Managing Risk and not Returns

Managing Risk and not Returns

As global equity markets continue to hit all-time highs, clients, family, and friends tend to ask the question: How is the market doing?  This previous question only touches on the return factor in investment management as individuals tend to be more focused on quantifying how much they are up or down.  As the father of value investing, Benjamin Graham, once wrote, “The essence of investment management is the management of risks, not the management of returns.”  Risk tends to be harder to quantify and thus seldom talked about by financial professionals.

Quantitative Measures

There are two quantitative measures that HFS Wealth Advisors utilizes, the Sharpe ratio and Max Drawdown, which can help investors understand risk in their portfolio.

Sharpe ratio – is a risk-adjusted return that is calculated as the average return of an asset in excess of a risk-free rate divided by the volatility of that asset.  The benefit of this formula is that it allows an investor to determine if they are being compensated for taking on additional risk.  A higher Sharpe ratio implies a better risk-adjusted return.

Max Drawdown – measures the worst performance of a stock, index, or portfolio over a given time frame from market peak to market bottom.  In the last financial crisis (Oct 2007 – Mar 2009), the Max Drawdown of the S&P 500 was -53%.  In dollar terms, a $100,000 portfolio would have been worth only $47,000!  It would have taken until March 2012 for an investor to break-even on their initial investment.

Qualitative Measures

The qualitative assessment tools HFS Wealth Advisors often use are strategic Asset Allocation models, Alternative Strategies, and Due Diligence.

Asset Allocation and Risk – Since there is no crystal ball that tells us where the markets are heading next it is important to have a strategic allocation that ties in a client’s ability and willingness to take risk while achieving their goals.  Most clients fall in a Growth and Income allocation of 50% Equity and 50% non-Equity.  At times we may move to a tactical allocation and hold anywhere from 40-60% in Equity and 40-60% in non-Equity.  What we attempt to avoid is taking a speculative approach to investment management where a Growth and Income portfolio takes on too much risk and begins to look like a Growth portfolio.  As an asset class begins to exceed its tactical band, rebalancing and risk management become imperative.

Alternative Strategies – Alternative strategies are part of the non-Equity sleeve of our portfolio and have proven to increase the long-term risk-adjusted return of a typical Equity/Fixed Income portfolio.  The strategies we use provide two main benefits to client portfolios:

  • Low or negative correlation with Equity and Fixed Income markets
  • Lower volatility than can be expected from Equity markets

Alternative strategies allow us to take a more defensive posture and can make up 5-20% of a client’s portfolio.

Due Diligence – Though our models have shifted over the years to more passive, focused, and tax-efficient ETFs, we continue to use mutual funds for more specialized strategies (Alternatives, Fixed Income, and Emerging Markets) that are harder to replicate and where a fund manager’s approach can add value.  At HFS we continue to monitor the funds we have purchased and ask questions about each investment.

  • Has there been a change to the fund’s management?
  • Has the manager’s investment approach changed or been affected negatively over the recent quarter?
  • Has performance underperformed their category over a lengthy period?
  • How does the risk-adjusted return compare to the fund’s category average?

So as we wait here patiently (and calmly) for the pullback that many are expecting, please feel free to contact us if you would like to discuss how we manage risks in your portfolio.

*These are the opinions of Antonio Belmonte and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice.  Past performance is no guarantee of future results.  Diversification and asset allocation strategies do not assure profit or protect against loss.