Managing Personal Wealth in Volatile Markets

Transcription

1 Click to edit Master title style Managing Personal Wealth in Volatile Markets An ERM Approach Jerry A. Miccolis, CFA, CFP, FCAS March 15, 2011 Call :: Visit brintoneaton.com

2 By way of (re)introduction Principal & Chief Investment Officer, Brinton Eaton Wealth Advisors Former Principal & ERM Global Practice Leader, Towers Perrin Former Chair, CAS ERM Committee Author/co-author: Asset Allocation For Dummies (Wiley, May 2009) Enterprise Risk Management: Trends and Emerging Practices (IIA, June 2001) Related publications Member of the Financial Planning Association (FPA) and the New York Society of Security Analysts (NYSSA) 35+ years of actuarial, risk management, and investment experience Call :: Visit brintoneaton.com 1

3 A brief overview of today s discussion Personal wealth management is risk management ERM is the natural conceptual framework to build and protect wealth This has certain implications Investment strategy needs to be focused on the right goals MPT needs modernization Asset allocation needs to be dynamic Catastrophe protection needs to be creative Ask questions! All this is achievable with currently available tools Call :: Visit brintoneaton.com 2

4 Investing has always been an exercise in taking, and managing, risk But, the game has changed DB plans DC plans, 401(k)s Underfunded Social Security Risk-shifting to the individual investor Now, more than ever, wealth management IS risk management And the risks are substantial 2008 a wake-up call; contagion like never before It can happen again Fault lines in MPT have been starkly exposed Something more is needed Call :: Visit brintoneaton.com 3

5 Enter ERM MPT ERM MPT ERM owes a lot to MPT It s time for ERM to return the favor Premise: the core principles of ERM can form the basis for successfully building personal wealth Build on four key pillars of ERM Strategic focus Natural hedging Risk exploitation Catastrophe protection Call :: Visit brintoneaton.com 4

6 These four pillars support a strong bridge between corporate and personal best practices ERM Pillar Organizational ERM Individual ERM Strategic Focus Natural Hedging Risk Exploitation Catastrophe Protection Customize risk management around, and in service to, the organization s specific strategic objectives Look across operational silos to find risky operations that offset each other Use the ERM-enlightened view to do informed risk-taking, exploiting areas deemed too risky by competitors Transfer only those risks that can t naturally be hedged away, and insure those risks only at catastrophic levels Customize your investment strategy around your own unique long-term financial objectives which is the real purpose of your investments Diversify and allocate investments among uncorrelated asset classes using up-to-date tools Employ informed risk-taking to exploit highperforming but risky assets making volatility work for you Use safety net portfolio protection as catastrophe insurance against major market shocks that diversification can t handle and in a cost-effective way Brinton Eaton, 2011 Call :: Visit brintoneaton.com 5

7 Strategic Focus ERM Pillar Organizational ERM Individual ERM Strategic Focus Natural Hedging Risk Exploitation Catastrophe Protection Customize risk management around, and in service to, the organization s specific strategic objectives Look across operational silos to find risky operations that offset each other Use the ERM-enlightened view to do informed risk-taking, exploiting areas deemed too risky by competitors Transfer only those risks that can t naturally be hedged away, and insure those risks only at catastrophic levels Customize your investment strategy around your own unique long-term financial objectives which is the real purpose of your investments Diversify and allocate investments among uncorrelated asset classes using up-to-date tools Employ informed risk-taking to exploit highperforming but risky assets making volatility work for you Use safety net portfolio protection as catastrophe insurance against major market shocks that diversification can t handle and in a cost-effective way Brinton Eaton, 2011 Call :: Visit brintoneaton.com 6

8 What s your situation? Lifestyle Requirements Planning Horizon Risk Tolerance Income Sources Retirement Objectives Investable Assets Gifting/estate Intentions Tax Status Charitable Inclinations Investment Constraints Call :: Visit brintoneaton.com 7

9 What s riskier? Call :: Visit brintoneaton.com 8

10 Hard Luck Harry has a choice to make Risk doesn t exist in a vacuum Call :: Visit brintoneaton.com 9

11 Lifetime Cash Flow Projections Assumptions Call :: Visit brintoneaton.com 10

12 Lifetime Cash Flow Projections Assumptions Call :: Visit brintoneaton.com 11

13 Lifetime Cash Flow Projections Results Call :: Visit brintoneaton.com 12

14 The results can be counter-intuitive Illustrative Client Example 88 Confidence Level E 83 D 82 A B C Beginning Investment Strategy D E A B C Ending Investment Strategy Call :: Visit brintoneaton.com 13

15 Strategic Focus Recap Customize your investment strategy around your own unique long-term financial objectives which is the real purpose of your investments Your financial situation has many moving parts Financial planning tools can capture the complexities in a coherent way The right investment strategy is the one that best secures your own financial future Call :: Visit brintoneaton.com 14

16 Natural Hedging ERM Pillar Organizational ERM Individual ERM Strategic Focus Natural Hedging Risk Exploitation Catastrophe Protection Customize risk management around, and in service to, the organization s specific strategic objectives Look across operational silos to find risky operations that offset each other Use the ERM-enlightened view to do informed risk-taking, exploiting areas deemed too risky by competitors Transfer only those risks that can t naturally be hedged away, and insure those risks only at catastrophic levels Customize your investment strategy around your own unique long-term financial objectives which is the real purpose of your investments Diversify and allocate investments among uncorrelated asset classes using up-to-date tools Employ informed risk-taking to exploit highperforming but risky assets making volatility work for you Use safety net portfolio protection as catastrophe insurance against major market shocks that diversification can t handle and in a cost-effective way Brinton Eaton, 2011 Call :: Visit brintoneaton.com 15

17 MPT the beginning Conceptual breakthrough Risk/return tradeoff Asset class correlations Efficient frontier Prudent Investor Rule MVO Single period Everything is Normal Risk is standard deviation Efficient frontier derived via closed-form solution Can solve equation by hand Useful in the 1950s! Return Risk Call :: Visit brintoneaton.com 16

18 MPT evolves High-speed computing MVC-based simulation Non-normality Fat tails Multiple periods Compound returns/risk drag Rules-based rebalancing More realistic risk measures Shortfall risk Conditional VaR MPT has come a long way Call :: Visit brintoneaton.com 17

19 but it s still only as good as its assumptions MVC Mean/Variance/Covariance Mean Expected asset class returns move in cycles Momentum/mean reversion Valuation Variance Volatility is not constant Clustering Covariance Correlation does it really measure what matters? Call :: Visit brintoneaton.com 18

20 Correlation it gets the obvious cases right ρ = +1 ρ = ρ = Call :: Visit brintoneaton.com 19

21 Correlation does it measure what matters? ρ = 0 ρ = ρ = -0.5 you name it! ρ = Call :: Visit brintoneaton.com 20

22 Correlation can it mislead? ρ = Call :: Visit brintoneaton.com 21

23 Correlation what would Scooby Doo say? ruh ρ! While the Pearson Rho correlation coefficient serves the limited purpose of quantifying the degree of linear relationship between random variables, the actual relationship among asset classes is sufficiently complex that a measure more robust, observant, relevant, asymmetric, multi-dimensional, and dynamic is needed to capture the deep, imbedded, structural relationship among those asset classes Call :: Visit brintoneaton.com 22

24 Clearly, improvements in MPT tools and techniques are needed Correlations ρ ρ ρ ρ ρ ρ ρ ρ ρ ρ copulas MVC (statistical) models Parameter risk ARMA momentum/mean reversion structural models GARCH volatility in volatility, clustering Risk budgeting Regime-based optimization Call :: Visit brintoneaton.com 23

25 Natural Hedging Recap Diversify and allocate investments among uncorrelated asset classes using up-to-date tools MPT is still the right conceptual framework But, most applications are very much out of date The needed tools are available Call :: Visit brintoneaton.com 24

26 Risk Exploitation ERM Pillar Organizational ERM Individual ERM Strategic Focus Natural Hedging Risk Exploitation Catastrophe Protection Customize risk management around, and in service to, the organization s specific strategic objectives Look across operational silos to find risky operations that offset each other Use the ERM-enlightened view to do informed risk-taking, exploiting areas deemed too risky by competitors Transfer only those risks that can t naturally be hedged away, and insure those risks only at catastrophic levels Customize your investment strategy around your own unique long-term financial objectives which is the real purpose of your investments Diversify and allocate investments among uncorrelated asset classes using up-to-date tools Employ informed risk-taking to exploit highperforming but risky assets making volatility work for you Use safety net portfolio protection as catastrophe insurance against major market shocks that diversification can t handle and in a cost-effective way Brinton Eaton, 2011 Call :: Visit brintoneaton.com 25

27 Diversification reduces risk $270 $250 $230 $210 Asset A Asset B 50/50 Mix $190 Account Balance $170 $150 $130 $110 $ Year Call :: Visit brintoneaton.com 26

28 Rebalancing improves return $270 $250 $230 $210 $190 Asset A Asset B 50/50 Mix Rebalanced 50/50 Mix Account Balance $170 $150 $130 $110 $ Year Call :: Visit brintoneaton.com 27

29 What about in real life? S&P 500 US RE Call :: Visit brintoneaton.com 28

30 Diversification reduces risk in real life too 11.7% Results Return 11.6% 11.5% 11.4% 11.3% S&P 500 US Real Estate Combined 50/ % 11.1% 11.0% 15.0% 16.0% 17.0% 18.0% 19.0% 20.0% Risk Call :: Visit brintoneaton.com 29

31 and it also improves return 11.7% Results Return 11.6% 11.5% 11.4% 11.3% S&P 500 US Real Estate Combined 50/50 Combined w/ rebalancing 11.2% 11.1% 11.0% 15.0% 16.0% 17.0% 18.0% 19.0% 20.0% Risk Call :: Visit brintoneaton.com 30

32 Rebalancing puts the inherent volatility among assets to work for you Call :: Visit brintoneaton.com 31

33 The more volatile your assets, the more mileage you get from rebalancing The more distance your pistons travel, the more powerful your engine Call :: Visit brintoneaton.com 32

34 There is a more proactive way to exploit risk Dynamic asset allocation Explicitly treats momentum/mean reversion Utilizes early warning indicators Signals can be internal and external Moving average algorithms Valuation measures DAA reflects the fact that MPT is only as good as its assumptions Recognizes that assumptions can change dynamically Structurally sound way to: Test your foundational assumptions Nimbly make adjustments as appropriate Leading Economic Indicators Credit spreads/money flows Call :: Visit brintoneaton.com 33

35 Sector rotation is an example of DAA Call :: Visit brintoneaton.com 34

36 Risk Exploitation Recap Employ informed risk-taking to exploit high-performing but risky assets making volatility work for you Rebalancing is the classic way to exploit volatility Dynamic asset allocation takes rebalancing to the next level You can capture higher returns than those investors who have a less enlightened risk perspective Call :: Visit brintoneaton.com 35

37 Catastrophe Protection ERM Pillar Organizational ERM Individual ERM Strategic Focus Natural Hedging Risk Exploitation Catastrophe Protection Customize risk management around, and in service to, the organization s specific strategic objectives Look across operational silos to find risky operations that offset each other Use the ERM-enlightened view to do informed risk-taking, exploiting areas deemed too risky by competitors Transfer only those risks that can t naturally be hedged away, and insure those risks only at catastrophic levels Customize your investment strategy around your own unique long-term financial objectives which is the real purpose of your investments Diversify and allocate investments among uncorrelated asset classes using up-to-date tools Employ informed risk-taking to exploit highperforming but risky assets making volatility work for you Use safety net portfolio protection as catastrophe insurance against major market shocks that diversification can t handle and in a cost-effective way Brinton Eaton, 2011 Call :: Visit brintoneaton.com 36

38 Traditional ways to protect portfolios are not enough High allocation to cash / US Treasuries Precious metals Annuities Puts / collars Call :: Visit brintoneaton.com 37

39 More creative approaches are needed Additional portfolio diversifiers Market neutral/absolute return strategies Commodity momentum plays Portfolio safety nets Hybrid puts Correlation plays Volatility plays Buyer beware Call :: Visit brintoneaton.com 38

40 Criteria for an effective safety net Sudden appreciation in severe market downturns Severe denoting sudden, substantial, unexpected decline in market value across most major asset classes, as in 4Q08 (i.e., when diversification doesn t help) Appreciation to a degree sufficient to meaningfully offset the decline No give-back during market recovery! Very low cost Minimize diversion of funds from productive use No sacrifice of upside portfolio potential I.e., it is insurance we expect not to use Minimal disruption to portfolio Maintain what works in vastly more likely markets Don t throw the baby out with the bathwater Call :: Visit brintoneaton.com 39

41 The criteria in a picture Call :: Visit brintoneaton.com 40

42 Effect on the portfolio Call :: Visit brintoneaton.com 41

43 How does it work? S&P 500 Total Return Index 9/22/10-9/28/10 Volatility swap /22/2010 9/23/2010 9/24/2010 9/25/2010 9/26/2010 9/27/2010 9/28/2010 Buys daily volatility Sells weekly volatility Published index; transparent formula Accessed via a structured note 1X exposure to S&P 500 Stock Index 3X exposure to swap index Call :: Visit brintoneaton.com 42

44 Catastrophe Protection Recap Use safety net portfolio protection as catastrophe insurance against major market shocks that diversification can t handle and in a cost-effective way Treat only those risks that asset allocation/ rebalancing aren t designed to cover Think outside the box, as traditional risk hedges are inferior on several levels Call :: Visit brintoneaton.com 43

45 Have we covered all the bases? Personal wealth management is risk management ERM is the natural conceptual framework to build and protect wealth This has certain implications Investment strategy needs to be focused on the right goals MPT needs modernization Asset allocation needs to be dynamic Catastrophe protection needs to be creative Ask questions! All this is achievable with currently available tools Call :: Visit brintoneaton.com 44

46 For more information on these ideas Read: AssetAllocationBook.com Visit: Library Research Briefs White Papers Podcasts Webinars Blog Call: Call :: Visit brintoneaton.com 45