Investors can take precautions, but at some point, they need to realize that no one can predict the future.
Risks always have been part of the investing equation, but the shock of the 2008 financial crisis was a wake-up call for many investors who assumed that modern financial markets had been built to prevent such deep drop-offs. In fact, what are rarer in the history of markets are long periods of calm. As investors have come to grips with this reality, they are seeking ways to moderate the effects of the meltdowns of the future. But are investors thinking about risk in the right ways? Is it even possible, or advisable, to try to build a portfolio that can withstand whatever bad event will next hit the markets? To discuss these issues and others, we invited two professional investors who think about risk every day to discuss their views.
Joseph Davis, who has a Ph.D. in economics, is the head of the Vanguard Investment Strategy Group. Dennis Stattman, CFA, managing director and portfolio manager, is the leader of BlackRock’s Global Allocation team. Our conversation took place Feb. 26 and has been edited for clarity and length.
Hal Ratner: I’d like to start off our conversation by getting from both of you a definition of risk and how it should be viewed in an investment framework.
Dennis Stattman: The most important things that I can say about risk are that it’s key to look at it from a number of different perspectives, to look at a lot of measures, and then also to look at risk qualitatively. In the Global Allocation fund
Ultimately, risk is about client objectives; it’s important to see risk from the clients’ point of view. What’s their motivation for investing in a particular portfolio? And what could happen that would lead to a failure of that portfolio to live up to their objectives and expectations? So, that’s the context in which we need to be thinking about risk. It has to be in relation to clients’ objectives and expectations for a particular portfolio.
We always look at risk in the context of a variety of measures. It’s been popular in our industry for a long time to use mean-variance analysis, and in fact, we use that, as well. But we don’t think of risk as just being variance, or volatility, or beta, or standard deviation, or tracking error. We don’t think of it as being any single measure. We look at a lot of different measures.
We also try to look at risk in qualitative terms. We are value-oriented investors, and we think price matters a great deal. We think that if you do a good job of identifying value that you’re actually lowering the risk of the portfolio in two particular ways. One of them is building an asymmetry of return, meaning more upside than downside. The second is building in the characteristic that time is on the investor’s side.
So, if one has identified an undervalued security, it will tend to accrete value faster than the market. That puts time on your side. If you believe in your analysis, then it puts the psychological staying power on your side, to both hold through periods of volatility and even perhaps increase position size if a period of volatility has lowered prices. That allows one to take advantage of volatility rather than being driven by it. We think that’s particularly important because volatility and implied volatility, while they’re very popular measures of risk, tend to behave somewhat perversely, in that actual volatility and implied volatility are very often inversely related to price. In other words, if price has gone down a whole lot, then volatility and implied volatility tend to be high. That’s just exactly the opposite of the intuition that we might want to have in most circumstances, which says when prices are low, you want to increase your risk-taking, as opposed to reduce your risk-taking. So, blind adherence to volatility can put one in a position of disadvantage in market dynamics.
Another area that we think is important is to look at various scenarios of how things might play out, various shocks that might happen to the system. We look at how portfolios might behave in these scenarios. Some that we’ve used at BlackRock are Nemesis, which is a crisis situation we named after the Greek goddess who punishes the prideful; growth, which would be its opposite; inflation; and so forth.
One environmental concern that we have today is policy risk. The environment that we’ve had for the past four or five years has been partially defined by extremely aggressive government policies, both on the central bank side and the fiscal side, to try to mitigate the effects of the financial crisis. But in doing so, we believe it has put forward a set of risks in the market that are not what investors have typically had to deal with at this magnitude.
There are two facets to this. One is the uncertainty of what will actually happen to policy. You can think of it in the past as the magnitude of surprise at the various quantitative easings. In the future, what will happen to the policy of quantitative easing? You can think of it in the past in terms of the fiscal cliff. You can think of it in the future as the question of what will be done to deal with the unsustainability of the federal deficit? So on one level, it’s about the uncertainty of policy. Because of the magnitude of policy, it’s become very important.
But the second facet that concerns us a great deal is a more subtle one, and we think this underlies a lot of investor anxiety today. We have an asymmetry of policy today. In other words, we have had the benefit of fiscal policy stimulating profit and monetary policy pushing down capitalization rates. Those are two of the most important factors in asset prices. So, policy has been very positive for asset prices since 2009.
But that’s already embedded in prices, and at some point, those policies are going to normalize. Interest rates are going to go up. They’re no longer going to be near zero at the short end, and no longer going to be negative in real terms way out in the government-bond yield curve. They’ll go up. Capitalization rates on assets will go up, and that tends to be tough on prices. And we believe that a big fiscal deficit financed by Federal Reserve money creation is a big subsidy to profits. As those fiscal deficits wind down, that subsidy to profits will wind down and could mean that profit growth is attenuated and that profit expectations are too high. Again, that normalization could be tough on asset prices. So, that underlying set of factors is riskier today than was the case, say, pre-financial crisis.
On the other hand, there is both apparent risk and risk that people haven’t recognized. Before the financial crisis, there was less apparent risk, but there was much more risk in the financial system due to misunderstood assets and lower levels of capital.
Ratner: Joe, what is your view of investment risk and how you think about it?
Joseph Davis: Similarly to Dennis’ comments, we view risk in the context of the portfolio and the clients’ objectives, and that’s related with what we perceive as the investor’s risk appetite, what their objectives are, and what they’re trying to achieve with that portfolio. Investment risk is multifaceted. Clearly, there is risk not just in the markets themselves, but also economic risk, growth and inflation, and policy risk. We agree that policy risk in many ways has not been this high in quite some time, certainly in more than a generation.
Risk is often associated with volatility or variance, but volatility is the realization of risk. Risk can be highest when volatility is low or when perceived uncertainty is low. Interest-rate volatility by some measures is very low, and yet interest-rate risk could be high. When trying to think through that, I think quantitative analysis is very important. There have been some important developments over the past several decades. Models are just a start, and I’d view them as simply one tool in a broader portfolio-construction and asset-allocation context.
Qualitative judgment is critical, both with respect to what historical episodes are relevant, and also how historical relationships may have changed over time. Risk, in many ways, can be asymmetric, particularly with respect to clients’ aversion to downside risk, especially for those investors who may be drawing down a portfolio. We also do a great deal of analysis both from a broad portfolio-construction context, as well as within actively managed funds. We will try to assess various states of the world.
Dennis mentioned some scenarios. We do similar scenarios, as well, in terms of trying to assess the potential impact they could have—not only on levels of market risk, but the implied risk premiums, which we as investors would be expected to be rewarded if we should bear that risk. So, that’s a key tenet, as well as trying to be realistic, and applying a heavy dose of humility to try to see how much we really know or perhaps do not know with respect to future states of the world. When one applies that framework, one consistently comes back to more balance, rather than less, in part because one’s appreciation not only for risk but for the inherent uncertainty of financial markets comes to the fore.
Ratner: Are you finding today that your clients are, by and large, more risk-averse than they were five, six years ago?
Davis: We’re seeing two general patterns. In one sense, we have seen some investors shy away from equities in the past several years, although that’s been more from long-only active than it has been from broad, low-cost, index vehicles where investor appetite seems to be very strong. So, in one sense, there’s an increase, at the margin, to risk aversion.
At the same time, particularly more recently, and it gives us some pause for concern, there is the increased risk-taking with respect to fixed-income investing, as well as the desire for increased yields or income. We have seen moves out of, say, more-conservative fixed-income and money-market vehicles into more-aggressive corporate and municipal bond offerings, even into dividend-paying equity funds.
So, whether it’s explicit or unintended, and that will vary by the investor, we’ve clearly seen greater interest and cash flows into higher credit-risk exposure, greater interest-rate risk, and greater equity risk, although it’s generally viewed as just more of an income positioning.
Stattman: Coincident with the financial crisis, there was a very large and sudden shock to risk appetites—a shock downward in people’s tolerance for risk within their portfolios. It was effectively a realization of two things: that there was greater risk than previously understood in the environment and that, unfortunately as is the case with human nature, brought out the real as opposed to imagined levels of risk tolerance in investors. In other words, many investors did not understand how much risk they were willing to tolerate until that risk was manifest and wealth was lost. So, there was a very sharp decline in willingness to take risk that we can date to 2008.
But since then, as Joe noted, and especially within the past two years, the thirst for yield and income in what has become an extraordinarily low interest-rate environment has led a number of investors who would have preferred lower-risk vehicles to earn their income—those investors have been, in some sense, forced, if they’re going to get income—to take a higher level of risk. Because effectively, very low-risk vehicles provide returns that are inadequate for many investors.
An investor who might have been accustomed to earning inflation plus 1% on a Treasury bill now earns inflation minus 2% on a T-bill. Finding that unsatisfactory, they’ve moved from a risk level of T-bills to some higher risk level, and it might even be as high a risk level as a high-yield bond or a dividend-paying stock. This is consistent, I believe, with what the Federal Reserve is trying to get people to do, but that doesn’t mean that it isn’t ultimately dangerous.
Along with this, there has been a quiet extension of duration in many of the fixed income markets. If and when interest rates rise, investors might be unpleasantly surprised at the price impact that occurs.
Risk of Integrated Markets
Ratner: We’ve been living in a world where the capital markets are becoming increasingly integrated. An isolated event in one market can lead to a global crisis. Do you think these periods of extreme volatility followed by possibly swift recovery in the capital markets is going to characterize how things might be going forward?
Stattman: It’s hard to say. The markets are more integrated, and they’re much faster to respond. We’ve gone from essentially a hand, calculator, pencil, paper, and batch-processing computer world a generation ago to one that’s online, real-time, worldwide, 24/7. As Warren Buffett said, never before have so many people been poised to hit the sell button all at once. That’s just the fact of our environment.
When you combine that with changes in financial regulation and leverage in financial services firms, the willingness or ability of investment banks and capital market firms to take the other side of a trade is categorically less than it used to be, if it exists at all. So, there isn’t that kind of buffer of inventory increase and decrease at the capital market firms that there used to be.
The part of the question that’s harder for me to address is the idea that markets will necessarily snap back. It seems to me, turning back to what I said about policy, that the degree to which we could expect aggressive policies to levitate asset prices again has to be limited by where interest rates and deficits are today, compared to where they were pre-crisis. There will be, at some point, a normalization in rates and fiscal policies that could mean we have a decline that isn’t followed by quite the snap back we’ve seen lately.
Davis: I would just add, in many ways over the past several years, we weren’t terribly surprised to see some of the rebound in risky assets and the financial markets. For long-term investors over five-, 10-year, 15-year horizons, much more important than, say, economic growth, per se, is the price paid for growth, and things such as valuations and so forth were at extremes. I would agree with Dennis. The rapidity of the response and how quickly news is discounted are measured in fractions of seconds today. The volume in global trading just is astonishing. So, it’s tough to envision correlations across similar risky assets dropping back to where they were in the 1950s or 1960s. But that said, a lot of that rests in terms of future realized volatility. There is a strong association between realized volatility in the financial markets and economic volatility. One could see a scenario where risk at the margin declines if one sees slightly higher growth.
But I would counterweight that. I have anxiety about the volatility that could be introduced through the exit strategy of central bank policies, which have been unprecedented in both size and scope, as well as the uncertainty with respect to fiscal policy. We as investors have to be prepared for intermittent bouts of volatility.
That said, when I look over 200 years of U.S. market history, what I find much more remarkable is not some of the volatility we have lived with but the incredible long period of time of very low realized volatility in the financial markets that some academics portrayed as the Great Moderation.
There was this belief that there would not be recessions, there would not be business cycles, which in my mind was always tenuous— since the very belief in that assumption leaves the time stamp when that Great Moderation will end because of increased risk-taking and moral hazard behavior.
So, again, investment risk and market risk are part of the portfolio context, and it’s about continuing to go through that framework that both Dennis and I discussed at the beginning of this discussion.
Ratner: What models and techniques do you use to manage risk? What ways do you attempt to explain risk to your clients?
Stattman: We look at a whole lot of measures. So, let me touch on some of the things that don’t get talked about a lot but that we pay a lot of attention to. Then I’ll come to the more conventional portfolio measures.
First, we spend a lot of time on the nuts and bolts of getting the operation right. I’m not talking about just what’s in the portfolio. I’m talking about things like counter party risk, who we’re dealing with, and the security of clients’ funds in a variety of very high-risk, institutional-risk scenarios. Second, operational risk, just working to run a clean, error-free operation. Third, portfolio-alignment risks, where we have multiple portfolios. For example, an onshore portfolio and an offshore portfolio for the same investment objective. Are those portfolios as well aligned with our model as they can be? Execution risks. Are we trading as effectively—in terms of trading costs and risks that we’re taking in trading—as we can be? All of these things seem different from portfolio risk, but they’re things that one has to get right in order to do a good job for clients.
Then within the portfolio, we look at two types of measured risk: absolute risk, meaning the total return on the whole portfolio, and then relative risk, meaning compared to a benchmark or a market. What we are trying to do for our clients always is driving our views of risk. Our value proposition to clients is to provide a competitive return with less risk than the typical equity-only fund or equity benchmark.
That implies some particular characteristics that we feel the portfolio must exhibit for us to say we’re achieving client expectations. So in a weak market, our clients expect, and we aim to deliver, a portfolio that’s not down as much as the equity markets. Then, in a period of recovery, we want to get our client wealth, in terms of cumulative total return, back to a new all-time high sooner than the equity markets will do. So, a smaller drawdown and a shorter duration between periods of new highs in wealth have to characterize the outcome for our clients for us to be successful.
In terms of the models we use, they’re proprietary BlackRock risk engines. Years ago, we used industry-provided, off-the-shelf risk engines that were then customized for our particular portfolio. The shortcoming of that was that we didn’t control the engine. In particular for multiasset portfolios, the industry has not done a good job at all. The industry’s approach to risk is to build models for equities and separate models for fixed income.
So, BlackRock has a big risk-management operation that services not only the $3.7 trillion that we manage but approximately another $10 trillion of client assets where other investment managers and clients buy our risk work. There’s a huge amount of proprietary technology behind the risk measures that we get.
What do we look at? The basics are what’s the standard deviation of our portfolio, what is the beta of our portfolio versus our benchmark, what’s the beta versus the S&P 500, what’s the tracking variance or tracking error of our portfolio—how does that look in terms of the historic range, and how does that marry with our particular qualitative views of the environment?
In other words, do we believe that this is an environment in which risk-taking will be rewarded? In which case, we want some of those measures higher, especially our betas. Or is this a time of greater uncertainty, where we don’t think there’s a particular advantage to risk-taking in general or the particular insights that we have?
So, that’s the range of measures. Then, the techniques will include not only those measures but the aforementioned scenario analysis. We pick particular potential events and shock the portfolios with those events to see how they behave.
Davis: Risk management begins with the firm’s culture and people. Vanguard’s unique ownership structure, where we’re owned by our clients, clearly aligns with very serious attention paid to risk management. We have a very deep investment risk-management team, as well. John Hollyer runs a global group where operational-risk and investment-risk management are the primary objectives, and he reports right to our chief investment officer, Tim Buckley.
We have other groups, as well. Risk management is the primary area of focus, for example, in our fixed-income department, managed and run globally by Bob Auwaerter. We have a whole portfolio review department that oversees all of our actively managed funds. Ultimately, all of these departments and all our risk management are overseen by our portfolio review group, which is led by our chairman, Bill McNabb. Again, sitting importantly at that table is Tim Buckley, our chief investment officer.
So, risk management is at the fore of the products and services that we provide clients, and it’s truly embedded as a very high priority with respect to constructing welldesigned portfolios.
One simple example is single-fund solutions that we provide to plan sponsors and individual investors in the form of, say, target retirement funds. There, the objective is clearly never to simply maximize return. It is to look at how assets and portfolios interact and, in many ways, to diversify bad equity market outcomes, and to countervail that sort of diversification property with other risks that the investor may face—risks such as longevity risk, inflation risk, and so forth.
It is multifaceted. We take all of these into account, at an individual security level all the way up to the assets and firms that we’re dealing with, and then ultimately to measuring risk in various forms in the portfolio context. It’s important to look at risk measures beyond just volatility, although volatility is important, and as always is the case, trading off risk versus return. We go through different states of the world and view the portfolio at a horizon that would be consistent with what we would believe is the investor’s objective.
Accounting for the Unknown
Ratner: How do you incorporate the idea of uncertainty into your processes? By that, I’m using it in the Knightian sense of some event that may fall entirely outside of the probability distribution. The unknown unknowns.
Davis: The first part is very important. Human nature makes it tough for us to realize that no one can fully appreciate what can happen. We do know what may have happened in the past, but the actual outcomes could have been potentially wider and of different forms. That inherently has an impact on even the historical performance of asset classes in the economy, which form the basis of some risk management tools and software. So, I think that, in and of itself, is important to recognize.
Incorporating uncertainty is trying to think through various states of the world; to put a high primacy on the fact that we will always have incomplete information, and to treat the future with the humility it deserves. When one has that at the forefront of one’s mind in a portfolio construction and investment management context, it becomes a default mindset. We’re going to really put primacy on risk and diversification as best we can think through this process. But it starts first with a mindset and an acknowledgement that we will always have incomplete information, and to put that at the forefront in one’s decision-making.
Stattman: There was a very important word in there that I want to pick up on, and that’s humility. As people survive in this business, they survive by not letting their clients down. Everyone, even the best investment managers, makes mistakes, and plenty of them. The key to survival is to limit the negative impact of those mistakes. And the process of surviving in a variety of investment environments is one that teaches a great deal of humility.
One thing that becomes clear through this process is we know that we don’t know. There are simply things that will happen in the future that we have no idea of—9/11, for example. Now, we could have imagined that terrorists would do something big and heinous. We could have imagined New York City as a target. We might have even imagined, since it was the second go-around, the World Trade Center as the target. But we could not have imagined the exact details or timing. And that was an important shock to the market. It was not knowable.
There will be other areas where we apply our research and judgment and see that there’s risk. It was very clear to our team that there was a tremendous amount of risk building up in the financial sector around mortgages and big risk-taking on the part of lenders who were aggressively pursuing low-quality loans.
And despite this, we couldn’t know with any exactitude the timing of the peak in housing prices, the exact nature of which banks and financial institutions would suffer the very most. We could look at who was leveraged and who was exposed to the mortgage side, but there was not sufficient transparency to know exactly how bad these outcomes could be for particular institutions.
So, even in situations where we see a sector that has outsized risk potential, even if it’s not realized now, understanding the exact manifestations of how that risk will be actualized is impossible for anyone. That’s where humility comes in and helps us not push the envelope too far on risk-taking under the false assumption that we know more than we can know.
Ratner: Great, thank you for this discussion. I’d like to ask each of you for a final word to wrap up any additional thoughts you may have.
Stattman: Well, I’m just going to circle back to what I said at the outset, which is, ultimately, risk has to be judged within the context of meeting client objectives and expectations. Second, we should never, ever lose sight of one particular idea about risk, and that is the idea of risk as the chance of permanent loss of capital.
Davis: If we put our clients’ interests and their objectives first, and we always keep that at the forefront of our minds, then we as investment management firms and as investors will always be well-served. We need to acknowledge that we will never have complete information on the markets. That comes back to many time-tested and timeless investment principles: balance, diversification, and a long-term orientation.