The Risk Averse Investors' Playbook

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Includes: DFREX, DODGX, DODIX, MSCFX, NAESX, QSPRX, TBGVX, VBMFX, VGSIX, VIVAX, VMNFX, VTRIX
by: EB Investor
Summary

Risk averse investors often struggle to find the right investment vehicles to participate in the market while achieving lower levels of exposure to portfolio beta.

For many index fund investors, the solution would be increasing exposure to fixed income. In this low rate environment, that increases duration risk, and thus is not optimal.

Investors who take advantage of vast amounts of academic research, and include style premia investment strategies may be able to achieve better risk-adjusted portfolio returns.

I have come across several investors who want to participate in the market, and yet do not want to take on excessive risk. While I generally attempt to build a portfolio with extensive exposure to market beta, for these investors, conservative growth is far more important. In these days of very low interest rates, these investors also do not want to add duration exposure to their portfolio. Therefore, in constructing a portfolio for this investor, I aim to target a Sharpe ratio of 0.60 and market beta of 0.70. With 30% less risk than the market, the objective is to create a portfolio with far lower standard deviation and far higher risk-adjusted return. In my previous pieces, I explained the differences between speculation and investment in analyzing active managers, and that analysis will come into play when building a risk averse investors' portfolio.

Addressing the Question of Bonds

For a risk averse investor, at this juncture in history, there is no use trading equity risk for bond duration risk. While I continue to believe that bonds play a vital role in the portfolio and should not be eliminated, I do believe that risk averse investors would be well-served keeping duration low and limiting the fixed income component to no more than one-third of the total portfolio. With that said, it is important to note that each individual's circumstances will be different.

Additionally, I believe that disciplined active fixed income can add significant value for an investor who is risk averse, yet needs income from the portfolio rather than using fixed income strictly as a buffer. For example, the Dodge & Cox Income fund currently has a TTM yield of 3.07% and a duration of 4.20. This is a great example of a fund that can add value to investors' portfolios, while not producing high levels of duration risk. The 3.07% yield is particularly attractive in this low rate environment for investors who need income. Bonds play an important role, and should remain in an investor's portfolio.

Addressing the Question of Equity Risk

In setting out to build a portfolio for the risk averse investor, many passive investors would merely increase allocations to fixed income and hold less equity arguing that the cost of active management is not worth it. I couldn't disagree more, fiduciaries, operating active strategies can add immense value to investors' portfolios. In this section, I would like to take a look at equity risk through the lens of the risk averse investor. For many investors, the notion of being out of the market is unacceptable. However, taking on complete market risk and having high exposure to market beta is also unacceptable as it opens an investor up to extensive losses in a bear market. For investors who follow the principles of Warren Buffett, there are only two rules: Rule 1. Don't lose money, Rule 2. Follow Rule number 1. While no professional investor or portfolio manager can provide assurance that they will not lose money, there are many strategies that seek to provide a lower risk exposure to market beta.

In my last piece, The Art & Science of Investing, I discussed the role of core and explore in building portfolios. I specifically explored Tweedy, Browne & Co., and its flagship Global Value fund. The global value fund (MUTF:TBGVX) is particularly attractive for the low risk investor for many reasons. First, the partners seek to manage capital with a risk averse approach of seeking value. They are not afraid to hold cash when there is little value to be had in the market. While this opens investors to increasing cost through cash drag, it can be far more costly for investors to be fully exposed to equities for the sake of a particular strategy and then suffer extensive losses as a result. In the world of value investing, when values are sparse, portfolio managers should be willing to take fiduciary actions to protect shareholders' capital. This includes being willing to hold cash when market valuations provide few opportunities. Analyzing Tweedy, Browne's approach demonstrates its appeal for the risk averse investor. The fund takes less risk than the market, has had an incredible track record of producing alpha and has produced a superior return per unit of risk taken. Tweedy, Browne's exceptional performance during bear markets is particularly important for those averse to risk.

(Source)

Alternative Investments for the Risk Averse Investor

In my previous piece An Evidence Based Approach to Alternatives, I introduced investors to style premia investing and, particularly, the AQR Style Premia fund. For risk averse investors, the style premia fund produces a particularly attractive risk reward ratio. The fund seeks to capture the premium of four known sources of outperformance defensive, momentum, value, and carry. Style premia investing has a long history in the academic literature and is well documented. Seeing as the fund is aiming to capture premia from multiple sources, the fund is uncorrelated to traditional assets, and can provide investors with unique benefits unmatched by most alternative strategies. AQR targets a higher Sharpe ratio and seeks to provide an alternative asset that can be a powerful hedge against inflation. Creating an asset allocation that evenly divides assets between traditional fixed income, equity, and alternative assets can be a powerful way to produce solid portfolio returns while reducing overall risks. As the chart below demonstrates, including 30% to style premia investing raises the Sharpe ratio to 0.73. If we further amend the portfolio model to include low risk equity strategies, we can increase the Sharpe ratio further while lowering market beta.

Constructing a Risk Averse Portfolio

Objective:

An investor can take many paths towards creating an investment portfolio that meets their goals of being risk averse. For many investors, a typical balanced fund approach is the most popular. I believe investors can achieve better outcomes when they employ sound academic research and seek to gain the benefits of style premia investing. For this example, we are going to compare a low risk strategy which includes style premia with a traditional balanced index comprised of index funds. To analyze the effectiveness of the portfolio, we are going to use a few rules:

  • Keep total portfolio costs low, under 1.00%
  • Seek to achieve a Sharpe ratio 50% higher than the market
  • Seek to achieve a beta that is 20% lower than the market
  • Seek to achieve a standard deviation of returns that is 30% lower than the market
  • Seek to achieve a return at or above the market return

Portfolio:

MARKET PORTFOLIO

PERCENTAGE

RISK AVERSE PORTFOLIO

PERCENTAGE

Vanguard Total Bond Index (MUTF:VBMFX)

20%

Dodge & Cox Income (MUTF:DODIX)

20%

Vanguard Real Estate (MUTF:VGSIX)

15%

DFA Real Estate Securities (MUTF:DFREX)

15%

Vanguard Small Cap Index (MUTF:NAESX)

15%

Mairs & Power Small Cap (MUTF:MSCFX)

15%

Vanguard Value Index (MUTF:VIVAX)

10%

Dodge & Cox Stock (MUTF:DODGX)

10%

Vanguard International Value (MUTF:VTRIX)

20%

Tweedy, Browne Global Value

20%

Vanguard Market Neutral (MUTF:VMNFX)

20%

AQR Style Premia (MUTF:QSPRX)

20%

Metrics:

SUMMARY DATA MARKET PORTFOLIO RISK AVERSE PORTFOLIO RISK AVERSE PORTFOLIO ADVANTAGE

Beta 20% lower than the market portfolio

0.84 0.51 24%
Sharpe ratio 50% higher than the market portfolio 0.49 0.82 69%
Standard deviation 30% lower than the market portfolio 13.16 9.05 31%
Return at or above the market portfolio return 6.45% 6.93% 0.48%

*Data from Morningstar.com, compiled by the author

In conclusion, risk averse investors can still aim to achieve competitive investment returns without taking undue risk. In this piece, I have explored some of the portfolio construction techniques that seek to add return while minimizing the marginal risk an investor needs to take to achieve their investment goals.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.