Fool-Proofing Your Portfolio For Risk

In times of volatility, the need to protect a portfolio against risk is clear, but the way to achieve that protection isn’t.

While some say that broad diversification in strategic asset allocation is key to mitigating risk in a portfolio, others say that achieving that diversification is increasingly difficult as correlation among assets rise. Diversification alone may no longer suffice in the quest to mitigate risk, some say.

So, we asked three ETF strategists: Is broad diversification no longer an effective way of mitigating risk in strategic asset allocation? Have markets changed so much that investors have to be tactical to manage risk?

Here’s what they have to say:

Justin Sibears, managing director of Newfound; Boston:

The problem is not with diversification itself, but rather with unrealistic expectations of the protection afforded by diversification. Diversification is not the “free lunch” it’s often made out to be. Instead, we view diversification as similar to fire or flood insurance. Viewed from this insurance perspective, diversification has three primary issues going forward.

First, the premium is getting more expensive. One of the unique realities of the last 20 years has been that the bull market in U.S. Treasurys has temporarily turned fixed income—which is traditionally a risk mitigator—into a return generator. With historically low yields, this is unlikely to continue.

Secondly, policy sizing is difficult. 2008 highlighted that a static portfolio, such as a 60/40, can see huge spikes in volatility during times of market crisis.

Finally, the payoff is uncertain. Unlike insurance, diversification is not guaranteed. In other words, the macroeconomic environment may be such that our risk mitigators become sensitive to the very risks we’re trying to protect against. For example, bonds are unlikely to protect against an equity market decline caused by an inflation shock.

While a well-diversified, strategic asset allocation should serve as the basis for any investor’s investment policy, current economic and market conditions may lead to the decreased effectiveness of diversification as a risk mitigation tool.

We believe a tactical asset allocation approach that can dynamically react to emerging risks in the market can supplement traditional diversification and deliver a more consistent risk profile. By smoothing out volatility—and the emotional reaction to it—tactical asset allocation may enable investors to carry more risk-generating assets within their portfolio, which can lead to increased total return over their investment life cycle.

Stephen Blumenthal, chairman and CEO of CMG Capital Management, Philadelphia:

Traditional buy-and-hold looks at a broad set of equity and fixed-income exposure. Small-cap, large-cap, value, growth, emerging market (EM), international equities, various types of bonds from corporate to government, high yield, high quality, convertible, mortgage, EM and international.

The problem with the traditional mix is that all of the equity exposures are highly correlated—especially during times of crisis, as are the fixed-income exposures when your starting place is yields at ultra-low levels. They all have the same interest-rate risk at the same time, and this is before looking at default risk in high yield—such risk is highly correlated to equities.

So we find ourselves at a point in time where equity valuations are in the highest 20 percent of all median PE valuations recorded since 1984—the probable forward 10-year return when stocks are just 2 to 3 percent. Combine that with a Treasury yield of just 2.15 percent and the forward return for a traditional 60/40 mix is just 3.26 percent before inflation and advisor fees.

Through that traditional diversification lens, broad diversification is really not diversification. An allocation to a broader set of risks should be considered. I favor a tactical approach that considers the forward return potential for equities. Underweight equities when the forward return potential is low and tactical-shift to overweight equities when the forward return potential is higher.

For example, today I favor 30 percent to equities (hedged), 30 percent to fixed income (tactically managed due to the ultra-low yields) and 40 percent to alternatives, defined as anything other than traditional buy-and-hold.

Portfolios are really a collection of a number of risks. The best portfolios include a set of diverse, noncorrelating risks. Tactically shift back to an equity-overweight position when equity valuations become attractive again. Then a 60/20/20 mix or a 70/10/20 mix may make sense.

There are a number of well-managed tactical investment processes that can fit in your alternative bucket. There are also strategies such as managed futures, absolute return and multistrategy and more that provide a different path to returns—a path that is nondependent on a straight-up move in equities.

Rick Ferri, founder of Portfolio Solutions, Troy, Michigan:

Creating an optimal portfolio consists of estimating a portfolio’s future risk and expected return as accurately as possible, based on a variety of inputs. It’s that “as accurately as possible” qualifier that makes the exercise a substantial challenge.

Most modern portfolio theory analysis relies on historical return, risk, covariance and correlation, at least as a starting point. We know that past data can be period-sensitive, so these estimates are often adjusted based on subjective input factors. Investors may have broad views of future Federal Reserve interest-rate policy or of the future equity risk premium. This range of opinion can add wide variability to the accuracy of the outcome.

Using only historical data for covariance and correlation can lead to large errors in portfolio optimization. For example, the long-term average correlation between U.S. stocks and five-year Treasury bonds from 1926-2014 has been +0.1 (correlation ranges from +1.0 to –1.0). However, an analysis of rolling correlation shows this average is far from stable. The 10-year correlation passes through +0.1 on rare occasions, but isn’t there for long.

Correlations are not static. They shift over time in both directions.

Contact Cinthia Murphy at [email protected]