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Assessing Variable-Risk to Improve Portfolio Performance


The next several years will be a challenging period for investment advisors as investors, mindful of projections of low market returns, seek managers who can deliver results while protecting them from excessive risk.

Many investors believe the market meltdown of 2008-2009 stemmed from lapses in risk management. This is ironic because the general state of risk management before the meltdown was hardly a lapse. For decades, most investing methodologies had failed to address risk in respects essential not only to protecting investors but also to maximizing returns. Even after the general risk-management lessons of 2008-2009, this failure continues today.

The problem lies in the widespread misconception that the amount of risk posed by a given asset class is static. This misconception explains why many investing methodologies have assigned basically the same respective levels of risk to major asset classes for decades.

Yet these risk levels do not remain the same. Instead, they vary over time with changing economic, market and industry conditions. Despite this reality, few investing methodologies assess these risks with any regularity, if ever.

This shifting nature of asset-class risk compels a different approach, one that requires regular monitoring and appropriate changes in risk budgeting-the allocation of risk to each asset class relative to expected returns. We call this approach variable-risk assessment and its application to investing, variable-risk investing.

The widespread view of asset-class risk as static has given rise to asset allocations so rigid that they have become classic. For example, in individual investor portfolios, many financial advisers automatically use an allocation calling for those in their early 60s with a conservative risk tolerance to have roughly 60% of their portfolios in bonds, 30% in stocks and 10% in cash. By contrast, variable-risk assessment enables advisers to make periodic changes in asset allocations to increase returns relative to risk.

Historical examples demonstrating the need for variable-risk assessment abound in most asset classes, including fixed income. In the early 1980s, when 10-year Treasury bonds were yielding more than 14%, their risk characteristics were significantly different than those in the same bonds today yielding less than 3.5%.

As the reward-to-risk ratio of these bonds was higher in the 1980s than it is now, more risk should have been budgeted for this investment then than would be appropriate today.

The few investment managers who practice variable-risk assessment do so with the goal of making more informed decisions in choosing one investment over another within the same asset class. Rarely is this methodology elevated to the investment-policy level-guiding decisions on what asset classes should be in a portfolio and in what weight.

Typically, prospectuses dictate what investment classes should be in portfolios, so these choices become fixed, regardless of their merits. Advisors using variable-risk assessment have no such constraints.

For example, in assessing variable risk in large-cap domestic stocks, a manager might see that they are selling at above-average P/Es but that current prices have dipped below their 10-month moving average. This would indicate a likely decrease in P/Es unless dividends and earnings growth are rising at above-average levels.

The moving-average dip also indicates a likely rise in near-term volatility and hence, increased risk. This would prompt managers to allocate less of their client's total risk budget to large-cap domestics-prompting reduction of current holdings or avoidance of new investment-and to seek opportunities elsewhere. If emerging market stocks had P/Es and dividends similar to those of large-cap domestics and were trading above their 10-month moving average with higher anticipated earnings growth, this asset class might be a desirable alternative.

Variable-risk assessment is also helpful in evaluating risk/return characteristics in inefficiently priced investments, such as closed-end funds. Rather than reflecting rational evaluation, the prices of closed-end funds are more like results of Rorschach tests of investors' emotions. As these funds sometimes trade at a significant discount or premium to their net asset values, they have exhibited some of the highest and lowest risk-adjusted potential returns of any investment. By analyzing the variable risks of these investments, managers can more informed judgments concerning their true value.

How frequently managers should assess variable risk depends on the imperatives of their investment policy statements. Fund managers who trade moderately might want to perform asset-class risk assessments at least quarterly; more trading would compel greater frequency. Retail advisors would do well to consider integrating variable-risk assessment into their annual rebalancing of client portfolios.

As more than 70 million Americans head for retirement this decade, they and the financial institutions that hold their money are extremely sensitive regarding wealth preservation. Advisors who adopt the variable-risk methodology can enhance relative returns and thus increase their ability to attract business from these risk-conscious investors.

 

Ted Schwartz, CFP AIF, is president and chief investment officer for Capstone Investment Financial Group (http://capstoneinvest.net). He is the advisor to the CIFG MaxBalanced Fund and advises Capstone's endowment, corporate and individual clients. He can be reached at ted@cifgfunds.com.