Chart showing the Chicago Board of Exchange Volatility Index (VIX) from January 2, 1990 to October 24, 2017. Throughout its history, the VIX has closed below 10 on precisely 43 out of over 7,000 trading days, 34 of which have occurred in the past six months leading up to publication. If you are in need of the data found in this graph, please contact BBHPrivateBanking@bbh.com
This world is a risky place. Disruption and uncertainty abound wherever we look. The United Kingdom is negotiating a challenging divorce from the European Union as ethnic populations such as the Catalans contemplate independence of their own. China is negotiating a tricky transition from an emerging market to a global economic leader while a rogue state on its own border poses an increasing global security risk. The multilateral agreement to contain Iran’s nuclear ambitions teeters, threatening to damage a fragile status quo in the Middle East.
The United States is not immune to disorder. The 2016 election and its aftermath exposed deep rifts in civic opinion, raising fundamental questions about the appropriate role of government and the appropriate relationship between the United States and the rest of the world. In spite of eight years of economic growth and an unemployment rate near 4%, U.S. workers remain worried about sluggish wage growth and the twin threats of automation and globalization. Inequality of wealth and income has widened dramatically.
The Federal Reserve has begun a long-awaited and unprecedented effort to reduce the size of its balance sheet while continuing to raise interest rates in pursuit of more normal monetary policy. Leadership of the Fed in 2018 remains an open question. Political dysfunctionality in Washington seems to have attained new heights, as debates about healthcare, tax reform, immigration and infrastructure remain fractious and unresolved. In the private sector, business models such as Amazon, Uber and Airbnb are challenging the notion of business as usual, with as-yet-unknown implications for jobs, economic growth and inflation. The pace of change is breathtaking; uncertainty, volatility and risk are everywhere.
What, Me Worry?
Everywhere, that is, except for financial markets. The Chicago Board of Exchange Volatility Index (VIX) hit an all-time low on October 5. Throughout its history, the VIX has closed below 10 on precisely 43 out of over 7,000 trading days, 34 of which have occurred in the past six months. The S&P 500 hasn’t dropped 5% or more since June 2016, the fourth-longest stretch of becalmed trading since the index’s creation in 1927. The worst daily decline in the S&P 500 so far this year was a modest loss of only 1.8% (May 17). The 10-year government bond began 2017 with a yield of 2.45% and stands a mere 5 basis points lower at 2.40% as of late October, despite two Fed interest rate increases this year, with a third hike likely when the Federal Open Market Committee meets in mid-December.
|Number of Trading Days Without a 5% Market Correction|
|Source: Standard & Poor's and BBH Analysis. Data as of October 24, 2017.|
One of the fundamental lessons of successful investing is to pay attention where others aren’t. This dichotomy between the real world and financial markets reminds us of Warren Buffett’s observation that astute investors are greedy when others are fearful and fearful when others are greedy. There is a precious absence of fear in financial markets today, which prompts us to turn our attention in this article to the subject of investment risk: how to define it, measure it and manage it. We’ll approach the question first from the top-down perspective of asset allocation and portfolio construction, and then explore how our analysts and portfolio managers address the issue of risk when allocating capital in various asset classes. Along the way, we’ll see that Benjamin Franklin was right: The proverbial ounce of analytical prevention is well worth the pound of cure.
A Brief History of Investment Risk
The identification and management of investment risk at the portfolio level is a well-established article of faith on Wall Street, albeit one with which we disagree. In 1952, Harry Markowitz published a seminal paper in The Journal of Finance succinctly titled “Portfolio Selection.” In his opening paragraph, Markowitz posits that “the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing.” He goes on to argue that investors seek not to maximize return, but to optimize return for any level of risk, where risk is defined as price volatility. It’s a clever theory, and one that garnered Markowitz the 1990 Nobel Memorial Prize in Economic Sciences.
Risk is simply the possibility that the balance sheet doesn’t balance and that the investor must therefore reduce her liabilities (lifestyle, legacy, philanthropy).
On initial consideration, this foundational claim of modern portfolio theory makes sense, as volatility is certainly uncomfortable and can tempt investors to make decisions based on emotion rather than analysis. Yet not all volatility is created equal: We like upside volatility – it’s the downside we can do without. Indeed, for the disciplined investor, volatility is an essential contributor to investment success. Price volatility allows a patient investor to take advantage of the difference between price and value.
Having defined risk as volatility, modern portfolio theory proposes diversification as a means of managing and minimizing this risk in a portfolio. The idea depends on the benefit of owning assets that are less than perfectly correlated, so that when one asset class is falling, another is rising, or at least stable. Yet in periods of market stress, correlations between asset classes rise, robbing an investor of the benefit of diversification at precisely the point she needs it most. We ultimately disagree with the identification of risk as volatility and believe that diversification on its own is an unsatisfactory approach to mitigating portfolio risk.
Instead, we approach portfolio construction as an exercise in balance sheet management. Individuals and families have balance sheets, just as corporations do, with the caveat that many of the liabilities on individual balance sheets are more qualitative than quantitative. An investor may want to retire at a certain age or with a certain lifestyle, pursue philanthropic goals or leave a legacy for future generations. These objectives may be difficult to quantify, but they nonetheless represent volitional or even aspirational liabilities.
The objective of asset allocation and portfolio construction is therefore to arrange the asset side of the balance sheet so that it supports the liability side both today and into the future. A robust definition of investment risk then follows. Risk is simply the possibility that the balance sheet doesn’t balance and that the investor must therefore reduce her liabilities (lifestyle, legacy, philanthropy).
In this context, asset allocation reflects liability allocation, and the risk associated with these liabilities informs what asset classes should be held. For example, if an investor has tuitions and mortgages to pay, those liabilities bear liquidity risk: Bills are due on certain dates, and the cash has to be available as those dates draw near. The asset that best hedges this liquidity risk is fixed income or cash. On the other hand, longer-term liabilities such as retirement or legacy planning carry inflation risk and are best protected through an allocation to equity-like asset classes. To support these longer-term liabilities, an investor might forgo liquidity altogether for a period of time by investing in asset classes such as private equity.
Diversification still plays a role in this approach but not as a risk-reducing tool in and of itself. Instead, appropriate diversification recognizes that different asset classes play different roles in a portfolio and that assets should be allocated to address the risks on the liability side of the balance sheet. Strategic asset allocation is driven primarily by what the investor needs in order to make her balance sheet balance, not by the pure pursuit of investment opportunity.
Documenting these needs is a critical contributor to investment success and underscores the importance of developing an investment policy statement or statement of investment objectives. When well-constructed, these documents serve as a roadmap to successful balance sheet management. But they must be revised on a regular basis. Liabilities change over time, and so, too, should asset allocation. Lifestyle goals change, kids graduate from college and sometimes boomerang back home, philanthropic objectives might shift, and so forth.
Defining portfolio risk in balance sheet terms furthermore requires careful planning as a complement to asset allocation. Where an investor holds assets (asset location) can improve the investment efficiency of a portfolio by minimizing taxes. Similarly, how those assets are transitioned can enhance the probability of attaining legacy or philanthropic objectives. Integrated wealth planning and asset allocation are fundamental to the pursuit of successful balance sheet management and risk mitigation.
The portfolio managers and analysts who allocate capital for our clients share this absolute understanding of risk. Jeff Hakala, chief executive and investment officer of Clarkston Capital, defines risk as “the permanent impairment of intrinsic value,” a sentiment echoed by all the managers with whom we work. Risk is simply the possibility that an investor might lose her money and not get it back, which poses an obvious threat to successful balance sheet management.
Unlike most institutional investors, our managers do not define risk in relative terms. Underperforming the market for a period of time is of no concern to a manager focused on preserving and growing capital in the long run. Indeed, the pursuit of relative returns lies at the heart of why most portfolio managers fail to keep up with the market. It leads to a focus on price rather than value and an emphasis on return rather than risk. Successful investing is about value recognition, not price anticipation.
This difference in defining investment risk is starkly illustrated by asking a portfolio manager, “What are you more afraid of, losing money or missing out on an opportunity?” The manager who feels the need to chase every opportunity prioritizes return over risk management, almost always to the detriment of both.
Individual security risk falls into two broad categories: fundamental risk and price risk. Fundamental risk is the likelihood that the intrinsic value of an asset becomes impaired. This has nothing to do with trends in financial markets, but with the underlying quality of the asset, whether it is a stock, bond or piece of real estate. Our colleagues at Brown Brothers Harriman (BBH) look for evidence of fundamental quality by identifying companies that provide essential products and services to a loyal and returning base of customers, that enjoy a competitive advantage that forms a moat around the business model, that have strong balance sheets and prodigious free cash flow and that are operated by managers with aligned interests and a record of efficient capital allocation. This is a lofty definition of quality, and the vast majority of companies don’t come close to demonstrating all of these characteristics.
Fundamental risk is best identified and managed through rigorous research. Similar to BBH, Brian Bares, the founder of Bares Capital Management, manages fundamental risk by seeking to identify companies with durable competitive advantages, led by capable management teams whose interests are aligned with shareholders and which possess the ability to compound earnings growth through the reinvestment of capital. Bares furthermore points out that a company’s balance sheet can pose unacceptable risk: Excessive leverage can derail the best-laid strategy in a period of financial stress, as we witnessed repeatedly during the 2008/2009 economic crisis. Companies that possess these fundamental characteristics and operate with strong balance sheets have a far better chance of surviving and even thriving through adverse market or economic environments.
Knowing a company at this level of detail is time-consuming, and, to make matters more difficult, the analysis is never done. The competitive landscape shifts, reinvestment opportunities wax and wane, and management teams change. Diligent portfolio managers underwrite the investment case of every security in their portfolio on a continual basis, in recognition of Buffett’s admonition that “risk comes from not knowing what you’re doing.” This has an interesting implication that is counterintuitive to the traditional and institutional understanding of risk management. In order to obtain this depth of company knowledge, diligent investors end up managing risk through concentration, not diversification. Diversification might lower the risk of performing differently from a passive market index, but concentration allows a manager to identify the fundamental risks that might threaten intrinsic value.
Addressing fundamental risk through rigorous research isn’t enough. After all, an investor can lose a great deal of money by overpaying for even a great asset with unimpeachable fundamental quality. Only by acquiring a quality asset at an appropriate discount to its intrinsic value does an investor obtain a margin of safety. Safety, therefore, is a function of both fundamental value and acquisition price. Hakala, employing an apt analogy for a portfolio manager based not far from Detroit, simply “wants a Cadillac for the price of a Chevy.”
But it can be dangerous to start the analytical exercise with value. As tempting as it is to screen a large number of stocks for the appearance of value, and then apply fundamental analysis to determine if the perceived value is warranted, Hakala warns that this approach “runs the risk of confirmation bias.” If a stock or bond looks cheap, it is human nature to seek affirmation of this initial judgment rather than look for contrary evidence. It is far better to identify fundamentally attractive industry structures and competitive advantages, and then wait for market volatility to present the opportunity to buy those companies at an appropriate discount.
For Ed Turville, the founder and managing partner of Real Estate Management Services Group (REMS), the real estate cycle itself offers insight into appropriate valuations. Coming out of the 2008/2009 financial crisis, the lack of new supply was a tailwind for real estate values. Falling interest rates provided an additional backstop, as most real estate carries some degree of leverage. At later stages in the cycle, when supply has returned and interest rates are moving higher, the margin of safety on real estate isn’t as great, and pricing discipline must therefore tighten.
There is a risk in pursuing too much precision in the determination of intrinsic value. It can lead to overconfidence in a single calculation, and therefore underappreciation of threats to value. It is far better to acknowledge that valuation is a range rather than a point, in the interest of being approximately right rather than precisely wrong. For this reason, our portfolio managers typically prefer assets with more predictable cash flows, as this leads to a tighter and more durable range of valuation estimates. By contrast, it is far harder to arrive at the intrinsic value of a company with widely fluctuating cash flows, and why make it any harder than necessary? Hakala would rather “look for 18-inch hurdles that I can step over instead of 42-inch hurdles that I have to leap.”
Eric Lloyd, head of global private finance at Barings, points out that investors often rely too much on liquidity to manage risk. The knowledge that you can sell a security if you change your opinion on the fundamental appeal or valuation can provide a false sense of comfort and lead to lowered investment standards. Lloyd’s portfolios comprise private debt, and the illiquidity of those assets sharpens the focus on value (price risk), as the market isn’t there every day to bail him out of a bad decision. Private markets require this discipline, but even in the public markets, liquidity isn’t the insurance policy that many institutional investors believe it to be.
Cash is a risk management tool for active managers as well. A disciplined investor would rather hold cash than lower her investment standards and increase portfolio risk. Not surprisingly, periods of heightened valuations (such as the present) lead to higher cash levels in general. Rising cash levels provide evidence of the investment discipline that we look for in portfolio managers, while also creating the ability to take advantage of price disruptions when they inevitably happen. Once fundamental research identifies a company worth owning, a price decline creates the opportunity to acquire it at an appropriate price. It requires patience as well as discipline, but the fact is that price volatility is the friend of the long-term investor.
|The Active vs. Passive Debate|
|The long-standing debate between active and passive investment strategies highlights the competing definitions of risk - that is, defining risk as volatility vs. defining it as permanent capital impairment. While we acknowledge the fee benefits that passive strategies provide, it is impossible to conduct fundamental analysis across the entirety of an index, which implies that a passive investor winds up owning all the good, the bad and the ugly that the index includes. Fundamental risk is simply embraced, not analyzed. Furthermore, index investors forgo any real handle on intrinsic value and are therefore robbed of the ability to manage price risk by buying at a discount to intrinsic value. To make matters worse, price is the only real visible variable for an index investor. In the absence of a value anchor, volatility can cause investors to give into the behavioral temptation to act based on price movements alone. As mentioned in this article, successful investing is a matter of value recognition, not price anticipation. The real benefit of passive investing is the fact that indices have very little turnover. The tax-efficiency and compounding of a passive approach can be obtained through a patient active approach as well.|
Risk management starts at home – literally. The first step in portfolio construction is to determine what you need your assets to do for you based on the nature, duration and risks attached to the liabilities on your own balance sheet. Asset allocation is therefore the primary risk management tool when it comes to making sure that your own balance sheet balances. These risks have little to do with market cycles, monetary policy and macroeconomics. Risk is absolute, not relative. This requires an integrated approach involving investment decisions, wealth planning and tax planning. If asset allocation is an exercise in determining what investments one should hold to balance against present and future liabilities, and manager selection determines how those allocations are to be implemented, then wealth planning determines where they should be held.
At the capital allocation level, risk is the simple and yet visceral threat that the assets won’t be there when you need them. It’s not about short-term price volatility or relative return – hence our managers’ insistence on fundamental quality that can only be identified through rigorous research, coupled with the discipline and patience to acquire assets only when they trade at an appropriate discount to intrinsic value. A disciplined approach to identifying and managing risk provides the ounce of prevention necessary to long-term financial health.
Coniderations for Managers
These product structures may be ideal for an asset manager who is managing active strategies and is wary of publishing their holdings daily. When considering whether these products are right for their firm, managers should ask themselves:
- Which product structure is right for my strategy?
- How will I price these products alongside my existing investment menu?
- Should I seek to replicate existing strategies or launch something new?
- Will broker/dealer platforms support these products?
- What are the operational nuances that are unique to these products?
- How will I need to adjust my distribution strategy to support these products?
- How should I structure my capital markets team to support these products?
Asset managers should consider what strategies may work in this wrapper and how a proxy-basket, semi-transparent active offering could be added to their capabilities. BBH is ready to discuss these products in more detail and welcome the opportunity to engage with firms in deeper dialogue about this development.
Over the past 15 years, Brown Brothers Harriman (BBH) has partnered with more than 40 asset managers and sponsors to bring ETFs to market in the US, Europe, and Hong Kong. BBH has worked with all four proxy product sponsors and other third-party providers to design an operating model to service these products.
On December 10, the SEC approved new proxy-based, semi-transparent active ETF structures from Natixis/New York Stock Exchange (NYSE), T.Rowe Price, Fidelity, and Blue Tractor Group. While each of the products is unique, they all use “proxy baskets” to avoid the possibility that investors will use disclosed information about an ETF’s holdings to front run the strategy. These structures may provide a compelling option for active managers to enter the ETF market without revealing their “secret sauce.” In this edition of Exchange Thoughts, we break down the different features of these active structures.
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