Advisors feel betrayed by conventional wisdom. The investment ideas they've been taught, the technology tools they've been given and the lessons they've learned seem ineffective in the face of the market meltdown born of this global economic crisis. Modern portfolio theory and the efficient market hypothesis seem irrelevant. In light of recent history, "buy and hold" seems as disingenuous as, "Yes, America can," George W. Bush's 2004 campaign slogan. New ideas are needed. Old approaches have been of little help in the global financial crisis.
A good friend suggested that if I wanted some new ideas, I touch base with Mark Kritzman, president and CEO Windham Capital Management, which manages more than $30 billion in institutional portfolios. Kritzman prefers discussing quantitative market theory more than his pedigree or the innovative software he offers advisors. But he's also a senior lecturer at the MIT Sloan School of Management and a two-time recipient of the prestigious Graham and Dodd Award, in 1993 and 2002. And he has authored a number of scholarly books and articles, a list of which runs several pages in length.
We spoke recently about his definition of market turbulence and how advisors might use it to help clients navigate today's exceptionally rough financial waters.
Gluck: I want to talk about your ideas about how to view turbulent markets and your software. But first let me ask your view of what's happening in the markets.
Kritzman: The markets are in a state of total panic. The best analogy I've heard is that it's as if, after a car accident, somebody shows up in the emergency room. The bailout plan is the tourniquet to stop the bleeding. Addressing the injury is figuring out how to keep people in their homes. The rehabilitation would be putting in place a better, more effective regulatory system. I think we're still at the tourniquet stage.
Gluck: Market turbulence is something you've been looking at for a while, right?
Kritzman: Yes, I started about ten years ago, before it became fashionable. My expertise is mainly in quantitative approaches to portfolio construction and risk management.
Gluck: How do you define turbulence? It's not the same as volatility, is it?
Kritzman: We consider turbulence a measure of statistical unusualness that is caused by two things. One is that during turbulent periods in the market, returns are very large in an absolute sense, either far above or below their average. The second is that returns interact in a strange or uncharacteristic fashion. For example, two asset classes that normally have a very high positive correlation-that is, their performance tracks each other closely-may instead move in opposite directions during a particular period. We define turbulence as any kind of uncharacteristic behavior that we observe within returns. By looking at both volatility and correlations, we get a statistically unbiased description of whether or not we're in a turbulent episode.
Gluck: Based on your definition of turbulence, you came up with a quantitative way of measuring it. Where did that lead you?
Kritzman: Having developed this quantitative measure of turbulence, we looked at turbulence scores through time and saw that they coincided with turbulence you'd be aware of by reading the newspaper. We found that episodes that should be particularly turbulent, based on our statistical approach, coincide very nicely with actual events that we all know-the stock market crash, the Asian currency crisis, the Russian default on its sovereign debt. And, of course, what we're going through today.
Gluck: So you were looking for periods during which the normal correlations between asset classes broke down.
Kritzman: Yes. Either correlations break down or returns are far from their average. Returns are unusual in their size or in their interactions.
Gluck: How far back did you go?
Kritzman: As far as we could. In some cases, with monthly data, that takes us to the 1920s. With daily data, you can usually go back to the '80s or '90s.
Gluck: How many asset classes have you looked at?
Kritzman: We've done domestic and foreign stocks and bonds, real estate, commodities. And we've done all of the developed market currencies. We've also looked at data for all sectors within the U.S. equity market. Recently, our turbulence index has been hitting record highs [http://www.windhamcapital.com/research/TurbulenceIndex/default.htm]. This may be the most extraordinarily turbulent period we've seen in the data. Our next step is to look at the extent to which the unusual patterns we've observed in the data can help predict other conditions. For example, could turbulence be a leading indicator of a credit crunch? There haven't been enough crunches to be statistically reliable, but we may be able to learn something. What we already know, and this is actually pretty important, is that once we enter a turbulent period, it persists. During the weeks and months following the first appearance of a turbulent day, turbulence is much, much greater than average. Turbulence may arrive randomly, but once it's here, it persists for a period of time. That's important because it enables investors to respond.
Gluck: Respond how?
Kritzman: Let me back up. Investment strategies perform much differently during turbulent periods than during quiet periods. A good example is the carry trade for currencies. Here you basically overweight discount currencies and underweight premium currencies to pick up the difference in yields. That strategy has worked well for decades, but it doesn't perform well during turbulent periods. Knowing that, when turbulence begins, portfolio managers can scale back exposure to the carry-trade strategy. Currency markets are very liquid, so that's pretty easy to do quickly. Just knowing that the performance of various strategies is different during turbulent environments, and that turbulence is persistent once it arrives, means investors can react by increasing or reducing their exposure to a particular strategy.
Gluck: Is there also persistence in the behavior of strategies? In other words, apart from breaking away from how they normally perform, do strategies during turbulent times behave consistently? Is that predictable, too?
Kritzman: My conjecture is that during turbulent periods, investors become either more risk-averse and scale back their exposure or, because they're leveraged, they have to scale back. In the case of currency strategies, that may simply mean getting out of their positions, which is easy to do in deep, liquid currency markets. In fact, that's why this strategy does poorly during periods of turbulence.
Gluck: But how does all this affect my readers? Most financial advisors for high-net-worth individuals don't use currency strategies.
Kritzman: To the extent that they participate in hedge funds, they may be invested in these strategies without knowing it. But it also works for other strategies. About ten years ago, we published an article in the Financial Analysts' Journal called "Optimal Portfolios in Good Times and Bad." That's when we introduced the notion of turbulent periods that could be statistically identified. Our approach, then and now, has largely been focused on managing risk, rather than on increasing returns, or alpha. It's only recently that we've become interested in using this information to protect and enhance alpha. Our initial thought, and this remains valid, is that understanding how correlations and volatility differ during turbulent periods and quiet periods should help us construct portfolios that are more resilient in turbulent environments.
Gluck: Huh?
Kritzman: Suppose that we know that the correlations between certain asset classes increase when markets are stressed-so that just when you most need diversification, it goes away. But there may be other assets whose correlations go down during stressed markets, and if you incorporate those assets in your portfolio, you may increase diversification during those markets. But you won't see those patterns if you look at long-term, average correlations. Suppose you observe a correlation of 30% between stocks and bonds. What if that's really the average of a 90% correlation during turbulent markets and a negative 20% correlation during calm markets? What good does the 30% do? What does it tell you?
Gluck: So you're saying there are really two markets. There is a usual, average market that holds sway during long periods. Then there's a different market during compressed times of turbulence.
Kritzman: Right. And to manage risk, you need to care about what happens during turbulent periods. If you can construct your portfolio so that it should hold up better during turbulence, even if you can't forecast when it's going to arrive, that should give you more comfort and may prevent you from making hasty and ill-advised decisions. If you can do that without giving up much wealth accumulation over the long run, that may be a better way to manage assets than just looking at average, long-term correlations.
Gluck: Can you be more specific about changes in correlations among core asset classes financial advisors might use? For example, they may use foreign investments as a hedge, but we all know that recently foreign markets have declined just as much as domestic markets. So while these asset classes may not be closely correlated most of the time, that correlation apparently breaks down during turbulent times.
Kritzman: What I want to tell you to answer your question is based on older research that I need to update. But a few years ago, we discovered that, as you shift from quiet to turbulent periods, the correlations within asset classes but across countries go up. This means that geographic diversification doesn't benefit you when you need it most. When stocks go down in the U.S., they go down everywhere. But we also noticed that within countries, as you change from quiet to turbulent periods, correlations between stocks and bonds go down-so that asset class diversification within countries was actually more beneficial than usual during turbulent periods.
Gluck: So during turbulent periods, owning foreign bonds might provide more diversification?
Kritzman: Or domestic bonds. In other words, bonds diversify stocks during turbulent periods better than foreign stocks diversify domestic stocks. Another thing we looked at is how correlations among financial assets change when markets become turbulent. During turbulent periods, most correlations increase. But the correlation between financial assets as a group and real assets such as commodities is lower during turbulent periods than when calm markets prevail. One approach to making portfolios more resistant to turbulence is to include less risky assets such as Treasury accounts. But that means giving up a lot of return. So what if, instead, you included a larger exposure to commodities? You might build a portfolio more resilient to turbulence without sacrificing as much wealth accumulation as you would by going into Treasury bills.
Gluck: So should advisors sharply increase allocations to gold, for example, during turbulent times?
Kritzman: It's probably too ambitious to try to time this kind of market behavior. But you can prepare a portfolio for turbulent times-possibly by increasing allocations to certain asset classes, such as commodities, or by relying less on geographic diversification. If a portfolio is based on what we know happens during turbulent periods, rather than on what occurs on average over all markets, it may perform better. You may not be able to know when turbulence will come, but you know it will come, eventually. And with this approach, you may be better prepared to deal with it. This is really a buy-and-hold strategy. Also-and I think this is almost incontrovertible, though unpopular-investors should be passively, not actively invested. The amount of alpha that it takes to overcome the higher costs of actively managed portfolios is much, much greater than most people appreciate. Finally, investors need to rebalance in a very disciplined, tax-efficient way.
Gluck: Skeptics might look at this and say, "Well, he's looking in the rearview mirror. We can't predict the future based on what's happened in the past." What do you say to that?
Kritzman: We're not looking in a rearview mirror at all. You can't develop trading rules during a particular market period and then test them during the same period. That's not fair. Obviously, if you do that, you're always going to come up with something that works. What we did was to develop rules based on one period, using only the information that would have been available up to that point, and then we applied those rules for subsequent periods. I think that's a perfectly legitimate way to go about testing strategies.
Gluck: Advisors are seeing the destruction of the conventional wisdom for managing investments, and are very open to these new ideas for managing portfolios. But how can they implement these ideas?
Kritzman: You either need to find people who can help you implement them or you have to write or purchase software that can do it. I could give a big sales pitch about all the things that we do, but that's not my style.
Gluck: I was trying to give you that opportunity.
Kritzman: Most of the work we've done over the years has been for very large institutional portfolios, pension funds, sovereign wealth funds and government agencies all over the world. Also, for many years, our software for asset allocation and risk management has included a feature that lets you partition historical returns into turbulent and quiet periods and build portfolios based on that information. What we're focusing on now is putting all of this into a form we can deliver to private investors. Part of that effort is to introduce our turbulence index on our Web site.
Gluck: How could a financial advisor use your tools?
Kritzman: We have software, Windham Financial Planner, which we license and it incorporates all of these features that allow you to measure turbulence and build portfolios.
Gluck: You have two products, right?
Kritzman: There's the Windham Portfolio Advisor, which is targeted more at the institutional market. There's also Windham Financial Planner [http://www.windhamcapital.com/products/financial_planner.asp], directed more toward the financial planning community. It has the same features, but it's more user-friendly for people who aren't professional quantitative risk managers.
Gluck: When did the Windham Financial Planner become available?
Kritzman: It has been out for about a year. Right now, it's a desktop product, but we're working on a Web-based version that should be available within three to six months. One unique feature of the software is that it measures risk, not just at the end of the investment horizon, but also within the horizon. Most risk measures, whether you're looking at probability of loss or value at risk, are based on the range of returns you'd expect at the end of the investment horizon. That ignores what might happen along the way. For example, if an investor looks at a five-year horizon and asks, "What's the likelihood that this portfolio will lose 10% or more?" there may be only a 5% or 6% probability of that happening by the end of five years. But if you ask, "What's the likelihood that this portfolio might be down 10% at some point during the next five years?" that probability may be greater than 50%. So investors could have a false sense of comfort that there's a very low exposure to loss-whereas, if you measure it properly, it's probably more likely than not to happen at some point along the way. That doesn't necessarily mean you should invest more conservatively; you just need to be aware that this could happen. We do the same thing with value at risk, which tells you the probability of the worst that can happen. So instead of just considering that at the end of the horizon, we look at what could happen during the period. That's a nice way of stress-testing a portfolio.
Gluck: It sounds like a good way to illustrate risk to clients. Of course, risk is on everyone's mind right now. What's your prognosis for what's going to happen in the market?
Kritzman: What's going on is completely unprecedented. But I've had a chance to talk with some of the country's top economic advisors, and I think we're going to come together, both within the U.S. and globally, to address the problems. There are a lot of really, really smart people with very innovative ideas to help us through this mess. But I don't see how we're going to avoid a deep, protracted recession probably more serious than any other postwar event. The silver lining for investors is that the market, historically and fairly reliably, leads the economy. The bad news is that we're going to have tough economic times. But I think there's a strong likelihood that the market will rebound.
Andrew Gluck, a longtime writer and journalist, is CEO of Advisor Products Inc. (www.advisorproducts.com), a Westbury, N.Y., marketing company serving 1,800 advisory firms.