|Bringing the Science of Investing Into the 21st Century
The next generation of investment risk management is within our grasp.
November 17, 2011
The market crash in late 2008 caught the financial advisory industry largely by surprise and, as a result, we failed to fully protect our clients from it. Although markets have since recovered from this historic decline, volatility is still ever present thanks to geopolitical and global economic uncertainty. In this environment, wealth management is risk management. However, many of the models and methodologies we have traditionally used to design and protect investment portfolios have proven inadequate.
Modern Portfolio Theory: Shaking Off 60 Years of Rust
Modern Portfolio Theory (MPT) has governed the science of investment risk management since its groundbreaking introduction in 1952. And why not? Its greatest tool, asset allocation, works the vast majority of the time. However, three years ago, when the smoke cleared after all asset classes and sectors fell in unison, the fault lines of MPT were clearly and dramatically exposed for all in the industry to see. The bottom line is that the mathematics of MPT does not adequately reflect the complexity and multifaceted nature of today’s capital markets.
A model is only as good as its assumptions and the MPT model in use today must be brought up to date. Specifically, more sophisticated inputs to the three principal assumptions used in MPT — returns, risk and relationships — must be implemented. Most notably, correlation — which attempts to capture the interrelationships among asset classes — doesn’t measure what really matters. MPT uses a one-dimensional correlation coefficient that measures linear relationships. In order to capture the actual relationship between asset classes, which is actually quite dynamic and complex, the MPT model must move from correlations to copulas. Copula dependency functions reflect the dynamic relationship between asset classes across the full range of their behavior and, therefore, are much better suited to model contagion. The use of copula dependency functions instead of one-dimensional correlation statistics to fully capture how assets behave relative to each other in different markets is a powerful tool to identify the degree to which a portfolio is vulnerable to contagion.
State-of-the-Art Portfolio Design: Three Components
In addition to bringing MPT into the 21st Century, dynamic asset allocation, momentum-based sector rotation and cost-effective tail-risk hedging strategies represent other approaches that are necessary and will take investment risk management to the next level.
Dynamic Asset Allocation
Dynamic Asset Allocation (DAA) is all about adjusting your strategic asset allocation when certain economic and market signals tell you that your assumptions need to change. This proactive strategy guides the timely restructuring of portfolios to protect them from serious damage. The basic premise of DAA is to stay fully invested within a well-diversified portfolio and make defensive maneuvers when scientifically tested and reliable indicators signal the need to do so.
Momentum-Based Sector Rotation Strategies
Momentum-based sector rotation strategies are designed to identify trends in market segments quickly, providing “sell” signals early during declines and “buy” signals early during advances. These strategies are not new to the industry, but they must be refined to detect, with greater certainty and speed, when downward trends are developing within a particular sector.
It is possible to design a momentum strategy that is very sensitive to movements in the market; however, this strategy will give frequent buy and sell signals and can often be wrong. It is also possible to design a strategy that is very stable, providing relatively few buy and sell signals; however, those signals are often late — typically too late, on the way out, to avoid much of the decline and, on the way in, to capture much of the appreciation.
Constructing an appropriate strategy is about balancing sensitivity to market movements with signal stability. The ability to dynamically go from being more sensitive to more stable — and layering multiple signals into this decision — is one way to be more nimble in responding to fundamental market changes.
Cost-Effective Tail-Risk Hedging
DAA and momentum-based strategies alone are not enough to protect client portfolios from catastrophic market declines. What is needed is a cost-effective tail risk hedge — a safety net, if you will, that protects the portfolio in times of extreme market downturns when all else fails. The ideal safety net should incorporate the following characteristics:
Of the many approaches we have analyzed, investing in market volatility itself has great potential for meeting all three of our criteria. Volatility tends to spike suddenly when markets go into dramatic decline. The trick is to invest in volatility in such a way that the investment does not lose its appreciation when markets — and volatility — return to normal. There are a number of innovative approaches to this solution now coming to market.
We Are in a Race Against Time
If we are ill prepared the next time the market crashes, our clients may not be as forgiving as last time. Financial advisors have a duty to their clients to seek out the best risk-management solutions possible to help them protect and grow their assets. The flash crash of May 2010 and the more recent volatility of the third quarter of 2011 make this need for urgency abundantly clear. The tools discussed above are available and these improvements, achievable. Those professionals who take up the cause and implement changes will reap the rewards: well-managed, protected portfolios and, most importantly, clients who can invest with confidence.
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Jerry A. Miccolis, CFA®, CFP®, FCAS, MAAA, is the chief investment officer and a principal at a Madison, NJ-based national wealth advisory firm of Brinton Eaton. He is also the co-author of Asset Allocation For Dummies® (Wiley 2009). Register today for the 2012 Advanced PFP Conference on January 16-18, 2012 in Las Vegas to hear him speak on this topic.