A
Bullet Proof Portfolio
‘Lessons
from An Insider’
Article
Writer: Kipley
J. Lytel, CFA
After
spending several years working in the hedge fund world, followed by another
(too long) period working as a lead ‘sell-side’ securities analyst for a
securities brokerage house issuing ratings and price targets on securities in
tandem with published research reports, my concern for individual investor’s
welfare has markedly increased. That
said, rumors of conflicts of interests are widespread and, in my opinion, have
been quite valid for several reasons: (i) yes, analysts are often directly or indirectly pressured
for positive ratings and lofty price targets on securities from investment
banking departments (bonus incentive), from trading desks (to sell more), and
from the companies covered (for better access); (ii) yes, brokers are often
encouraged to actively trade accounts, often to the disservice of their
clients; and, (iii) the system is fraught with inappropriate incentives, such
as loads for mutual funds sold and poor price transparency on corporate bonds
traded to customers in which the brokerage company handsomely profits from a
‘hidden spread’ – often 0.5% up to as high as 1.5% of value, on top of the
commission.
But there are also many other pitfalls that average
investors have fallen prey, such as actively trading their own accounts (from
day trading to week trading now) or owning individual stocks without
understanding diversification and exposure to sector or asset class risk. Indeed, research shows that over 90% of the
return is attributable to proper selection of and allocation between asset
classes, rather than stock "picking." In my opinion, the costs of
trading or the risk of holding individual securities is simply dangerous
without financial stock knowledge, ‘living and breathing’ the market and having
diverse holdings. And if you use a
broker, you must ask yourself these questions: Does your broker listen to the
company conference calls? Does your
broker have access to management? Do you
think your broker wants to call you when one of your stocks just blew up with
an accounting scandal, management corruption or disappointing earnings? Even if the brokerage house has analysts
covering these matters, how involved is your broker in the process and is he
brave enough to tell you to “sell & sell now” – not to mention was it
appropriate for this stock or bond to be in your portfolio in the first
place? And even if you are lucky enough
to have a brilliant broker, if you didn’t act in the first ten minutes of the
breaking news, you likely missed your chance to limit your losses.
So what do you do?
Do you buy a mixture of stock and bond mutual funds, and if so which
ones and how much of each? The answer
goes beyond your return requirement, risk tolerance, individual constraints
(liquidity, taxes, income needs etc.) or even your age and size of financial assets. Granted, you must consider all these factors,
but for the appropriate investment allocation to be correctly implemented, it
should involve a degree ‘financial science.’
First, let me educate you on Modern Portfolio Theory.
Modern Portfolio Theory advocates a process first
developed by Nobel Laureate Harry Markowitz, of
selecting an optimal mix of asset classes based on past and forecast returns,
volatility (i.e., standard deviation and beta values), and cross relationships
(i.e. correlations and co-variances) that matches investor's quantifiable risk
tolerance and gives them best possible rate of return. The goal is to have a low covariance
portfolio based on each investors risk profile and return requirement so that
the mean-variance is optimized (this is technical but I will make it
clearer). Indeed, an addition of a
high-risk asset class with low correlation with the overall portfolio may
actually increase the portfolio return and reduce overall risk.
Investors used to take comfort in the notion that a
portfolio diversified among domestic stocks and bonds would provide sufficient
returns at the price of only moderate risk.
There was good reason for this comfort.
Many investors have been aware of the important role that correlation
between portfolio components plays in determining the risk of a portfolio. The
lower the correlation, the better, which used to be exactly what domestic stock
and bond investors experienced. From 1926 to 1969, the correlation between
annual total returns for
Here is the problem, many assets have become more
correlated, markets have become more correlated and countries have become more
correlated. This is especially the case
in market crashes, technically termed as negative gamma events. That is the problem, just when you want your
low correlated portfolio to constrain volatility it is at its greatest
risk.
What is the solution? Well, I will discuss in broad terms the
correct approach to bullet proof your portfolio, but let me first acknowledge
that the financial knowledge and investment tools to construct the optimal
allocation are likely only found with experienced investment professionals or
advisor that practice Modern Portfolio Management. But, of course, if you choose to ‘go-it
alone’ here is a road map to navigate.
I suggest that you need to consider a host of new
investment classes open to individual investors to mitigate this risk and these
include hard assets, hybrid stock strategies and hedge fund strategies. This serves two purposes: First, these assets have very low correlation
with bonds and stocks and each other and, Second, one flaw
I find with Modern Portfolio Theory (MPT) is that it is predicated on markets
being efficient. Let’s just say that
there are strategies that benefit from inefficiencies in the market and by
exploiting these anomalies the market gets more efficient – though, in my
opinion not perfectly. Now by having a
portfolio with substantial allocation to alternative class investments you
benefit from low correlation attributes (lower risk) and in my opinion, these
asset strategies partly offset MPT’s flawed paradigm
that all markets are efficient.
In a
"In
the months after arriving from the Rockefeller Foundation back in 1990, one of
his biggest decisions was to settle on diversification as a key theme. Relying
on techniques of modern portfolio theory to get the best returns with lowest
level of risk, Harvard needed to cut its exposure to publicly traded U.S stocks
and bonds, and increase its investments in foreign stocks, commodities and
private companies. The result: Right now the Harvard endowment has about only
half its portfolio in
Let me start by saying, I would suggest you do not
invest in any single company or fund for the alternative class exposure. Just like individual stocks there are too much event risk and you are better served with
pooled holdings. At my firm, Montecito
Capital Management, we have between 25%-45% allocation to alternative classes
and only use liquid vehicles (easily sold) with broad holdings and have nominal
initial investments. Also we steer away
from many hedge funds that have long minimum holding periods, short performance
histories and avoid hedged strategy funds using over 25% leverage. One must be
vigilant with hedge fund vehicles as they often are not regulated by SEC and
are known for self-serving fees.
Nonetheless, hedge funds, when added to a
traditional portfolio of stocks and bonds, both improved returns and reduced
risk. According to Van Hedge Fund Advisors, the average five-year net annual
returns for the top 25% of U.S. Hedge Funds has been 20.4% for the first
quarter of 1998 to the fourth quarter of 2002, compared to 5.6% for mutual
funds during the same period. There are
some new hedge fund products available for investment advisors to add to client
portfolios that are quite unique which the average investors should
consider. For example, there is a Hedge
Funds S&P Index which has performed about 9% annually over the past five
years that will become available to advisors next month. This product does not have a ‘qualified
investor’ mandate (net worth of $1,000,000 or investor having income of
$200,000+ in past two years) and has an affordable minimum investment of
$25,000 with only a one-year holding period (can exit early but pay exit load
if before one year). Further, the index
has many subclass of styles, which will eventually be
open to investors & these include: merger arbitrage, long/short equity,
equity neutral, fixed income arbitrage, convertible arbitrage, special situations
etc.
You can also synthetically design many of these
types of hedge funds (though you can’t get the levered returns of private
funds) through mutual funds, which are usually classified as ‘hybrid
domestic.’ There is a merger fund, an
arbitrage fund, long/neutral funds, short funds, bond arbitrage funds and
convertible arbitrage funds available to the average investor. But stay away from loads and be mindful that
though the expenses are typically higher for alternative styles, we offset the
weighted average expense with dynamic asset allocation between a selection of
over 100 exchange traded funds in which we adjust correlation exposure by
sector, styles, market capitalization etc. (note: the low average 0.25%
expenses help offsets the overall high expense of alternate class funds).
Turning to hard assets, these classes represent the
ultimate in tangibility: real estate, precious metals, oil and gas, timber and
other commodities. Cyclical and volatile, these investments have long been
considered ideal portfolio diversifiers because of their relative low
correlation to the stock market. Real
assets may be divided into "hard" and "soft" assets. Hard
assets are non-perishable real assets and include real estate and
commodity-related assets such as energy (e.g., oil and gas), precious metals
(e.g., gold and silver), industrial metals (e.g., aluminum and copper), and
timber. "Soft" assets are perishable and consumable and include the
commodities of agricultural products and livestock. The inclusion of hard assets
can potentially improve performance. The higher efficient frontier is derived
from an optimization that includes hard assets into consideration.
Like real estate, commodities -- oil, lumber and
other hard assets -- have a decent record of negative correlation with stocks.
Inflation sends the price of these hard assets up and it hurts the stock
market. For example, the
non-correlation between stocks and commodities was dramatically highlighted
during 1973 and 1974 where stocks dropped 41% and commodity prices soared 114%.
During the S&P's two worst declines during the
past decade, managed futures recorded net profits. Also during September to
November 1987, when the S&P 500 fell nearly 30 percent, managed futures
rose 10%. And, the three-year return of
Goldman Sachs Commodity Index (annualized from June 2002) is 10.91% - we invest
in this class through the PIMCO Commodity Real Return, among other funds.
One can also cobble together a "precious metals
index" which will estimate the long-term return of this asset. The
Morningstar database of mutual funds has a precious metals fund index which
goes back to 1976, and before that the Van Eck International Fund, which
started operations in 1956, became a precious metals fund sometime in 1968.
Combining the Van Eck data for 1969-75 with the Morningstar data beginning in
1976 provides a 27.75 year time series -- just long enough to provide a
reasonable estimate of the "true" long term return of this asset. The
results are startling -- the annualized return from January 1969 to September
1996 was 12.81%. This is actually higher than the S&P500 (11.24%),
Additionally, the natural resources class typically moves
independent of bonds and stocks. The Lipper Natural
Resources Index fourth quarter return was 7.56%, with a 7.92% average return
from inception in 1995. Among the many
natural resource vehicles we use are the iShares
Goldman Sachs Natural Resources Index fund, which is up 1% year-to-date,
however, it is a bit to concentrated in energy so we
usually blend this hard asset allocation with a couple funds. We also may
want to underweight positions in one of these areas (e.g. energy) &
may use more of Ivy Global Natural Resources since it has both more
international exposure and lower energy positions (under 50%) relative to its
peers. We also like the Oppenheimer Real
Asset fund marked by its a low correlation, unique strategy, performance, no
load, palatable expense & high bond positions as opposed to peer's using
more equity. Like the other alternative classes, this investment class
adds both return with less risk given it is appropriately applied to a
portfolio.
Finally, we turn to one of the most common
alternative classes, real estate investment trusts (REIT). We prefer REITs
that have exposure to many different asset classes (office, shopping malls,
retail & apartments) and broad geographic markets (not just one regional
presence). Just as the bear market began
in earnest in early 2000, REITs began their
impressive winning streak. From
Alternative asset classes are hard to understand and unless advisors
understand the nuances of modern portfolio management, many advisors continue
to steer clear from alternative investments, specifically hard assets. They look and say, ‘Gosh, look at the poor
returns and volatility. How can that possibly help my client?" Except when you sit down and do the math, a
5% to 15% allocation of hard assets goes a long way in reducing overall
portfolio volatility, while improving returns.
Now let’s pull this together. A typical investor who wants exposure to the
overall market but lower downside risk must understand the upside will be
capped. That is how it works since risk
and reward are interrelated. A typical
investor may be a client with no immediate investment income needs and doesn’t
plan to retire for over 10 years and financial assets of $500,000. Given the earnings visibility remains poor,
we are at war, fiscal and monetary polices have become more futile and we now
face terrorism threats, our portfolio for a typical client may resemble this: (i) 30% exchange traded equity funds with different
exposures to value/growth, market cap sizes and sectors (we are more value, and
weighted in defensive sectors like consumer staples, consumer non-cyclicals, healthcare etc.); (ii) 35% alternative classes
(arbitrage funds, long/short, neutral, opportunity strategies etc.); (iii)
12.5% hybrid fixed income (high yield, distressed, convertible bond); (iv)
12.5% hard assets (REITs, Commodity, Precious Metals
& Natural Resources); and (v) 10% corporate bonds, mortgage
backed-securities, TIPs & treasuries. Also remember that you should have exposure
to international markets with a speck of emerging markets too, for both equity
and fixed income allocation (we currently are overweight in countries like
Kipley
J. Lytel, CFA, is Senior Partner
at Montecito Capital Management (http://www.mcapitalmgt.com). He received his Masters of Business
Administration (MBA) with Honors from the Peter F. Drucker
School of Management at