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Tuesday, September 8, 2009

Sorry If I Don't Get What Is So New Here

The WSJ today writes about the new innovative way some fund managers are now approaching the downside risk on their portfolios (my bold and my comments in italics)

Some Funds Stop Grading on the Curve


Last year, a typical investment portfolio of 60% stocks and 40% bonds lost roughly a fifth of its value. Standard portfolio-construction tools assume that will happen only once every 111 years.

With once-in-a-century floods seemingly occurring every few years, financial-services firms ranging from J.P. Morgan Chase & Co. to MSCI Inc.'s MSCI Barra are concocting new ways to protect investors from such steep losses. The shift comes from increasing recognition that conventional assumptions about market behavior are off the mark, substantially underestimating risk.

Though mathematicians and many investors have long known market behavior isn't a pretty picture, standard portfolio construction assumes returns fall along a tidy, bell-curve-shaped distribution. With that approach, a 5% or 6% stock-market return would fall toward the fat middle of the curve, indicating it happens fairly often, while a 2008-type decline would fall near the skinny left tail, indicating its rarity.

Recent history would suggest such meltdowns aren't so rare. In a little more than two decades, investors have been buffeted by the 1987 market crash, the implosion of hedge fund Long-Term Capital Management, the bursting of the tech-stock bubble and other crises.

Investors using standard asset-allocation approaches have been hammered. Last year, all their supposedly diversified investments plummeted in unison. In short, the underlying assumptions failed.

"We got blindsided by some developments that weren't accounted for by the models we were using," says Clark McKinley, a spokesman for the giant pension fund California Public Employees' Retirement System, or Calpers. As a result, the fund is looking at incorporating an extreme-events model into its risk-management approach.

Many of Wall Street's new tools assume market returns fall along a "fat-tailed" distribution, where, say, last year's nearly 40% stock-market decline would be more common than previously thought.

Fat-tailed distributions are nothing new. Mathematician Benoit Mandelbrot recognized their relevance to finance in the 1960s. But they were never widely used in portfolio-building tools, partly because the math was so unwieldy blockquote>>

So practitioners have known for years that the model used doesn't reflect reality, a prominent academic and many others have written about this problem for years even options traders in the futures pits acted based on the "fat tail " distribution for decades (by pricing out of the money options higher than would be implied with a standard deviation) but the top fund management and analysis companies are just know updating their approach...pardon me if my head is spinning.

The article goes on to describe seemingly arcane models and techniques to measure and protect downside risk. But at least for many instruments we have long had a mechanism to lmit downside risk: they are called put options. And Mr. Market can tell you everyday what the best estimate of that risk is...the option premium or the cost of buying that protection. And of course that protection comes at a price that will limit upside return. The article does point out that reality (big news: there is no free lunch):

Insulation from extreme market events doesn't come cheap. Allianz SE's Pacific Investment Management Co., or Pimco, which systematically hedges against extreme market events in several mutual funds launched last year, says the hedges may cost investors 0.5% to 1% of fund assets a year. Pimco uses a variety of derivatives and other strategies to hedge the funds.

"You're spending some of your upside to buy the insurance" against catastrophic losses, says Vineer Bhansali, a Pimco managing director.

Any technique other than one that incorporates some put buying will just amount to market timing or relying on an imprecise quantitative model,

And there is nothing new in risk managed funds. The Gateway fund (GATEX) has existed for years. It buys put options on the S+P 500 for downside protection and sells calls (limiting the upside) to finance some of the cost of those options. Not surprisingly it has underpreformed the s+p 500 2.77% vs 14.6 for the vanguad sp 500 fund ytd.<

I do agree with this comment at the end of the article:
Pimco's Mr. Bhansali is unimpressed. Since it is so difficult to forecast extreme events, investors should focus on their potential consequences rather than the probability they will occur, Mr. Bhansali says.

As for comprehensive measures of risk, he says, "they fail you in many cases when you need them the most."

In other words: either buy put options or own a significant amount of treasury bills so that you can ride out the storm. Don't rely on any "extimates of the risk bell shaped or fat curved

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