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Portfolio Construction & Systematic Risk

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Portfolio Construction & Systematic Risk

Vir­tu­al­ly every port­fo­lio man­ag­er claims to invest in a risk-con­trolled man­ner. How­ev­er, investors look­ing at their month­ly state­ments dur­ing the cred­it cri­sis of 2007-08 were prob­a­bly won­der­ing what hap­pened to those risk con­trols as their wealth plum­met­ed.

How were these loss­es pos­si­ble? If both the top-down, port­fo­lio-builders and the bot­tom-up, stock-pick­ing mon­ey man­agers were all focused on risk, how did investors man­age to lose so much mon­ey in such a short peri­od of time?

One expla­na­tion is that there are dif­fer­ent ways to think of and define risk.

MVO Portfolio Construction

Many port­fo­lios were con­struct­ed using mean-vari­ance opti­miza­tion (MVO), a strat­e­gy that seeks to min­i­mize the volatil­i­ty of an over­all port­fo­lio by diver­si­fy­ing across uncor­re­lat­ed asset class­es. At this top-down lev­el, risk is defined as volatil­i­ty, or how much an invest­ment devi­ates from its long-term aver­age. The very tech­nique used in the cre­ation of many port­fo­lios- mean-vari­ance opti­miza­tion — reveals the objec­tive of the strat­e­gy. MVO opti­mizes the return-ver­sus-volatil­i­ty trade-off.

Once the over­all port­fo­lio strat­e­gy was set, the job of actu­al­ly invest­ing was often imple­ment­ed by a col­lec­tion of active man­agers.

Active man­agers often have a dif­fer­ent def­i­n­i­tion of risk. For many active man­agers risk is mea­sured against a pas­sive mar­ket bench­mark, such as the S&P 500 or the Rus­sell 2000. Posi­tions are tak­en to over- or under­weight an aspect of a bench­mark. Suc­cess is mea­sured in terms of bench­mark met­rics – for exam­ple, rel­a­tive met­rics like alpha or infor­ma­tion ratio. Insights are gleaned via Elephant-in-the-roomattri­bu­tion analy­sis quan­ti­fy­ing the sec­tor or stock picks that helped or hurt rel­a­tive per­for­mance.

What do all of these steps have in com­mon? The frame­work for think­ing of and mea­sur­ing risk is all rel­a­tive to a mar­ket bench­mark.

The Elephant in the Room — Systematic Risk

So what is miss­ing in this approach? How does this mod­el some­times fall woe­ful­ly short? The ele­phant in the room is mar­ket risk, some­times known as sys­tem­at­ic risk. Nei­ther the top-down asset allo­ca­tion strat­e­gy or bot­tom-up stock selec­tion, explic­it­ly address­es mar­ket risk. 

When the mar­ket racked up loss­es of over 50% in 2007-08, both the asset allo­ca­tors and the stock selec­tors were able to claim they were doing what they were hired to do – build a port­fo­lio in the asset allocator’s case and pick win­ning stocks in the stock picker’s case. Yet, we find that nei­ther the asset allo­ca­tors nor the stock pick­ers are address­ing mar­ket risk.

Defining Risk in Portfolio Construction

Swan’s Defined Risk Strat­e­gy (DRS) is built dif­fer­ent­ly. At its incep­tion in 1997, the pri­ma­ry objec­tive of the DRS was to remain invest­ed while direct­ly man­ag­ing and avoid­ing the large mar­ket sell-offs that peri­od­i­cal­ly befall the mar­ket.

For Swan, risk man­age­ment is defined as min­i­miz­ing the depth, dura­tion, and fre­quen­cy of loss­es. For more on the mer­its of mea­sur­ing risk in this man­ner, see our post on the Pain Index and the Pain  Ratio.

The DRS strat­e­gy is always invest­ed in the mar­ket, and always hedges its invest­ment in the mar­ket via pro­tec­tive put options, with the goal of cap­i­tal preser­va­tion in down mar­kets and sig­nif­i­cant par­tic­i­pa­tion in up mar­kets.

It is because of this unique approach to direct­ly address risk that the DRS can replace both the top-down asset allo­ca­tion and the bot­tom-up active man­age­ment. The DRS sup­plants both tra­di­tion­al approach­es by defin­ing risk in terms of loss­es and active­ly address­ing that risk by hedg­ing.

To learn more about Swan’s DRS invest­ment approach and how this approach has fared in the past, please con­tact Swan at 970–382-8901.

 

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

Impor­tant Dis­clo­sures: Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non­qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains.  This analy­sis is not a guar­an­tee or indi­ca­tion of future per­for­mance. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970.382.8901 or vis­it swanglobalinvestments.com.  017-SGI-042715[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]

By | 2017-08-21T15:14:08+00:00 October 15th, 2016|Blog|Comments Off on The Elephant in the Room: Systematic Risk