.
That was clearly the case in 1985, when correlations reached +0.86, and
again in 1995 when they reached +0.99. Moreover, bonds are not immune
from correlation spikes during periods of market turmoil, as we saw in
1998 during the Long Term Capital Management crisis, when stock/bond
correlations rose to +0.44.
The diversification benefit from adding an
allocation to international stocks, however, is far from clear. In
looking at correlations between the S&P 500 and the MSCI EAFE
Index, we see that correlations have steadily increased over time. This
makes intuitive sense, as the integration among the world's economies
and capital markets has marched inexorably forward. We see in Table 1,
that correlations between domestic and international stocks jumped to
over +0.90 in 1980 and have remained high ever since.
But as we discussed earlier, risk management is all
about mitigating the large losses that can be so destructive to an
investment objective when markets go through their periodic crises. In
this, international stocks appear to be ineffective. During the
two-month period encompassing the 1987 stock market crash, daily
correlations were +0.86.
If adding international stocks to a portfolio isn't
an effective risk management technique, what about mixing up market
capitalization and investment style? Many of us have been taught to
think that if we have allocations to large-, mid- and
small-capitalization stocks as well as allocations to growth, blend and
value, then we have covered our bases. But is this true?
Unfortunately, the answer appears to be no. Looking
at five-year snapshots going back to 1980, both of these techniques
offer questionable diversification benefits. In looking at monthly
correlations between the large-cap Russell 1000 Index and the small-cap
Russell 2000 Index correlations were +0.90 or higher in five out of six
observations, the exception being 2000 when the correlation between the
two indexes dipped to +0.55.
The limits of style-based diversification are a
little less clear-cut, ranging from +0.99 in 1995 to -0.39 in 2000.
However, from a risk management perspective, style-based
diversification suffers from the same correlation spikes seen in other
asset classes. For example, during the bursting of the "tech bubble" in
March of 2000, the correlation between Growth and Value was +0.92.
A related shortcoming associated with traditional
risk reduction approaches is their reliance on long-only investment
strategies. The long-only constraint makes effective risk management a
challenging proposition.
The common perception of risk is that it is a
relatively static target. Under the current approach to MPT, all one
needs to do is 1) determine the investor's risk tolerance, 2) establish
the appropriate stock/bond cash allocation, 3) diversify by market cap,
style, maturity and credit quality and, 4) periodically rebalance.
Layered on top of all this is often a tactical asset allocation
overlay, which typically results in relatively modest changes to the
portfolio's asset mix.
But, as Table 3 points out, portfolio risk is
anything but static. The traditional portfolio construction approach
results in dramatic swings in risk exposure over time. The classic
60/40 stock-bond portfolio-continuously rebalanced-had a standard
deviation as low as 8.75% in the 1970s and as high as 14.5% in the
1980s. Thus, the traditional approach resulted in a near-doubling of
portfolio risk from one decade to the next. This is far outside the
definition of acceptable risk tolerance under most investment programs
and raises serious potential suitability issues for the financial
intermediary.
So in a real sense, traditional risk management
techniques result in precious little risk management. It is as if the
investor is being managed by risk, not managing it.
If traditional asset allocation is not an effective
risk management strategy, are there other options? The good news is
that there are. We are at a point in the evolution of the financial
industry where what were once considered nontraditional investment
strategies are now widely available and highly liquid-strategies that
have been used and proven in the institutional marketplace for many
years.
The key, as always, is correlation. If one is to get "true
diversification" in a portfolio of financial assets, then it is
imperative to include asset classes that do not respond to, or at least
respond differently, to the same set of inputs. The essential
shortcoming of traditional stock-bond asset allocation is that, under
many circumstances, these assets respond to changes in interest rates,
inflation, economic growth and changing risk premiums in the same
manner.
However, the recent explosion of investable
investment strategies and asset classes now makes it possible to
achieve the kind of risk management originally promised by MPT. Once
esoteric investing strategies, such as managed currency and commodity
futures, real estate, short selling, arbitrage and event-driven
strategies, allow portfolio risk management to be taken to the next
level.
Lets take a look at how this might work in practice.
If an investor held a portfolio of 50% S&P 500 stocks, 30% long
Treasury bonds, 15% international stocks (MSCI EAFE) and 5% cash for
the ten-year period of 1994-2004, that portfolio would have earned an
annualized return of 9.85% and had a standard deviation of 9.26%, as
shown in Table 4.
Now let's add some of the asset classes and
investment strategies discussed above. By slightly paring back
allocations to traditional asset classes and adding small allocations
to real estate, commodities and hedge fund strategies, the
characteristics of the portfolio are vastly improved. What we see in
Table 5 is that portfolio risk has been substantially
reduced-annualized standard deviation falls by nearly 14%-with a slight
increase in annual returns.
A couple of important benefits arise from this
exercise. The first is the clear reduction in portfolio risk by the
introduction of investment strategies and asset classes that exhibit
"true" diversification. This is now a more efficient portfolio with
improved risk/reward characteristics.
Perhaps more importantly, this is now a more
flexible portfolio. If the investor was comfortable with the original
risk profile of the portfolio, she is now free to add leverage-in a
measured way-to enhance expected return without increasing risk.
Moreover, by moving away from the constraints imposed by long-only
mandates through exposure to hedge fund strategies, the investor has
introduced an absolute return component to the portfolio, which
historically has had a positive impact on the risk profile of
traditionally structured portfolios.
Thus, by broadening her investment horizon, the
investor has taken advantage of the only free lunch in
finance-diversification.
David Reilly is director of portfolio
strategies at Rydex Investments. He often is quoted by the media and
has published numerous articles on financial topics.