Portfolio management guide 2018

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PORTFOLIO MANAGEMENT: THEORY & PRACTICE LAST REVISED APRIL 2008 SCHULTZ COLLINS LAWSON CHAMBERS, INC. INVESTMENT COUNSEL 455 MARKET STREET, SUITE 1450 SAN FRANCISCO, CA 94105 (415) 291-3000 www.schultzcollins.com COPYRIGHT © 2008 TABLE OF CONTENTS Preface: Obstacles To Prudent Investment Decision Making ...................................................... 1 Obstacles to Prudent Decision Making ................................................................................ 2 Chapter One: Basic Investment Concepts .................................................................................... 5 Investment Objectives and the Investment Policy Statement ............................................ 5 Investment Prudence............................................................................................................. 7 Market Efficiency ................................................................................................................... 8 Risk ....................................................................................................................................... 11 Diversification ...................................................................................................................... 12 Asset Allocation .................................................................................................................... 17 Chapter Two: Asset Classes And Asset Class Investing ............................................................. 21 U.S. Equities ......................................................................................................................... 21 U.S. Fixed Income ................................................................................................................ 24 International Equity .............................................................................................................. 26 International Bonds ............................................................................................................. 30 Real Estate ........................................................................................................................... 33 Emerging Markets ................................................................................................................ 37 Chapter 3: Dimensions of Risk and Return ................................................................................ 41 Aspects of the U.S. Money Management Industry ............................................................. 41 Value/Growth Asset Class Investing v. Undervalued Stock Picking ................................. 43 The Historical Evidence: Is Value a Strong Law of Asset Pricing? ..................................... 46 The Small Company / Large Company Dimension ............................................................ 50 The Three Factor Model: Empirical Results ........................................................................ 53 Factor Loading and Unsystematic risk ............................................................................... 56 Chapter Four: Building the Portfolio ............................................................................................ 58 The Risk / Return Continuum ............................................................................................. 58 Starting In ................................................................................................................................ 62 Defining Asset Class Weightings ......................................................................................... 63 Chapter Five: Investment Strategies and Investment Vehicles ................................................. 65 Active versus Passive Management ................................................................................... 66 Active Management ............................................................................................................. 66 Performance of Active Managers ........................................................................................ 70 Survivorship Bias ................................................................................................................. 73 Performance Consistency CASE STUDY: THE FORBES MAGAZINE ‘HONOR ROLL’ .......... 74 Evaluating Active Manager Performance ........................................................................... 76 Passive Management .......................................................................................................... 79 Evaluating Passive Fund Performance ............................................................................... 80 Chapter Six: Portfolio Management............................................................................................. 82 Asset Allocation Approaches ............................................................................................... 82 Theoretical Payoffs to Different Asset Management Approaches .................................... 83 Impact of Trading Activity on Portfolio Returns .................................................................. 85 Liquidity Costs of Portfolio Management Strategies ......................................................... 87 Trading Decisions, ‘Best Execution’ and Loss of Investor Wealth .................................... 88 Taxes, Inflation and Turnover .............................................................................................. 89 Conclusion: Independent Investment Counsel ........................................................................... 92 Investment Policy and the Prudent Investor Rule .............................................................. 93 Our Approach to Portfolio Supervision ................................................................................ 93 PREFACE: OBSTACLES TO PRUDENT INVESTMENT DECISION MAKING More money is better than less. The paradox of investing is that, although investors generally agree with this statement, the pursuit of more money is not always prudent. This paradox explains, in part, why Schultz Collins Lawson Chambers, Inc. SCLC is not a money management firm. Money managers often seek to generate attractive performance results by trying to identify undervalued securities with above average prospects for future growth or income. Money managers market the portfolios formed from these ‘mispriced’ securities either to the retail public or to wealthy individuals qualifying as “sophisticated investors” under current securities laws. The easiest way for a money manager to claim superior performance is to outperform either their peer group of competitors or a benchmark such as the S&P 500 Stock Index. While this may sound like a good idea, many investors lack a clear understanding of the functional relationship between their personal and unique investment goals and the index returns that they see on the nightly business report. Is the return of the index sufficient to fund their future consumption and wealth accumulation objectives? Does the risk of an index align with their personal risk tolerance? Is the money manager taking greater risk than the index? Despite, or, perhaps because of the difficulty of interpreting personal goals in terms of risk and return, for many investors the investment problem reduces itself to finding a money manager with a good track record—a manager who can “beat the market.” Curiously, however, a money manager’s primary goal (the speculative objective of beating the market) is only tangentially related to the investor’s objectives—securing a retirement income, accumulating funds to pay college expenses, maintaining wealth sufficient to make gifts or bequests, and so forth. Prudent investment decision making is complex and extends well beyond the single dimension of historical track record. Prudent investing requires that the risks and returns of the portfolio align with concrete investor objectives rather than with abstract ‘beat-the-market’ goals. Undoubtedly, portfolios must generate returns sufficient to support the legitimate needs and expectations of their owners; however, such a portfolio is best synchronized to the investor’s aspirations rather than designed to outperform a peer group. Investment strategies desiged to maximize expected return may prove to be either financial bonanzas or financial catastrophes. Investment strategies designed to enchance the probability that a critical goal will be successfully met, however, are more prudent and suitable for most investors. Prudent investment decision making begins when the discourse shifts from discussing how to maximize return to determining the risks and returns required to secure an economic future. If you don’t need to outperform the S&P 500 to have a secure economic future, why should you take the risks necessary to do so? SCLC helps investors design portfolios to meet their savings and consumption objectives, within the preferences and constraints imposed by their personal circumstances and risk tolerance. Historically, the professional U.S. money management industry has offered investors a ‘treasure hunting’ model. Success under the treasure hunting model is a function of the manager’s skills in selecting undervalued securities and in timing price movements either between or within capital markets. The treasure hunting model requires correct and highly concentrated bets. For a variety of reasons, however, this ability has proved elusive. Although treasure hunting has produced examples of investment success, it has not served the average investor well: …the industry looks very much like an unconcentrated, highly segmented, service-oriented industry for which perceptions of the qualities of individual firms vary widely over time and across customers. The structure of this industry is not unlike that of hair salons or trendy restaurants…Money managers who can provide a good story about their strategy have a comparative advantage. In fact, the product sold by the professional money managers is not 1 just good performance but schmoozing, frequent discussion of investment strategies, and 1 other forms of hand holding. In the following pages, SCLC offers a view of portfolio design and management that is more prudent than traditional treasure hunting. A prudent investment approach begins by identifying the returns required to generate money sufficient to meet the wealth accumulation goals or cash flow liabilities that the portfolio must discharge. Although returns above the risk-free rate require investors to take risk, investment risks must be commensurante with the return objectives. Furthermore, both risk and return must be measurable and consistent with investor needs and risk tolerance. A prudent approach evaluates the evolution of the portfolio not solely in comparative terms (did I do better than a benchmark or a peer group?), but also in terms of progress towards objectives. OBSTACLES TO PRUDENT DECISION MAKING Many people have difficulty making effective investment decisions. Investors face significant obstacles: Complexity - informed financial decisions require insight into abstruse financial, economic, and mathematical relationships; and may require serious introspection to define personal objectives; Uncertainty - decisions must be made without complete knowledge of future consequences. Good decisions do not guarantee successful outcomes; bad decisions may result in outcomes that succeed by mere chance; Conflicting Objectives - an investment decision may facilitate progress towards one objective (e.g., generating current income in support of a dependent) while, simultaneously, impeding progress towards an equally important objective (e.g., wealth accumulation); Lack of Perspective or Multiple Perspectives - issues may be difficult to resolve because differing perspectives on the same data set can lead to different conclusions. An investor who remembers the Great Depression may, upon reviewing stock market returns, reach conclusions entirely different from those of an investor who started accumulating wealth in the 1980’s; Information Overload - investors are deluged by an ever-deepening torrent of financial, economic legal and tax information. Determining which data really matter may be close to impossible. Successful investors must overcome these obstacles. A general understanding of the fundamental nature of capital markets and investments is a necessary starting point. Recent advances in the scientific understanding of markets make it possible to deal with each of these obstacles systematically. This document provides an overview of relevant academic developments pertaining to financial economics and portfolio management. We first address some basic investment concepts that investors must consider in formulating any successful investment program. These include investment prudence, market efficiency, risk, diversification, and asset allocation. We then proceed to a more detailed discussion of the mechanics of portfolio construction and wealth management. Topics include: Characteristics of asset classes that may be included in a portfolio; Determinants of return: Designing a suitable portfolio structure; 1 Lakonishok, Josef, Shleifer, Andrei & Vishny, Robert W., “The Structure and Performance of the Money Management Industry,” Brookings Papers On Economic Activity (Brookings Institution, 1992), pp. 339-391. 2 Selecting appropriate investment vehicles; and An overview of alternative asset management approaches. Often, there are no absolute “right” or “wrong” decisions. Depending on the context of the decision, one course or another may be appropriate. As Independent Investment Counsel, SCLC’s primary job is to 1. Help investors make good decisions by informing them about the merits of alternative investment elections; 2. Facilitate the implementation and supervision of a portfolio once investment strategies and tactics have been selected; and, 3. Evaluate the economic consequences of asset management decisions as the portfolio unfolds over time. This monograph introduces investors to important investment topics and to fundamental concepts in asset management. It is not an introductory textbook in investment analysis; nor, is it a self-help guide on how to pick winning securities. Rather, its purpose is to provide a non-technical understanding of 1. the nature and scope of prudent investment policy decision making (good decisions increase the probability of good outcomes); 2. how to evaluate the variety of portfolio management elections that are available to you; and, 3. how to select the portfolio management elections that are best suited to your particular investment objectives. Investor’s sometimes confuse ‘making money’ or ‘generating investment returns’ with investment policy— “my ‘policy’ is to make money.” However, a return generating process that does not flow from a carefully considered investment plan often relies on mere luck. Depending on the nature and scope of the investment endeavor, investment policy encompasses the planning steps required to determine:  Which assets are suitable investments (asset selection and retention policy)?  How should the investor combine the assets into a portfolio (asset allocation policy)?  What is the portfolio return required to achieve my investment objectives (‘required’ return vs. ‘desired’ return)?  What is the portfolio’s risk (the probability of failing to meet the required return over the applicable planning horizon)?  Does the portfolio require tax payments (tax management policy)?  Does the portfolio require periodic adjustments to maintain its strategic asset allocation (rebalancing policy)?  If the portfolio is funding periodic distributions, how much money can be spent without jeopardizing the investment capital (distribution policy)?  If the portfolio consists of several taxable and non-taxable accounts, what is the optimal location for the assets (asset location policy)?  As the portfolio evolves through time, how are investment results evaluated (monitoring and evaluation policy)? If this process is completed with sufficient care, skill and caution, the investor may begin the return generating process armed with the confidence that investment choices have been well considered prior to their implementation. Although a prudent decision making process cannot guarantee a good result, it 3 greatly enhances the probability of a successful financial outcome. SCLC’s website (www.schultzcollins.com) is a source for more information, often at a greater level of detail. Previous issues of two publications Investment Quarterly and Fiduciary Forum may be found on the website. Additionally, the website contains working papers, reprints of published articles, and links to other helpful information and resources. For clients of SCLC, there is a special password-protected area that permits access to course notes from Economics 746: Asset Management. This course, taught by Patrick Collins, is part of the University of San Francisco’s Masters of Science (combined MBA / Masters in Financial Analysis) curriculum. The lecture notes provide an advanced discussion of many of the topics covered in this document. 4 CHAPTER ONE: BASIC INVESTMENT CONCEPTS Certain basic concepts are necessarily incorporated into any investment program, whether or not the investor is aware of their significance: Investment objectives and the Investment Policy Statement; The Prudent Investor Rule; Market efficiency; Risk; Diversification; Asset allocation. INVESTMENT OBJECTIVES AND THE INVESTMENT POLICY STATEMENT Every investor has objectives, however loosely defined. When objectives are not clearly and consciously articulated, investors may make decisions that actively frustrate their attainment. It is therefore wise to clarify investment objectives, so as to gain a clear understanding of what the portfolio is intended to accomplish. It is particularly important to distinguish between desired return and required return. Investors may believe that high rates of expected return are better than lower rates of expected return (the “non–satiation principle” states that more money is always better than less). However, the connection between rates of return and spendable dollars is opaque. Higher rates of return entail greater risk; and, the greater the risk, the greater the uncertainty regarding future dollar wealth. Another way of understanding invesment risk, therefore, is to treat it as the level of uncertainty that critical goals will, in fact, not be reached. This risk is known as “shortfall risk.” Good decision making is possible only when the investor knows that the portfolio’s expected return is sufficient to the task and that the shortfall risk is within the bounds of prudence. Compound return, which determines the portfolio’s terminal wealth, is approximated, in lognormal 2 distributions, by the equation:A Compound return = average return -1/2(variance of return). This equation says that dollar wealth is increasing with respect to the portfolio’s rate of return, but 3 decreasing with respect to the variance in the return. 2 A lognormal distribution has a bell curve shape. 3 Investors spend dollars not rates of return. It is possible to construct a portfolio with a high expected rate of return that produces a paltry amount of spendable dollars. This result is another investment paradox; and, is a reason for establishing sound investment policy prior to buying or selling securities. As Yogi Berra remarked: “If you don’t know where you are going, you may end up somewhere else.” 5 4 Mitigating variance—or, as it is usually expressed, standard deviation of returns —therefore makes the wealth-building process more likely to succeed. In fact, an investor can often generate more long-term spendable wealth by employing risk control strategies desiged to mitigate variance than by simply chasing higher expected returns. It is apparent that mere labels and slogans e.g., “growth,” “double-digit return,” “safety,” “low risk,” “balanced,” “all-weather portfolio,” “disciplined investing process” are too subjective and ill-defined for prudent portfolio design. It is folly to Implement the portfolio process without understanding both the compound return required for savings and consumption objectives, and the likelihood of falling short of portfolio objectives. In a nutshell, the portfolio’s expected return must align with the required return at a risk level that allows for a good night’s sleep. The prudent investor seeks not just expected return, but overall welfare. Furthermore, the prudent investor monitors progress towards the goal (and makes appropriate adaptations as the future unfolds) rather than trusting in blind luck. Investors should document investment objectives in a written Investment Policy Statement IPS. An IPS is the document that avoids ill-defined and subjective investment labels by operationalizing the key aspects of portfolio design and implementation. The IPS takes verbal expressions of economic objectives (“safe,” “aggressive,” etc.), translates them into quantifiable measures, and outlines the strategies that will promote their successful attainment. An IPS separates the “amateur” investor from the “professional” investor. It expresses the investment objectives unique to each investor, defines the strategy through which important economic goals will be attained, and puts forth a system through which progress may be monitored and measured. In this sense, investment policy comprises the set of guidelines and procedures that direct the 5 long-term management of a (portfolio’s) assets. 4 The statistical definition of variance is the dispersion of the return generating density function about its mean. Standard deviation is the square root of variance. The standard deviation statistic that tells you how tightly all the various examples are clustered around the arithmetic mean in a series. The standard deviation of a series of asset returns is a common measure of the volatility, or risk of the asset. When the data set are tightly bunched together, and the bell-shaped curve is steep, the standard deviation is small. When the examples are spread apart, and the bell curve is relatively flat, that indicates a relatively large standard deviation. All else equal, there is greater uncertainty regarding the final outcome. One standard deviation away from the mean in either direction on the horizontal axis (the red area on the above graph) accounts for roughly 68 percent of the samples in the set. Two standard deviations away from the mean (the red and green areas) account for roughly 95 percent of the total sample set. Three standard deviations (the red, green and blue areas) account for about 99 percent of the data points. 5 Bailey, Jeffrey V., “Investment Policy: The Missing Link,” Pension Fund Investment Management, ed. Frank J. Fabozzi (Probus Publishing Co., 1990) p.13. 6 An IPS can ensure that a portfolio does not seek contradictory objectives from the outset. More important in practice, however, and with a greater beneficial effect on long term returns, adherence to the procedures set forth in a Policy Statement deters hasty, ill-considered reactions to market volatility. The principal reason for articulating long-term investment policy explicitly and in writing is to...protect the portfolio from ad hoc revisions of sound long-term policy, and to...hold to long- term policy when short-term exigencies are most distressing and the policy is most in doubt. History teaches that both investment managers and clients need help if they are to hold successfully to the discipline of long-term commitments. This means restraining themselves from reacting inappropriately to disconcerting short-term data and keeping themselves from taking those unwise actions that seem so “obvious” and urgent to optimists at market highs and to pessimists at market lows. The best shield for long-term policies against the outrageous attacks of acute short-term data and distress are knowledge and understanding committed to writing. All too often, investment policy is both vague and implicit, left to be “resolved” only in haste, when unusually distressing market conditions are putting the pressure on and when it is all too easy to make the wrong decision at the wrong time for the 6 wrong reasons.” INVESTMENT PRUDENCE Whether or not investors define their investment objectives and procedures in a written Investment Policy Statement, they enhance their chances for achieving a successful outcome if they adopt a prudent investment approach. But what, exactly, constitutes prudence? Trustees and fiduciaries have long been legally required “to make such investments and only such 7 investments as a prudent man would make of his own property.” For fiduciary investors, state statutes or federal pension law govern the approaches that are acceptable and defensible. Fiduciary law is dynamic, as courts interpret legal requirements, and legislatures define and refine the trust investment process. Increasingly, trust law relies on developments in the academic community to ensure that individuals responsible for investing funds for others follow a sound decision making process. Prior law restricted trustees’ investment flexibility through the imposition of “legal lists” of approved investments, or through implicit endorsement of investments used by most other trustees (“safety in numbers”). This approach meant that trustees could find safety from liability primarily in extremely low risk, low return investments. Too often, however, the perverse result was that, after inflation and taxes, trust estates depreciated in value. To correct this problem, trust law was restated in the 1990s. Many state legislatures have enacted trust law based on new Prudent Investor Standards promulgated by the Third 8 Restatement of the Law (Trusts). For example, the California Uniform Prudent Investor Act, which became effective on January 1, 1996, represents the state’s explicit endorsement of many of the concepts underlying Modern Portfolio Theory. The investment principles embodied in the Act apply to any investor concerned with prudent wealth management: In evaluating the prudence of any individual investment, the investment must be considered as a component of the overall trust portfolio, rather than in isolation; The tradeoff between risk and return should be the fiduciary’s principal consideration; 6 Ellis, Charles D., Investment Policy. Business One Irwin Homewood, Illinois (1985), pp. 53-54. 7 Restatement of the Law, Second, of Trusts, §227 (1959) 8 Restatement of the Law, Third, of Trusts - Prudent Investor Rule (1992) Uniform Prudent Investor Act National Conference of Commissioners on Uniform State Laws Chicago October 1994. Adopted by the State of California July 5, 1995 7 No investment is deemed imprudent per se; consequently, the trustee may invest in any instrument that would play an appropriate role in achieving the trust’s objectives, provided that it meets the requirements of prudent investing; Fiduciaries must diversify the trust’s investments unless it is prudent not to do so; Trustees may delegate responsibilities for investment management to appropriately selected qualified third parties; The fiduciary must balance the need for current income with protection of purchasing power; A prudently managed portfolio avoids unjustified expenses. The updated and revised Prudent Investor Rule frees trustees from the straitjacket of low risk / low return investments, and gives them broad latitude to invest in essentially any asset. The price they pay for this liberty is adherence to standards of prudence that require use of appropriate care, skill and caution in the design, implementation and management of portfolios. A prudent asset management process considers diversification, asset allocation, risk management and cost control to be critical components of investment success for any modern portfolio. A prudent investment management process contemplates something more than looking for the investment or investment manager with the best track record. SCLC believes that portfolio design and asset management deserve the same level of care, skill and caution required by prudent fiduciaries investing money for the benefit of others. MARKET EFFICIENCY In a seminal work published in 1970, Eugene Fama argued that the U.S. stock market is efficient, in the sense that the current price of every security fully reflects all available information that could have possible 9 bearing on its market valuation. Information includes all knowledge of past price movements and all publicly available information such as that found in corporate financial statements, government and industry reports, management announcements, etc. This information cannot help anyone develop a trading strategy (after accounting for research and transaction costs) that generates abnormal or excess profits because the security’s current price already reflects all known information. The rate of such incorporation has accelerated 10 in recent years through widespread use of computer and communications technologies. 11 David Friedman draws a useful analogy between the investor confronting an efficient market and a commuter deciding whether to change lanes: When traffic gets heavy, your lane is always the slow one. You switch. A few minutes later, the battered blue pickup that was just behind you in the lane you left is in front of you. To understand why it is so difficult to follow a successful strategy of lane changing, consider that other people are also looking for a faster lane – and cars moving into a fast lane slow it down, just as people moving into a short line in the supermarket lengthen it. In equilibrium, all lanes are equally slow. Similarly, as each datum of new information becomes known to the markets, the first few traders to obtain it, correctly gauge its effect on prices, and execute trades accordingly. In the terms of the traffic analogy, they gain a slight advantage in speed over other commuters by being the first few drivers to move into the faster lane. As the datum spreads – almost instantaneously – through the population of traders, the advantage of trading diminishes rapidly. It disappears altogether when prices fully reflect the new datum. By that point, 9 Fama, Eugene, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance (May, 1970), pp. 383-417. 10 Froot, Kenneth A. and Perold, Andre F., “New Trading Practices and Short-Run Market Efficiency,” Working Paper 3498. National Bureau of Economic Research. Cambridge, MA (1990). 11 Friedman, David, Hidden Order, Harper Collins Business, 1996, NY, NY. 8 however, trades based on that (no longer novel) datum are still working their way through broker/dealer back offices, en route to the trading floor. When these tardy trades are executed, they generate relative decrements to return, just as the last cohort of drivers to change lanes find their prior lane outpacing them. For individual investors, the same phenomenon plays out time and time again. When a fund manager begins to accumulate a good track record, a hoard of investors rushing to chase returns rapidly dilutes his future success. Cash flows into the fund rise dramatically, and the manager must work harder to apply market insights over a broader range of buys and sells. Furthermore, if the manager truly possesses skill, he or she will raise fees to reflect the fact that skillful managers are both highly valued and in short supply. At the end of the day the manager, rather than the investor, captures the economic rents associated with investment skill. In short, the market-beating investor must discover the skillful manager before there is enough data to confirm the exisence of his skill. Given that it may be harder to pick a good manager than a good stock, this is a neat trick. There are now more mutual funds than stocks listed on the New York Stock Exhange The implications of Fama’s argument are profound. If the market prices assets efficiently and rationally, then there are neither hidden nuggets of undervalued stocks, nor overvalued securities ripe for a fall, and futile attempts to beat the market are a waste of the investor’s time and money. Because the decision to buy just one stock is also a decision to forgo the investment opportunities of all other stocks, the price of each security implicitly reflects the prices of all other securities, and of all available information about them. That is, each security’s price includes information about:  its own expected return;  the expected returns available from all other securities; and,  the degree of uncertainty (risk) surrounding each security’s return forecast. Thus each individual security’s price discounts for the unique risk/return factors of all securities. Consequently, securities prices are net of risks unique to any specific investment, and are discounted for differential expected returns to different securites. In an efficient market, all assets have the same risk-adjusted returns (the discount rate for more risky investments is higher than the discount rate for less risky investments). If a security offered a risk/reward tradeoff more attractive than that offered by the market as a whole, profit maximizing investors would, according to the theory, sell their positions in the market (thus lowering the market price) to buy positions in the more attractive security (thus bidding up its price). This adjustment is made quickly and continues until the risk/reward equilibrium among all securities is restored. In the language of economists: an efficient market offers no projects with the expectation of positive net present value. The upshot of this line of argument is that, on average, the current market price of any security should be close to its economically justified price. It is difficult to beat the market simply because it is difficult to identify mispriced securities. Although elegant and mathematically compelling, the Efficient Market Hypothesis remains controversial. Many portfolio managers claim that they have the skill to form portfolios with expected excess profit—i.e., returns higher than commensurate with the risks they take. However, earning a high return by assuming great risk is not a sign of skill anymore than earning a low return by investing in conservative investments signifies a lack of skill. The problem is that, whlile in any period there are managers who beat the market, their ranks are not at all stable. Professional managers may be correct in thinking they can beat the market today, but this claim is difficult to prove; and, is it not easy to identify which managers will outperform during future periods. A prudent choice requires a careful statistical analysis encompassing much more than a naïve examination of the realized sequence of investment returns (“track record”). If the realized sequence of returns is the product of luck, placing wealth in the hands of such a manager is not prudent and may lead to unpleasant consequences. 9 The key question, then, is whether to try to beat the market. Many investors seek to solve “intertemporal 12 cash flow timing problems.” Borrowers use financial instruments like mortgages to move money from the future to the present; savers (buyers of financial assets) move money from the present into the future. A retirement accumulation portfolio, for example, is appropriate for individuals with current surplus labor income wishing to support future retirement consumption from financial asset income. The purchase of a Certificate of Deposit provides future interest earnings, the purchase of a stock provides the expectation of future dividends, the purchase of commercial real estate provides the expectation of future lease income, and so forth. Investors will sell the assets when they choose to bring the future income streams back into the present (redeem the money previously moved forward in time). A critical decision point for all investors is how they seek to solve their intertemporal cash flow problems. If investors have no special insights or trading skills, or are unable to find profitable opportunities to exploit, then they will tend to use investment strategies that generate market-based returns. If investors have private information or unique skills that lead to a credible expectation that they can earn a higher-than-market return, they will forgo purchasing diversified, market-based financial instruments in favor of establishing more concentrated investment positions. However, generating excess returns may require great levels of skill (skills must not be merely better than average; but require the investor to be better than other competing 13 professionals also seeking to beat the market). 14 Thus the decision to employ an active management investment strategy is warrented when the investor is confident either that he or she has a skill set sufficient to identify and profitably exploit investment opportunities; or, has identified managers with the requisite skills. The Prudent Investor Rule for trustees provides guidelines appropriate for individual investor portfolios: Active strategies, however, entail investigation and analysis expenses and tend to increase general transaction costs, including capital gains taxation. Additional risks also may result from the difficult judgments that may be involved and from the possible acceptance of a relatively high degree of diversifiable risk. These considerations are relevant to the trustee initially in deciding whether, to what extent, and in what manner to undertake an active investment strategy and then in the process of implementing any such decisions. If the extra costs and risks of an investment program are substantial, these added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves judgments by the trustee that: (a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks; (b) the course of action to be undertaken is reasonable in terms of its economic rationale and its role within the trust portfolio; and (c) there is a credible basis for concluding that the trustee—or the manager of a particular activity—possesses or has access .15 to the competence necessary to carry out the program. Given the academic presumption of market efficiency, hiring a manager to beat the market is prudent only if careful analysis documents consistent and persistent investment skill. A credible analysis, however, requires a sophisticated set of statistical tools with which to evaluate an historical track record. 12 Harris, Larry, Trading & Exchanges: Market Microstructure for Practitioners (Oxford University Press, 2003), p. 178. 13 Ibid., pp. 475-476. 14 A passive investment management strategy consists of tracking the market without attempting to anticipate its evolution; active management, by contrast, is the attempt to perform better than the market primarily through security selection or market timing. 15 Restatement of the Law, Third, of Trusts - Prudent Investor Rule (1990), Comment h (Prudent investment: theories and strategies). 10 There is a risk/return tradeoff implicit in choosing any investment management strategy. Active investment management may provide additional funds at the cost of assuming a higher risk of failing to 16 achieve the portfolio’s required return. On the other hand, passive management secures market-based returns in broadly diversified portfolios (thus avoiding risky bets); but may limit the investor’s ability to earn excess returns. The investor should develop a considered opinion about market efficiency, and should document the asset management approach in the Investment Policy Statement. When making the choice between passive and active investment management it is vital to determine if your investment goal can be defined as an attempt to solve an “intertemporal cash flow problem” or as an attempt to “beat the market.” Although the attempt to beat the market involves a speculative dimension that may or may not be justified in terms of the underlying investment objectives, it is nevertheless inappropriate to rule out such a strategy as imprudent. Indeed, if the returns of a benchmark index such as the S&P 500 bear little relation to the investor’s personal economic objectives, then a passive investment in such an index may be every bit as imprudent as hiring an active manager based primarily on the manager’s historical track record. RISK Securities pose two basic types of risk: Systematic risk (sometimes called market risk), “...due to common factors facing all firms in 17 the economy and/or industry: the business cycle, interest rates, inflation, and so on.” ; and, Unsystematic risk (also known as unique risk), the risk unique to each firm, such as the possibility of labor strife, litigation, product obsolescence, raw material scarcity, and management ineptitude. The global capital market, consisting of all the world’s capital allocated among all available investments, and considered as a single aggregate portfolio, is devoid of unsystematic risk. It is not uniquely risky to make any particular investment if one has made all available investments, weighing each against all the others. This is to say, a portfolio consisting exclusively of U.S. stocks and bonds carries the economic risks of unwise domestic fiscal and monetary policies. A global portfolio, however, mitigates such risks. An investor must be compensated for bearing risk. But, considered as a single investment, the global capital market has diversified away all unsystematic risk, and thus demands no compensation for it. Thus, the global capital market sets prices without any expectation of bearing unsystematic risk. Under classic capital market theory, individual investors paying full market prices cannot expect to be rewarded for bearing unsystematic risk by owning only selected portions of the market. Because the future pattern of returns of a given security is unpredictable, those returns are distributed stochastically across the whole population of investors. Tomorrow’s price for, e.g., GM stock may reward an investor who owns nothing else, or those who own none (i.e., everything but GM). The risk of owning nothing but GM, on the other hand, is borne completely by the owner. Unsystematic risk is, therefore, ultimately defined as “uncompensated risk.” The more effectively a portfolio is diversified, the less uncompensated risk it bears. The fully diversified individual investor choosing to invest globally has an unconditional expectation of reward as measured by the expected return (“price of risk”) offered by risky investments multiplied by the amount of risk taken by investor expected reward = (price of risk)(amount of risk). Investors placing money with active managers, however, have only a conditional expectation of reward. Their expectation is conditioned, of course, on the likelihood that they have, in fact, identified a truly skilled manager. 16 In the 2004 Chairman’s letter to shareholders of Berkshire Hathaway, Warren Buffett observes: “Over the last 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead, many investors have had experiences ranging from mediocre to disastrous.” 17 White, Gerald, Sondhi, Ashwinpaul., and Fried, Dov, The Analysis And Use Of Financial Statements. John Wiley & Sons New York (1994), p. 294. 11 Two conclusions flow from these observations, both of which are embedded in the Prudent Investor Rule: The riskiness of any particular investment cannot be judged in isolation, but only in terms of its effect on the portfolio (indeed, the American Law Institute cautions trustees that there are no “safe” investments because even short-term U.S. Treasury securities involve certain types of risk); and, “Failure to diversify on a reasonable basis in order to reduce uncompensated risk is ordinarily a violation of both the duty of caution and the duties of care and skill.... Diversification is fundamental to the management of risk and is therefore a pervasive consideration in prudent investment management. So far as is practical, the duty to diversify ordinarily applies even 18 within a portion of a trust portfolio....” Beyond the academic and legal discussions of investment risk, however, lies the more fundamental concept of risk from the investor’s perspective. Without taking risk, the investor can expect to earn only the risk-free rate of return, defined as the return on short-term default-free securiries like a FDIC-insured certificate of deposit or a U.S. T-Bill. Unfortunately, the risk-free return is usually insufficient to keep pace with inflation after paying taxes. In other words, the real, after-tax risk-free rate of return has historically been close to 0%. Prudent portfolio management is a not a process of avoiding risk altogether (this would also mean avoiding return), or of ignoring risk (this is required for strategies designed to maximize return). Prudence requires that risk be measured and managed. Unfortunately, such measurement and management remains an especially difficult task. Most investors conceptualize risk in terms of fuzzy labels: “low risk tolerance,” “safe,” “average risk tolerance,” “moderate,” “aggressive.” These Ambiguous characterizations, however, must be converted operationally to explicit and readily understandable quantitative measures. Often, risk measures may be expressed in terms of volatility: “the annual standard deviation of the portfolio must not be greater than x;” in terms of probabilities: “the probability of a loss over a specified period should not exceed y%; in dollar terms: “the likelihood of a decine in value equal or greater than should not be more than z%; or, in terms of failure rates or confidence intervals: “the portfolio has an x% confidence interval with respect to achieving this economic goal.” Other quantitative measures (range, shortfall probability, tracking error v. comparable benchmark, etc.) may also 19 have useful applications. No matter how you express the concept of investment risk, however, the fundamental point remains: “if portfolio managers are not managing portfolio risk, they are not managing 20 portfolios.” DIVERSIFICATION Harry Markowitz, investigating the question of how to invest under conditions of uncertainty, completed the seminal work on portfolio diversification in the early 1950s. There is more to diversification, he noted, than simply buying many different investments. Intelligent diversification takes into account the contribution of each investment to the risk and return characteristics of the entire portfolio. According to Markowitz, to assess that contribution, the investor must consider the following factors: The expected return of the asset. This refers to the statistically most probable (mean expected) rate of return. The return expectation can be a forecasted return, it may be based on the asset’s return history; 18 Restatement of the Law, Third, of Trusts (Prudent Investor Rule), Chapter 7 pp. 18, 23 and 25. 19 Investors may be faced with many risk variables including inflation risk, longevity risk, tax and regulatory risk, labor income interruption/termination risk, etc. 20 Sykes Wilford, D., “Risk Measurement versus Risk Management,” Improving the Investment Process through Risk Management, (Association for Investment Management and Research, 2003), p. 17. 12 The standard deviation of the asset. This refers to either the forecasted or the historical variability of the asset’s returns. The higher the standard deviation, the greater the probable variance of any one period’s return from the expected return. For example, an asset with an expected return of 10% and a standard deviation of 12 would be expected to generate actual returns of between -2% and +22% about 68% of the time, and between -14% and +34% about 95% of the time ± two standard deviations; The correlation of the asset’s returns to returns of other assets within the portfolio. The correlation coefficient measures how similarly the returns of any two assets behave under similar economic conditions. A correlation coefficient of perfect unity indicates that they will move in tandem, and that no risk reduction benefits can be achieved by their combination. Conversely, A correlation coefficient close to zero, or negative, indicates that the return patterns are not closely linked, and thus that a combination of such investments may significantly reduce overall portfolio risk. The value of the correlation statistic is an average taken over many periods and, for any single period, the actual co-movement of asset returns may differ from the average. Figure 1.1 depicts returns from three investments. A and B exhibit perfect negative correlation: B’s pattern of returns is the exact inverse of A’s. A and C, on the other hand, exhibit positive correlation: they both tend to 21 move in the same direction, to varying degrees, under similar economic circumstances. The long-term historical correlation of several asset classes may be seen in Figure 1.2. 21 Technically, negative correlation indicates that when asset A’s return is above its mean, asset B’s return tends to be below its mean. Thus, in the same period, both investments might exhibit positive returns but remain negatively correlated. Negative correlation does not mean that when asset A increases in value, B decreases in value. Such a portfolio would go nowhere fast 13 Figure 1.2: Correlation Matrix for Returns from Investment Categories 1973 through 2006 NAREIT Citigroup of US Large US Small MSCI MSCI Real World Months S&P 500 Value US Small Value EAFE Int'l Int'l Small Emerging Estate Bond Data Stocks Stocks Stocks Stocks Stocks Stokcs Markets Incex Index S&P 500 Stocks 3971.000.850.810.75 0.55 0.400.59 0.52 -0.03 US Large Value Stocks 3970.851.000.760.84 0.48 0.370.51 0.59 -0.08 US Small Stocks 397 0.81 0.76 1.00 0.92 0.50 0.45 0.65 0.63 -0.08 US Small Value Stocks 397 0.75 0.84 0.92 1.00 0.48 0.44 0.61 0.66 -0.11 MSCI EAFE Int'l Stocks 3970.550.480.500.48 1.00 0.850.58 0.360.43 Int'l Small Stocks 3970.400.370.450.44 0.85 1.000.54 0.310.40 MSCI Emerging Markets 228 0.59 0.51 0.65 0.61 0.58 0.54 1.00 0.32 0.00 NAREIT Real Estate Index 397 0.52 0.59 0.63 0.66 0.36 0.31 0.32 1.00 0.02 Citigroup World Bond Index 264 -0.03 -0.08 -0.08 -0.11 0.43 0.40 0.00 0.02 1.00 Fama French Large Value CRSP 6-8 Decile Fama French Small Value DFA International Small Index When investments are evaluated in isolation, their risk and return characteristics provide little information 22 about the effect they will have on a given portfolio. The correlation structure of the securities to be included in the portfolio is a key determinant of long-term investment success—yet, it often remains invisible to the average investor; or ignored in the chase to catch high returns. Comprehensive diversification makes the measurement and control of overall portfolio risk possible. A portfolio concentrated in a few securities is exposed to so much unsystematic risk that it is difficult to reach reliable judgments regarding the range of expected future returns. Consider the example of emerging markets during the period 1988 through 2006. As maybe seen in Figure 1.3, emerging markets were extraordinarily 23 volatile over the period: 22 Gibson, Roger C., Asset Allocation: Balancing Financial Risk (Business One Irwin, 1990), p. 118. 23 International Finance Corporation Data reported by Ibbotson Associates (Chicago, Ill.). 14 Figure 1.3: Emerging Country Returns 1988 through 2006 Brazil Korea Mexico Indonesia Thailand Portfolio 1988 129.9% 96.8% 66.3% 258.1% 47.5% 119.7% 1989 81.1% 1.4% 91.7% 81.9% 114.2% 74.1% 1990 -68.4% -27.1% 63.1% 5.9% -27.4% -10.8% 161.8% -15.5% 125.2% -44.0% 23.9% 50.3% 1991 1992 9.6% 1.1% 25.6% -0.6% 34.3% 14.0% 1993 73.0% 31.5% 49.2% 106.1% 105.0% 73.0% 1994 63.4% 23.8% -39.9% -26.2% -9.2% 2.4% -19.3% -3.1% -21.3% 8.9% -3.8% -7.7% 1995 1996 42.5% -38.2% 18.6% 27.9% -36.8% 2.8% 1997 27.4% -66.6% 54.0% -67.4% -73.4% -25.2% 1998 -39.3% 140.6% -33.6% -44.8% 10.9% 6.8% 1999 66.2% 92.0% 80.4% 92.7% 47.7% 75.8% 2000 -11.3% -49.5% -20.9% -62.2% -56.2% -40.0% 2001 -17.0% 48.7% 19.4% -8.5% 5.3% 9.6% -30.6% 8.6% -12.8% 42.8% 27.5% 7.1% 2002 2003 114.5% 35.8% 32.0% 78.2% 144.7% 81.1% 2004 36.8% 23.0% 48.0% 52.2% -1.0% 31.8% 2005 56.9% 58.5% 49.0% 15.9% 9.2% 37.9% 45.9% 12.8% 41.7% 74.7% 13.9% 37.8% 2006 1988-2006 23.4% 8.3% 25.7% 11.3% 6.6% 22.0% The average annualized return for these eight countries was 15%. On the other hand, an investor who followed a strategy of investing an equal percentage of a portfolio in each of these markets, rebalancing at the end of each year to restore that initial allocation, would have experienced a compounded annual return of 22%. The return premium due to the diversification (asset allocation policy) and risk control (rebalancing policy) was, therefore, 7%. The effect of the diversification strategy may be seen in Figure 1.4: 15 Figure 1.4: Growth of 1,000 in Emerging Markets 1988 through 2006 Mexico 80,000 77,249 70,000 Brazil 60,000 54,058 50,000 Portfolio 43,993 40,000 Averag e 28,375 30,000 20,000 Indonesia 7,643 Korea 10,000 4,554 Thailand 1,000 3,342 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 The risk posed by a diversified portfolio is less than the weighted average risk of its individual assets. An effectively diversified portfolio contains assets that respond differently to new information. Their patterns of returns tend to offset or neutralize each other. The expected return to a portfolio, on the other hand, is the 24 weighted average of the returns expected for each of its indiviudal assets. The reduction in risk due to diversification does not result in a reduction in return. Effective portfolio diversification thus provides investors with rewards commensurate with a level of risk higher than they actually bear: “This is a major reason why diversification is valued and why the prudence of a trustee’s investment is to be judged by its role in the trust 25 portfolio rather than in isolation.” Comprehensive diversification makes possible the measurement and control of overall portfolio risk. A portfolio concentrated in a few securities is exposed to so much unsystematic risk that reaching reliable judgments regarding the range of expected future returns is difficult. In Figure 1.4, the Indonesian market was down 44% in 1991, when the global trend in emerging markets generally was up (+50.3%). Indonesia in 1991 was not representative of emerging markets. Likewise, for any grouping of securities that are somewhat similar, and for any period, none of them are necessarily strongly correlated with the others, or with the group as a whole. By examining the behavior of any one of them, the investor can discern little about the behavior of all of them put together. When, on the other hand, a portfolio owns enough securities to allow for statistically significant sampling, the investor can reach reliable judgments about risk and return. The amalgamation of the whole array of emerging markets results in what is effectively a virtual security, with its own risk and return characteristics, different from those of any of its components. The same is true for comprehensively diversified holdings of any other type of security, such as domestic small company stock or municipal bonds. This is why investors are interested in the published indices (e.g., the S&P 500, the Lehman Brothers Corporate & Government Bond Index, etc.) which reflect comprehensive diversification across a class of securities, or asset class. The behavior of these indices provides a point of reference, or benchmark, for the performance of securities of the same type. 24 Farrell, James L., Portfolio Management: Theory and Application (Irwin McGraw-Hill, 1997), p. 22. 25 Restatement of the Law, Third, of Trusts (Prudent Investor Rule), The American Law Institute (1992), p. 26. 16

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