Manage portfolios to fixed risk levels

In judo, rather than confronting opponents with resistant force, you use their movements and strength against them. If they push in one direction, pulling them in the same direction harnesses their own momentum, allowing you to trip or redirect them to your advantage.

Market participants could benefit from similar skills. Buying a rising market and shorting a falling one captures that principle. But timing markets is not easy. Convention has led to asset mixes that reflect the investor’s risk tolerance or desired level of return, based on historical results. Periodically rebalancing to that fixed strategic asset mix has become routine.

Read: 2 risks of frontier markets

If investment time horizons are long enough that losses on one cycle can be made up by gains over the next one, this approach is fine. But rebalancing to a fixed mix has shortcomings, for example, when all asset classes move together.

Consider these two developments. First, increased market volatility has left some investors without enough leeway to make back losses. Second, the proliferation of ETFs has improved portfolio diversification for more investors and has lessened the impact of stock and sector picking.

So where do we find returns? The market explains about 90% of return variance for a three-sector ETF portfolio (for more, see AER May 2014). Add more ETFs, and the market’s influence increases further.

This suggests that while picking outperforming sectors can improve performance, adding ETFs to diversify a portfolio may reduce volatility and limit the positive influence of good selection.

Chart 1 Risk of a 60% Canadian equity and 40% Canadian bond portfolio

Most ETFs are already diversified, so combining them tends to force the risk and composition of a portfolio toward the broad market. These findings suggest that the best opportunity to add value beyond the market’s return is by adopting a disciplined risk-on, risk-off posture.

Read: UPDATED: Leveraged ETFs small but risky

Managing to constant risk

Chart 1 shows the risk (standard deviation) of a 60% Canadian equity and 40% Canadian bond portfolio from February 2001 to February 2014. Its risk remained between 5% and 10%, with a notable spike to 25% during the financial crisis.

The dotted line represents the long-term risk average of 7.5%. To test how maintaining a consistent level of risk would impact the portfolio, we adjusted the asset mix to keep the portfolio risk close to 7.5%. The result? Portfolio risk was lower whenever market risk increased, and vice versa (see Table 1). The portfolio’s return improved, overall risk was reduced, and most importantly, the worst 12-month period was -5% instead of -25%.

Maintaining a client’s portfolio at a risk level consistent with his risk tolerance is a prudent approach. But you can also use other risk avoidance signals.

Other signals

Markets with extended valuations revert to the mean over time.

Read: Frontier market investing myths

But the challenge is the “over time” part.

Using economist Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE; see Chart 2) and selling at over 30x would have saved you from the tech wreck in 2001. But you would’ve had to have sold in June 1997.

Chart 2 Cyclically adjusted price earnings ratio

If you still had clients left in 2001, they would’ve appreciated your acumen.

CAPE is currently at 25.2, putting it above its long-term average of about 16.5. That’s making some watchers nervous.

Warning signs

Many indicators warn of market excess: high price-to-book ratios, an inverted yield curve, falling consumer confidence, sagging leading indicators and other technical measures. But for all these indicators, the best we can expect them to provide is some sense that there are divergences from historical norms. React quickly, and there will be false signals; too slowly, and your portfolio will suffer. Monitoring market volatility makes sense because of its consistency, but it is not immune to timing challenges. To cope with this, target a risk level in your portfolio instead of an asset mix, and manage to it. Risk-on, risk-off tactics make sense because, increasingly, we must take what the market gives us and run. No matter your judo skills, when confronted with a gun, give up your money. Know when the risks are greater than your ability to overcome them.

Read: Different ways to construct ETF portfolios

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.