What is Investment Risk?

Jeff RauppJeff Raupp, CFA, Senior Investment Manager

One of the go-to formulas of horror movies is to try to avert the audience’s (and character’s) attention away from the real risk. Someone hears a noise in a (supposedly) empty room, they walk in and see an open window. The unfortunate character starts focusing on why the window would be open, maybe even leans out the window and starts looking around. At some point, the character is satisfied that the open window is no longer a threat (whew!), closes the window, turns around, and BAM! You find out the real risk came in through the window and was hiding in the room. Now, the settings and characters change (why don’t we try having a group of sharks caught in a tornado?), but the formula remains the same.

Similarly, investors can sometimes get caught focusing on certain risks, while it’s often the ones they’re not focused in on that cost them the most.

One of the most widely used ways that investors look at risk is the standard deviation of an investment. Harry Markowitz won the Nobel Prize largely on his work on Modern Portfolio Theory (MPT), which defines risk as standard deviation. The standard deviation gives you a basic measure of how volatile the return stream of an investment has been (or is expected to be), and is extremely useful in getting an understanding of what to expect in a normal environment.

11.22.13_Raupp_Whatisinvestmentrisk_2MPT took the concept of risk further in recognizing that the correlation of investments in a portfolio is also important, that the combination of investments with a low or negative correlation to one another can create an outcome where you can get a higher level of return for a given level of volatility. This enabled investors to create an “optimized portfolio,” which was the best possible mix of investments to maximize your return for a given level of risk.

The problem with this is that we don’t live in a normalized world, where return distributions are symmetrical and correlations between investments remain constant. 2007 and 2008 were shining examples of that. Quantitative strategies that had been effective in a “normal” environment collapsed when price moves that they had viewed as “once in a million year events” started occurring with regularity. Optimize all you want, but if you owned an investment vehicle backed by Lehman Brothers you probably didn’t have a good outcome, even if you were on the right side of the trade.  And not many people factored in the possibility of their money market fund breaking the buck, as happened to the Reserve Fund.

So, what’s the solution? Diversification. Inevitably you’ll find your investments adversely affected by some kind of risk; however, with proper diversification just part of your portfolio will be affected rather than the entire thing. But while the MPT concept of diversification starts you in the right direction, it doesn’t check all the nooks and crannies where danger might be lurking.

Thinking about how asset classes would react under different scenarios or events helps you to better protect your portfolio. Entering 2007 most investors would have thought commodities were good hedges against a stock market decline. Commodities had done very well in 2000-2002 when the tech bubble burst, and touted a negative correlation to stocks over most trailing periods, a huge consideration when optimizing a portfolio using MPT. But when a deep recession caused consumption and production to plummet, commodity prices dropped right along with stocks, leaving many investors scratching their heads. The credit crisis did that to nearly all asset classes with any level of risk associated with it, leaving the only winners investors in high quality bonds and a relatively obscure (at the time) strategy called managed futures.

11.22.13_Raupp_Whatisinvestmentrisk_1The lesson is clear. There are times when “normal” becomes abnormal and the way asset classes interact with one another changes. So while checking the open window in the empty room might be the right thing to do 99% of the time, it pays to be on the look-out for the monster in the closet.

Monthly Market and Economic Outlook: November 2013

MagnottaAmy Magnotta, CFA, Senior Investment Manager, Brinker Capital

The impressive run for global equities continued in October. While U.S. and developed international markets have gained more than 25% and 20% respectively so far this year, emerging markets equities, fixed income, and commodities have lagged. Emerging markets have eked out a gain of less than 1%, but fixed income and commodities have posted negative year-to-date returns (through 10/31). While interest rates were relatively unchanged in October, the 10-year Treasury is still 100 basis points higher than where it began the year.

After the Fed decided not to begin tapering asset purchases at their September meeting, seeking greater clarity on economic growth and a waning of fiscal policy uncertainty, attention turned to Washington. A short-term deal was signed into law on October 17, funding the government until mid-January 2014 and suspending the debt ceiling until February 2014. With the prospects of a grand bargain slim, we expect continued headline risk coming out of Washington.

The Fed will again face the decision to taper asset purchases at their December meeting, and we expect volatility in risk assets and interest rates to surround this decision, just as we experienced in the second quarter.  More recent economic data has surprised to the upside, including a +2.8% GDP growth rate and better-than-expected gains in payrolls. Despite their decision to reduce or end asset purchases, the Fed has signaled that short-term rates will be on hold for some time. Rising longer-term interest rates in the context of stronger economic growth and low inflation is a satisfactory outcome.

11.12.13_Magnotta_MarketOutlook_1However, we continue to view a rapid rise in interest rates as one of the biggest threats to the economic recovery.  The recovery in the housing market, in both activity and prices, has been a positive contributor to growth this year.  Stable, and potentially rising, home prices help to boost consumer confidence and net worth, which impacts consumer spending in other areas of the economy.  Should mortgage rates move high enough to stall the housing market recovery, it would be a negative for economic growth.

We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we approach the end of the year, with a number of factors supporting the economy and markets.

  • Monetary policy remains accommodative: The Fed remains accommodative (even with the eventual end of asset purchases, short-term interest rates are likely to remain near-zero until 2015), the ECB has provided additional support through a rate cut, and the Bank of Japan has embraced an aggressive monetary easing program in an attempt to boost growth and inflation.
  • Global growth strengthening: U.S. economic growth has been sluggish, but steady. The manufacturing and service PMIs remain solidly in expansion territory. Outside of the U.S. growth has not been very robust, but it is positive.
  • Labor market progress: The recovery in the labor market has been slow, but stable. Monthly payroll gains have averaged 201,000[1] over the last three months.
  • Inflation tame: With the CPI increasing only +1.2% over the last 12 months, inflation in the U.S. has been running below the Fed’s target level.
  • Equity fund flows turn positive: Equity mutual funds have experienced inflows of $24 billion over the last three weeks, compared to outflows of -$12 billion for fixed income funds.[2] Continued inflows would provide further support to the equity markets.
  • Housing market improvement: The improvement in home prices, typically a consumer’s largest asset, boosts net worth, and as a result, consumer confidence.  However, another move higher in mortgage rates could jeopardize the recovery.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets flush with cash that could be reinvested or returned to shareholders. Corporate profits remain at high levels and margins have been resilient.

However, risks facing the economy and markets remain, including:

  • 11.12.13_Magnotta_MarketOutlook_2Fed mismanages exit: The Fed will soon have to face the decision of when to scale back asset purchases, which could prompt further volatility in asset prices and interest rates. If the economy has not yet reached escape velocity when the Fed begins to scale back its asset purchases, risk assets could react negatively as they have in the past when monetary stimulus has been withdrawn.  If the Fed does begin to slow asset purchases, it will be in the context of an improving economy.
  • Significantly higher interest rates: Rates moving significantly higher from current levels could stifle the economic recovery.
  • Sentiment elevated: Investor sentiment is elevated, which typically serves as a contrarian signal.
  • Fiscal policy uncertainty: Washington continues to kick the can down the road, delaying further debt ceiling and budget negotiations to early 2014.

Risk assets should continue to perform if real growth continues to recover even in a higher interest rate environment; however, we expect continued volatility in the near term, especially as we await the Fed’s decision on the fate of QE. Equity market valuations remain reasonable; however, sentiment is elevated. Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high-conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Some areas of opportunity currently include:

  • Global Equity: large cap growth, dividend growers, Japan, frontier markets, international microcap
  • Fixed Income: MBS, global high yield credit, short duration
  • Absolute Return: closed-end funds, relative value, long/short credit
  • Real Assets: MLPs, company specific opportunities
  • Private Equity: company specific opportunities

Asset Class Returns

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John Coyne on Bloomberg TV

Brinker Capital Vice Chairman, John Coyne, sat down with Deirdre Bolton of Bloomberg TV to discuss the results of the 3Q13 Brinker Barometer Survey.

Click the image below to view his segment.

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Here is an infographic illustrating some of the key results from our Brinker Barometer that John discussed.

Why and How Will Housing Finance Be Reformed?

QuintStuart Quint, Sr. Investment Manager & International Strategist, Brinker Capital

The downturn in the housing market affected more than just the banks, but also the U.S. taxpayers. Nearly two out of every three dollars of mortgage debt is owned, guaranteed, or insured by agencies of the U.S. Government. The credit risk on the balance sheets of these agencies exposes the U.S. taxpayer to substantial risk in the event of a housing downturn.

The mandate to promote home ownership coupled with sub-optimal policies resulted in these agencies taking on excessive credit risk leading up to the 2008 financial crisis. Substantial credit losses from declines in home prices damaged the balance sheets of government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac. These companies were effectively nationalized during the 2008 crisis. The U.S. Federal Government was compelled to intervene by making their debt an explicit guarantee backed by the full faith and credit of the U.S. taxpayer.  While private capital withdrew from the market, the Federal Housing Administration (FHA) expanded its mortgage insurance program, especially for first-time home buyers, in the depth of the 2008 crisis. Arguably, it might have prevented the housing crisis from getting worse, but the FHA has also been saddled with credit losses and is gradually reducing its participation in the market.

11.08.13_Quint_Housing_2Rare consensus within Washington exists for promoting housing-finance reform, though details on how to implement reform vary. There is little dissension for reducing the role of the Federal Government in the housing market and thus the liability of the U.S. taxpayer. The common vision is to shift the agencies’ role toward being a lender of last resort and reducing credit exposure to last-in catastrophic exposure. Private capital should be the first line of defense in the event of another housing downturn. Policy emphasis would also change from promoting home ownership for all, to attempting to facilitate financing for home owners and renters via financing of new apartment construction.

Difference among various parties pertains to the speed and extent that this transition should occur. Some advocate an immediate unwinding of the federal agencies, though this proposal appears to have little support from majorities in either party. A more gradual unwinding, which to some extent is already occurring, appears more likely.  Agencies would cease to hold mortgages on their balance sheets while retaining their role as credit guarantors for third-party investors in exchange for a fee.

11.08.13_Quint_Housing_2_2The Senate Banking Committee hopes to issue a bill on housing reform by the end of 2013.  Timing for deliberation by both houses of Congress is tricky, but it does appear that bipartisan support for the general parameters of housing reform exists. If done in a responsible, gradual manner, housing reform could ultimately reduce risk to the U.S. taxpayer and perhaps lessen the risk of another housing collapse. However, a hasty and disorderly exit of the agencies from the mortgage market could end up restricting the flow of capital, and thus the pace of recovery in the housing market.

Safeguarding the Family Enterprise: Security

WilsonTom Wilson, Managing Director, Private Client Group &
Senior Investment Manager

This is the first installment of a continuing series on the safeguarding of the family enterprise

During a recent trip in Chicago, I had the opportunity to listen to a speech by Arnette Heintze.  Arnette is a former Secret Service agent who has since created a security firm that caters to the needs of wealthy families.  His presentation included many examples of how his firm has been deployed to safeguard these families.  Some of the stories were very alarming.

Arnette’s intent was not to scare the audience, but rather to make the attendees aware that threats to wealthy families are real.  From harassment and name defamation, to extortion and blackmail, to the more personal security issues of stalking, threats, and kidnapping.  The wealthy family demographic has a variety of security challenges.

Many families contact security firms after a crisis has arisen.  This is unfortunate as preventative measures can have a meaningful reduction in the risks to families.

10.29.13_Wilson_SafguardingFamilyEnterprise_SecurityA holistic approach to wealth management can go beyond asset allocation and financial planning.  If you have not discussed the subject of security with your wealthy families, consider including this on the agenda in your next meeting.  After all, awareness is one of the best preventative measures.

Investment Insights Podcast

Miller_PodcastMr. Miller comments on the U.S. Energy Renaissance, as reported by our friends at ISI (International Strategy & Investment Group LLC) in their Daily Economic Report as of October 31, 2013.

On this week’s podcast (recorded October 31, 2013):

  • What We Like — U.S. energy production increased in September to an all-time high
  • What We Don’t Like — Weaker survey data
  • What We are Doing — Looking for good ideas in the energy service industry.

Click the play icon below to launch the audio recording.

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The views expressed above are those of Brinker Capital and are not intended as investment advice.

Financial Advisors Finally Confident in U.S. Economy, Q3 Brinker Barometer Finds

We have the results of our third quarter 2013 Brinker Barometer® survey, a gauge of financial advisor confidence and sentiment regarding the economy, retirement savings, investing and market performance.

For the full press release, please click here, but in the meantime check out the infographic below for some of the highlights:

BrinkerBarometer3Q2013_WebFINAL

Sentiment

Jeff RauppJeff Raupp, CFA, Senior Investment Manager

In February 1637, tulip bulbs sold in Holland for as much as 4,000 guilders each, over 10x the amount a skilled craftsman would earn in a year.  Months later, many tulip traders found themselves holding bulbs worth just a fraction of what they had paid for.

As crazy as prices got, tulip mania actually started with good fundamentals. Tulips were a relatively new introduction to Europe, and the flower’s intense color made it a heavily-desired feature of upper-class gardens. Most desirable were the exotic-looking, multi-colored tulips, which was caused by a mosaic virus not identified until the 1970s and now called the “tulip-breaking virus.” At best, tulip bulbs weren’t easy to produce and those with the virus suffered even lower reproduction rates. In the beginning, what occurred in the tulip market was classic supply and demand—a highly sought-after item with limited supply increasing in price. In 1634, that started to change as 11.1.13_Raupp_Sentimentspeculators were attracted to the rising prices, and in late 1636 prices started to accelerate rapidly, to where even single-color tulips were attracting prices of over 100 guilders apiece. The Dutch created a futures market for tulips that enabled traders to purchase and trade contracts to buy bulbs at the end of the season. At the peak, tulips could be traded several times a day without any physical tulips actually being exchanged or either party ever having any intention of planting the bulbs.

Then in February 1637, buyers vanished. Some suspect an outbreak of the bubonic plague as the cause, some a change in demand caused by war in Europe. Any way you look at it, the sentiment for the future price of tulip bulbs took a big U-turn, leaving many investors ruined.[1]

11.1.13_Raupp_Sentiment_1History is full of similar episodes, where investor sentiment got to extreme levels and prices diverged meaningfully from the underlying fundamental value of something, be it stocks, real estate, currency, or even tulip bulbs. Most recently the dot-com bubble in the early 2000s and the housing bubble in 2008 proved that speculation is alive and well.

While periods of extreme sentiment are easy to identify in retrospect, they’re anything but obvious while you’re in them. And while extreme levels of sentiment usually result in big price reversals, more modest levels can mark periods when the market is overbought or oversold, often followed by a market pull-back or rally. Recently, Robert Shiller of Yale University won the Nobel Prize in Economics for his work on irrational markets.

11.1.13_Raupp_Sentiment_2So how can you gauge sentiment? Some of the more popular ones are the Consumer Confidence Index and the Michigan Consumer Sentiment Index, which both try to gauge consumer’s attitudes on a variety of things, including future spending, the business climate, and their level of optimism or pessimism. More direct, and generally more volatile, are the AAII Investor Sentiment Survey and the Wells Fargo/Gallup Investor and Retirement Optimism Index, which ask investors directly about their thoughts on investments. It doesn’t end there. Investors watch Closed-End Fund discounts, Put/Call ratios, even tracking the occurrence of certain words or phrases in the media. In addition, many firms create their own blend of surveys and indexes to best gauge the overall sentiment level.

Sentiment certainly isn’t the be-all, end-all for trading your portfolio. There’s a saying that is attributed to John Maynard Keynes, “The market can remain irrational longer than you can remain solvent.” When sentiment starts moving in one direction, it’s hard to say when the reversal will occur and what will cause it. But knowing where sentiment levels are at any given time can help you get a better understanding of what markets have been doing and what to expect going forward.


[1] Mackay, Charles (1841), Extraordinary Popular Delusions and the Madness of Crowds, London: Richard Bentley, archived from the original on March 31, 2008.