Risky Business Update

Investors Face Additional Challenges Amid Increased Uncertainty

Q&A: The Risk Report

When portfolios don't deliver outcomes as expected, the number one question is "Why?"

3 Pitfalls in Investing in Emerging Markets

Using Quantitative Techniques to Analyze Stocks

Risk Mitigation Opportunities: Taking Time to Re-evaluate Portfolio Strategies and Board Governance

Image by Michal Jarmoluk from Pixabay 

By FLOYD SIMPSON III & MALLORY SAMPSON/PFM Asset Management

The traditional 60% S&P 500 - 40% Aggregate Bond index investment portfolio has been the benchmark for portfolio construction for decades due to the inverse return relationship between equities and fixed income and higher historical bond yields. This simplistic mix had provided returns for pensions that allowed them to meet their actuary assumed returns. The S&P 500 index posted an approximate annualized average return of 11.3% for the past 10 years (ending 2019)[1], while the current yield on the Aggregate Bond Index less than 1.5% (coupon rate of hovering around 3%). The correlation between the two indexes has been slightly negative for the past ten years, and bonds have not provided a consistent offset for drawdowns within the S&P 500 index. Over the next five years, earning a 5% annualized return will be tough. Based on recent comments from the Federal Reserve (the Fed), the expectation for higher interest rates in the intermediate term is minimal. While investors cannot control what the Fed is doing, we can recalibrate current positioning and take a serious look at the risk within the portfolio and its governance.

Investment Strategy

The first question that most investors have started to ask themselves is how to replace the missing yield from the fixed income market. When seeking a replacement, many forget to fully vet the additional risks associated with finding an alternative. While there might be other public and private options, each one brings a different type of risk profile to the portfolio, which must be considered. Hence, swapping one investment for another is a naïve approach that could have detrimental effects if the understanding of current and potential strategies is vague. This is an important area to focus on, and what an investment advisor is paid to do. You might have a relationship with an advisory firm in which they present you with options or a fiduciary that does the decision-making and portfolio construction for you. In either case, this is the time for an investment committee to focus on oversight elements that are usually glazed over. From an investment perspective, members should take this time to:

• Re-evaluate their Strategic Allocation
• Update their Investment Policy
• Refresh their Objectives
• Evaluate their tactics around allocation of assets and assessment of those decisions
• Revisiting their Spending Policy

This is also an appropriate time to rethink how the committee gauges success of their portfolio. Instead of looking exclusively at the traditional aspects of asset classes and benchmark performance, committees should start to consider:

• Gauging the overall risk of their exposure
• Homing in on their underlying market exposures to events that could be detrimental to returns
• Measuring the volatility of returns for each fund and portfolio as a whole
• Considering drawdown of the portfolio

Governance Structure

Understanding and addressing the potential holes within the governance of a board is equally important to understanding current market conditions. Unfortunately, this rarely gets the same attention as the latest news from the stock market does.

As investment professionals, we spend far too much time talking about the markets, but clients’ governance structure usually has glaring holes and creates just as much risk for plans. The adoption of good governance starts with:

• Addressing educational needs within the board
• Introduction of term limits
• Staggering board terms
• Independent, third-party reviews of board investment process
• Proactively minimizing conflicts of interest
• Re-evaluate current investment advisor beyond investment performance
• Utilizing board assessments

While most boards would say they follow a couple of these best practices, very few that take time to adopt many of these items because they can be tedious and cumbersome to carry out. The board assessment can help in numerous areas. It can inform a board about members that are not contributing, bring up potential conflicts or educational gaps in knowledge and could even help in determining term-limits based on board needs. Pinpointing weak areas within the governance structure can help prevent surprises during times of distress.

It is crucial for boards to maintain discipline in their governance and review processes; while it may not seem as exciting as stock and fixed income movements, it is equally as important of an exercise for more efficient portfolio management.

PFM is an Associate Member of TEXPERS. The views expressed in this article are those of the authors and not necessarily PFM nor TEXPERS. 

Sources

[1] Bloomberg

About the Authors

Floyd Simpson III, CFA, CFP, is Senior Managing Consultant with PFM Asset Management LLC. As part of PFM’s OCIO business, Simpson works with clients across the country to develop and implement multi-asset class strategies for their portfolios. He also serves on the Multi-Asset Strategies Group and the Multi-Asset Class Investment Committee.

Mallory Sampson, CFP, is Senior Managing Consultant with PFM Asset Management LLC. Sampson manages PFM’s institutional multi-asset class relationships in Texas, with a focus on higher education, endowments, foundations and OPEB trusts.

BY MARK SHORE, Coquest Advisors

Investment volatility, or “vol,” as it is known on the street, is often measured by the standard deviation. Investors frequently use the standard deviation as a proxy for risk. But is the standard deviation a proxy for risk or a proxy for dispersion around the mean?

Mathematically, the standard deviation is the dispersion of data around the mean as the data points move farther from the mean (towards the distribution tails), the standard deviation increases. In a normal (bell-shaped) curve, one standard deviation should capture about 68% of the possible movement around the mean. A two-standard deviation move captures approximately 95%, and three standard deviations should capture an estimated 99.7% of the distribution. Therefore, volatility is both above and below the mean.

Investors often talk about volatility when portfolios are losing value. For example, you probably won’t hear much discussion about the stock market being volatile when it rallies. That discussion usually occurs when stocks decline. However, when an investment has profitable returns, it is still technically defined as volatility, sometimes known as upside volatility or positive volatility. Investors are usually accepting of the upside vol, as it implies the investment experiences positive returns. It’s the downside vol investors are often losing value as that is the tail risk they are usually trying to reduce. To paraphrase from my paper, Skewing Your Diversification, volatility is comparable to cholesterol. There is good and bad volatility.

The traditional view perceives higher standard deviation equating to higher risk. But is that always the case? As I often tell the students in my managed futures class, you should understand if the volatility derives more from the positive returns or the negative returns. If derived more from the positive side of the distribution, that is the dispersion of the positive gains that is inflating the standard deviation. If the volatility is derived more from the negative volatility than it is the dispersion from the negative returns and is the tail risk, that usually concerns investors.

Modern portfolio theory assumes a normal return (bell-shaped) distribution. However, distributions may be skewed (asymmetrical curve) to the right causing positive volatility or skewed to the left, causing negative volatility. The negatively skewed distribution may cause increased tail risk and losses, as noted in the chart below.



Understanding how an investment’s allocation impacts the portfolio’s skewness helps understand the behavior of the allocation relative to the portfolio. Does it expand the skewness to the left or the right? This concept is also known as co-skewness, according to the authors of Conditional Skewness in Asset Pricing Tests, published in The Journal of Finance.

In other words, an investment with a high standard deviation but more volatility coming from the upside could potentially reduce a portfolio’s volatility when the investment is allocated to a portfolio. It sounds counter-intuitive for a high standard deviation investment to reduce a portfolio’s standard deviation, but it’s the positive volatility that is offering the benefits to the portfolio to reduce the tail risk and downside vol.

An investment with a high standard deviation derived from positive skewness and coupled with a low or non-correlation to the portfolio may increase the added value of the allocation. It’s also possible for an investment with a low standard deviation, but more volatility attributed to the downside increasing the portfolio’s tail risk.
Therefore, only accounting for a standard deviation to be high or low is not enough. Drilling down to understand where the volatility is good or bad is an essential factor to consider. If the tail risk can be more efficiently controlled, than the portfolio’s drawdowns may also be reduced.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Coquest Advisors nor TEXPERS, and are subject to revision over time.

About the Author: 
Mark Shore is the director of educational research at Coquest Advisors. He is also an adjunct professor at DePaul University. He is a candidate to receive his doctorate in business administration in 2020. He has a master's degree in finance from The University of Chicago Booth School of Business. He also has a bachelor's degree in finance from DePaul University.

The Challenge: Generating Sufficient Returns

BY BOB PARISE, Northern Trust Asset Management

Increasing pressure to reduce risk coupled with a challenging market environment will make generating sufficient pension returns harder in the coming years. Volatility has returned, the yield curve has flattened and global growth has slowed — all of which can contribute to lower future returns.

To illustrate the magnitude of these negative shifts in the return expectations, we utilized our five-year risk and return forecasts to simulate various optimal portfolio outcomes. Compared to just 10 years ago, these hypothetical diversified portfolios have a ~2% drop in returns across all levels of risk, which compounded over time, can become a significant unfunded liability for pension plans.

Historical approaches to bolster returns generally involved increasing certain risk exposures, such as adding alternative and private investments. However, some plan sponsors are limited in the amount that they can increase their risk budgets. Others are already at their liquidity limits for more aggressive allocations. These limitations diminish a plan sponsor’s ability to meet its target return objectives of 6% to 7.25% without taking too much risk.

The Solution: Quantitative Multi-Factor Strategies
Multi-factor strategies could offer a consistent alpha contributor to your equity allocation without increasing your pension’s risk budget.

What Are Multi-Factor Strategies?

Factor-based, or quantitative, equity strategies seek to outperform a benchmark by exploiting market anomalies and behavioral biases using proprietary and quantitative models to select securities, construct portfolios and manage risk to deliver targeted outcomes.

Click image to enlarge.

Why Invest in Factors Now?

We do not advocate trying to “time” factors over short periods of time, but it is important to note the cyclical nature of factor returns. Factors have tended to perform well in any economic environment, but they have historically been at their best when the economy is moving out of periods of high expansion (Exhibit 1).

Click image to enlarge.

While markets can be cyclical, in our 20+ years of managing factor-based strategies, we’ve found quality to be a diversifier that potentially makes outperformance more consistent over varying returns cycles.

Similarly, in rising rate and low return environments, we have seen the same pattern of high excess returns, primarily in the low volatility and quality factors (Exhibit 2). While not all of these factors may align with your plan’s objectives, this framework can provide a helpful guide to gauge whether your portfolio is aligned to capture these potential drivers of outperformance.

Click image to enlarge.

Learn more about multi-factor strategies on northerntrust.com or contact Bob Parise.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Northern Trust Asset Management or TEXPERS. Click here to read Northern Trust Asset Management's full disclosure.

About the Author
Bob Parise is practice lead, Public Funds & Taft-Hartley Plans at Northern Trust Asset Management and a member of the Business Leadership Council. Parise has more than 24 years of financial industry experience, most of it at J.P. Morgan Asset Management and its predecessor firms. He earned a bachelor's degree in Finance from Western Illinois University and a master's degree from DePaul University. He holds Series 3, 7, 24, and 63 licenses.