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Todd Wood is the chief operations officer and co-chief investment officer of Provident Capital Management Inc. where he helps lead the company and provides total-return investment strategies for all clients. Todd has been a guest lecturer at the University of Notre Dame’s executive MBA program... More
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  • Modern Asset Allocation: Riskier Than You Think

    How one defines "conservative" is an important question. Conservative investing has different meanings to different constituencies, and perhaps has even been over simplified due to the pigeon-holing effect of investor risk categories.

    For many investors, being conservative means they can't afford to take risks that would potentially reduce or eat into principal; however, standard asset allocation models are static and typically heavily weight bonds for conservative investors. While this methodology has worked well in low inflationary markets, risk of a decade of bull markets in bonds means caution should be the primary message to investors. The future may be different from the recent past, and static allocations of heavily weighted portfolios in fixed income creates a poor risk reward senario.

    Standard Conservative Investing

    Conservative investors, and by default large bond holders, tend to hold on to their bond investments for long periods. Just a few years ago it would have been difficult for many fixed-income holders, including pension funds and individuals, to consider they would be facing the sovereign debt issues across Europe.

    It seems to be an investment norm that conservative investors should hold between 50%-80% bonds of varying maturities, issuers and quality, depending upon the client's income needs and risk tolerance. But this does not mean bonds are without risk for investors who have purchased bonds over the past few years at, or above, par. Rising interest rates causes bond prices to fall.

    The bond market crash of 1979-1980 had bond investors on their heels when then-Federal Reserve Chairman Paul Volcker announced he was going to raise the discount rate by two full percentage points. "By some estimates, investors have losses totaling 25% of the market value of their bond holdings, or more the $400 billion."

    Conservative investing is relative to the individual. Prevalent static-allocation models with a lack of active risk management, coupled with the attitude that markets will come back, could do a disservice to investors. Retiring baby boomers are at an increased risk of facing losses to the fixed-income portion of their portfolios, which may comprise more than 50% of investable assets based on current conventional wisdom.

    Modern Portfolio Theory and Risk

    The creation of modern portfolio theory (MPT) and subsequent methods of allocating one's portfolio into various asset and sub-asset classes has turned into an analytical function of form over substance. The most powerful tenant of MPT is finding and allocating a portfolio based on the correlation of the various investment options one has. What many professional advisors have failed to realize is that correlations are not static. As an example when equity markets fall sharply, correlations of various equity classes rise. The fairly static division of asset classes and sub-asset classes into portfolios of aggressive, growth, moderate or conservative risk profiles, considered the hallmark of the professional advisor using MPT as a crutch, has put investors at more directional market risk.

    Table 1.0 is a correlation heat map of the most common equity allocations, but also includes real estate as represented by the NAREIT Index. As one can see, these are highly correlated and offer very little diversification.

    Table 1.0

    From a directional risk perspective, an investor may as well just pick one of these sub-asset classes instead of allocating a portion of their 40% equities across seven different equity investments and leave a remainder of 60% in bonds.

    What the Numbers Really Say

    Perhaps a more detailed example will help illustrate the effects of a converging correlation among various asset and sub-asset classes. Let's look at a hypothetical allocation for a conservative investor with 60% of the assets spread between bonds, 35% in equities and 5% in real assets consisting of real estate and commodities. Overall this looks to be a very diversified and conservative portfolio; however, if one digs a little deeper to examine the correlation of the components and the R-squared values of the asset class to the overall portfolio, an interesting picture develops beyond the correlation of various equity alternatives and brings to light the directional risk of the overall portfolio.

    Graph 1.1 represents the allocation in % terms of the individual asset classes and sub-asset classes recommend by the mainstream financial community.

    Graph 1.1 Conservative Portfolio Allocation in Terms of Percent of One's Portfolio

    We took the returns of each sub-asset class from January 1995 to December 2010 in a hypothetical conservative portfolio, calculated the relationship of performance of each piece of the portfolio and how closely it moves with the overall portfolio (R-squared), and took the sum of the allocation percent times the R-squared times the standard deviation to give us an idea of the directional portfolio risk.

    Graph 1.2 Directional Risk Exposure of Conservative Portfolio Consisting of an Allocation 60% Bonds, 35% Equities, 5% Real Assets

    Graph 1.2 indicates the directional risk exposure, based on the pieces that comprise the "Conservative" portfolio and how they move in relationship to equities, bonds or real assets. What this research and analysis demonstrates is investors have much more directional risk than what is alluded to or explained by mainstream investment methodology, and what is considered a conservative portfolio by most professionals actually has nearly two times the directional risk exposure in equities. When equities are going higher, this doesn't present a problem to our conservative investor. However, when stocks are not doing well and going down, sometimes significantly as in 2000 and 2008 with over 50% losses to stocks each time, the conservative investor finds themselves with losses greater than ever expected.

    Differentiation for Better Results

    At Provident Capital Management, this analysis started what was to be a paradigm shift in portfolio risk analysis and how we determine the appropriateness of a particular investment approach for our clients. The findings have enlightened us about how we look at risk and have helped redirect our research and client portfolio allocation away from standardized asset allocation theme of stocks, bonds and alternatives. Our focus is more on the correlation effects, how the sub-components move in relation to each other and the overall portfolio in up and down market conditions. Developing portfolios containing truly non-correlated pieces helps to reduce the volatility and drawdown.

    In summary, traditional wall street analysis produces what appears at first glance to be a well-diversified portfolio, but is in fact fraught with the risk of substantial loss. Mainstream allocation models may lead investors to a false sense of security. In my view, a low volatility, low drawdown approach which may, over short periods of time move sideways, is much more acceptable then taking the rollercoaster ride of conventional benchmark strategies.

    See article here.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Apr 19 4:24 AM | Link | Comment!
  • PCM's February Total Return Index Commentary

    PCM Index Commentary February 1, 2013

    MACRO ASSET CLASSES

    1. Macro Asset Classes, European and US Equities, Broad Commodities, Corporate High-Yield Bonds and the Euro.
    2. Global Tactical Index showed a broad move from international equity, a great place to be the last 6 weeks, into U.S. equities.

    EQUITY MARKETS

    1. In the U.S. Equity Markets, Midcaps and the Russell 2000 are showing more strength than the larger-cap S&P 500.
    2. Brazil, Russia, India and China are strong in emerging markets going into February.
    3. International equities favor the European safe haven of Switzerland, along with Canada and Australia, with a slight risk exposure to Mexico.

    COMMODITY & CURRENCY MARKETS

    1. There is no change in our Commodity Index. We continue to hold Cotton and Oil.
    2. PCM's Currency Index continues to favor the Euro.

    FIXED INCOME MARKETS

    1. The U.S. Bond Total Return Index shows the most significant swing as it continues to be more bearish on long-term treasuries. Our index holdings, to a large degree, have slid to the shorter side of the yield curve (less than 24-month in duration) while maintaining an inverse (short position) in long term treasuries. This short-duration vs. short position spread indicates continued weakness in U.S. bonds with longer maturities and a rotation into other asset classes.
    2. Our managed TIPS (Treasury Inflation-Protected Securities) favors international inflation-protected bonds over US inflation-protected bonds. A theme that has existed for the past 8 weeks.
    3. PCM's Absolute Bond Index, which includes global bonds, is split between international corporate bonds (slightly higher risk) and short U.S. long term treasuries. From our perspective this is an interesting spread affirming a move away from US Treasury Bonds.
    4. The search for yield (higher investment income) continues for the main street investor and institutions alike. The trailing 12-month yield on PCM's Dividend & Income Players and Absolute Equity Income Indexes stand at 3.64% 4.61% respectively. There continues to be few options for income without excessive reach for yield and the corresponding associated risk.

    From a macro perspective, PCMs indexes are biased towards market bulls. Entering into the mid-first quarter, there is clear strength in U.S. Equities and continued weakness in U.S. Treasury Bonds. Whether or not the U.S. equity markets continue one of the best January starts in history into the first quarter of 2013 remains too been seen. On the short-term, U.S. Stocks appear to be the "place-to-be".

    On the longer term, we feel a little less optimistic as U.S. Policy Makers have not addressed the ongoing federal deficit or the unprecedented levels of U.S. debt. This is why we continue to advocate for our quantitative, risk managed index solutions. It seems there is consensus among many of our colleagues that the proverbial shoe will drop when Main Street recognizes the current patch to fiscal policy is unsustainable.

    Still, our short-term optimism does not conflict with our long term skepticism and it is our quantitative strategies and approach that provides peace of mind across all time horizons. For the long term, we continue to advocate PCMs lower-volatility indexes as a strong core to any portfolio.

    Clients whose accounts attempt to track our indexes will ride the strength in U.S. stocks and weather the gyrations in the US Treasury market. From a macro perspective we favor a broader commodity basket over a specific allocation to gold. Look for dividend yield and investment income in PCM indexes where the risk/reward relationship is more favorable to the investor.

    Todd Wood

    Co-Chief Investment Officer

    Chief Operations Officer

    Provident Capital Management, Inc.

    The views and strategies described herein are for illustrative purposes only and may not be suitable for all investors. The information is not based on any particularized financial situation, or need, and is not intended to be, and should not be construed as investment advice or a recommendation for any specific PCM or other strategy, product or service. Investors should consult their financial advisor prior to making an investment decision. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

    This material contains the current opinions of the author(s) but not necessarily those of PCM and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission. Provident Capital Management, Inc, PCM and Absolute Return Index are trademarks or registered trademarks of Provident Capital Management, Inc., in the United States.©2013, PCM.

    Disclosure: I am short SPY.

    Additional disclosure: I am currently own SPY Puts as a hedge to a long portfolio. For detailed disclosures information please go to pcminvestment.com/disclosure-legal.html

    Feb 04 3:08 PM | Link | Comment!
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