Risk, relatively speaking…
It is doubtful that there is an investment manager in the business today who hasn’t been thoroughly interrogated about their risk control processes. In meetings with clients and consultants, money managers are regularly put through their paces on how they control their benchmark risk, company risk, and a swarm of other factors that may – or may not – impact a client’s portfolio. These statistical measures of risk are almost all relative to a benchmark, not absolute measures, belying the underlying assumption that the asset class will generate the return needed; all the manager has to do is control relative risk.
This then, of course, puts the onus on the client (or, perhaps more accurately, on the consultant) to come up with an asset allocation designed to generate a return in line with their needs. And again, despite the absolute return needed by the client, risk control questions are primarily relative in nature. And throughout the process of asset allocation, manager selection and periodic reviews, the assumption is the market is efficient and that asset classes will generate returns that won’t be lost by managers employing appropriate risk control techniques.
The investment industry – or rather, the business of investment management – likes this current state of affairs: it’s a lot easier to measure and control statistical relative risk than it is to build a portfolio using a fundamental, bottoms-up, research driven process. Deviations from benchmarks can be quickly identified and corrected, reducing business risk for the investment manager. Diversification supplants research as a means of portfolio construction, reducing operating costs and key person risk. And finally, managing relative risk reduces the probability of losing a client’s assets due to price declines as the market is to blame for draw-downs, not the manager – of course, as long as the manager doesn’t relatively underperform.
Unfortunately, this focus on relative risk had a major fail in the “drawdown” of 2008/2009, doing little to identify the risk of embedded leverage in the financial system in the years prior to the collapse. This was a fundamental risk, not a risk that could have been identified by statistical analysis. So when asset prices collapsed, nearly all asset classes move in lock-step. Correlations between asset classes moved toward one.
The paradigm of evaluating risk using relative statistical measure from a top-down perspective remains in place today. And though it may be effective in identifying risks relative to other portfolios – or benchmarks – it has proven to be less so at identifying fundamental risks: those risks that are endemic to business and finance and markets. And it is these fundamental risks that are the yin-to-the-yang or risk and return that investors should be trying to capture; these are the risks that generate reward.
Volatility, sector over-weightings and other statistical risks are faint indicators of the risk in any portfolio, and have little relevance to the reward that investors should be seeking when they put their assets in the care of a fiduciary.
But as before the rise of the risk manager, there are still investors whose primary objective is absolute performance. For these people and firms, portfolio construction doesn’t start with a benchmark, but with an investment philosophy rooted in the objective of wealth creation. For them, volatility is seen as opportunity, not risk. And it is to this type of investor that the future will belong, as those that are focused on controlling their risk will completely lose sight of the opportunity to build wealth.
The material provided herein has been provided by Linde Hansen & Co. and is for informational purposes only. Linde Hansen & Co. serves as investment adviser to one or more mutual funds distributed through Northern Lights Distributors, LLC member FINRA. Northern Lights Distributors, LLC and Linde Hansen & Co. are not affiliated entities. 1434-NLD-9/19/2012This entry was posted in Contrarian Thoughts. Bookmark the permalink.