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Wednesday, September 2, 2009

Trading One Risk For Another ?

Today's WSJ Investing in Funds section includes an article entitled

On Second Thought...
Many financial advisers have tweaked their investment policies after big losses last year. Investors should be sure they're comfortable with the changes

my comments in bold italics:

While some of the ideas of the advisors cited seem reasonable,such as adding commodity exposure, others are downright scary. Also none of the strategies mentioned actually reduce risk: that would be done by adding high quality short term bonds, inflation protected bonds or cash. In fact the advisors are just trading one risk: asset class rish which at least can be easily managed by holding low cost transparent index instruments for another risk: the skill of the advisor or fund manager in rotating among asset classes.

From the article:

After turning in a horrific performance in 2008, many financial-planning firms are heading back to the drafting table—and rethinking how they protect their mutual-fund portfolios.

Last year, the traditional safety-net strategy—diversification—failed as a broad range of investments crashed and burned. Now many planners are going further. They're giving themselves more flexibility to move assets around based on market conditions. Others have sworn off certain asset classes or added some they hadn't dabbled in before.

I certainly agree with this comment:

Whatever the change, make sure you understand your planner's new methods and are comfortable with them, says Dr. Katz, who is also a financial planner. "While it's been difficult to bear the movement in the market, be cautious if a planner jumps to things that he or she never looked at before," she says

Here is one example from the article of an advisor's change in strategy:

Now we've moved away from that for 10% of our assets, and we're inviting in different funds with flexibility" in the securities they hold, Mr. Enright says. He adds that these types of funds may lag behind stock indexes in good times, but in market declines the manager may stem losses by pulling out of losing asset classes and moving into more stable ones without any limits....

..or he may utterly fail at doing this. One thing for sure since it is an actively managed mutual fund the investor and advisor likely won't know about the manager's strategy in real time. The manager is only required to report holdings quarterly in arrears. And one has to wonder if a manager with a mandate to move around asset classes won't be inclined to move things around too much just to show he is doing something. And the more he moves things around the greater the potential tax liability.

Mr. Enright says he uses two funds from Allianz SE's Pacific Investment Management Co. that can roam across asset classes and also short securities. One, Pimco All Asset All Authority, largely invests domestically. Over the five years through August, the fund's institutional shares returned an average 6.8% a year, while the Standard & Poor's 500-stock index gained an average 0.5%. The second, Pimco Global Multi-Asset, is similar in strategy but has no geographical limitations. It was launched in November 2008 and is up 13.2% so far in 2009.

In my view the advisors cited in the article (and many individual advisors) have confused diversification with risk control. It is true that many risk assets: domestic and foreign stocks,corporate bonds and reits do not have perfect correlation (i.e.) they do not always move in tandem. But all types of stocks and in fact all of the asset classes listed above have high and positive correlations. Spreading across various types of stocks diversifies market exposure but it does not significantly reduce risk in a portfolio. Furthermore: "the only think that goes up in a down market is correlation" in a sharp market downturn the correlation of risky asset classes increases significantly. Correlations among risk assets are dynamic, therefore the benefits of diversifying among these asset classes in terms of risk control is often overestimated. Past correlations are not predictive of the future.

The only way to reduce the risk of a portfolio with 100% certainty is to increase the holdings of cash and near cash instruments such as short term treasury bills. The characteristics of these asset classes will remain constant: low interest rate risk, no credit risk, and low returns. In fact the founder of Harry Markowitz the founder of Modern Portfolio Theory (MPT) has stated that this is all that his work had argued and extensions of it to other types of diversification was overselling the theory.

Therefore, what the advisors describe as their new strategy to manage risk is not managing risk at all. By adding strategies that incorporate active trading and switching among asset classes they are actually increasing risk by adding a new risk: manager risk to their portfolios. There is no reason to think that the timers will be particularly successful. The advisors have not limited the downside risk of their portfolios, they have simply increased the likelihood that their portfolios will underperform on both the upside and the downside.

It seems to me either the managers don't realize this fact themselves or they don't want to tell the clients the truth of risk management. If you want to reduce the risk of their portfolio with certainty they need to give up potential gains as well, not simply switch among risky assets.

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