I am often surprised at how the investment industry media finds ‘news’ in investment methods that Pinnacle has been employing for years. This weekend’s Wall Street Journal offered a wonderful example. In a Saturday article entitled, “Same Returns, Less Risk,” Ben Levisohn and Joe Light describe a new investment strategy where portfolio managers handle risk by targeting portfolio volatility instead of a portfolio’s asset allocation. I found this of great interest because we’ve been utilizing this technique for close to a decade. The article identifies three different methods for targeting volatility. It’s worth reviewing them here and pointing out which of the three is closest to what we do at Pinnacle.
According to the authors, “risk-based portfolios focus on volatility, not expected returns. Such portfolios change their holdings based on each asset class’s volatility at any given time.” The first technique for targeting volatility is called “risk budgeting,” which they describe as building a portfolio based on a desired level of volatility. This is close to what we do at Pinnacle.
The second technique is “risk parity.” This technique changes portfolio asset allocation so that each asset class ends up having an equal amount of volatility. To do so requires using leverage, which we believe unnecessarily adds to portfolio risk, so while we definitely understand the principal, we would pass on this technique for practical considerations.
The third technique mentioned is “risk control,” which involves buying and selling stocks constantly to keep volatility stable. While we don’t call this risk control, and we don’t describe our entire investment process in this manner, we do utilize the technique. We are constantly looking at volatility measures like the VIX Index, which measures the volatility of options traded on the Chicago Board of Options Exchange and is a well-known proxy for market volatility. When the VIX is spiking we are likely to consider buying, since panic selling often offers a good buying opportunity for value-oriented investors. The notion of buying high volatility and selling low volatility is a useful way to go about managing overall portfolio risk.
Back to the first technique: I love the term “risk budgeting.” I’m reminded of the first time I read an article about “Go Anywhere” mutual funds and realized that Pinnacle neatly fit the description. Go Anywhere funds are not constrained to own specific asset classes so the managers are allowed to go anywhere in their pursuit of value opportunities. We allow our own analysts this kind of flexibility as we consider what to own in our managed accounts. So ever since the industry invented the term, I’ve been calling our investment process a Go Anywhere strategy. (Of course we were a Go Anywhere manager for about a decade before the industry invented the term, but that’s beside the point.) With this weekend’s article, we now find ourselves in the happy position of stealing from the media another excellent description for what we do.
We have often explained our approach to managing volatility using a picture of five buckets of risk where each bucket is incrementally larger than the next. Each bucket represents a Pinnacle strategy, so the bucket names are Dynamic Conservative (DC), Dynamic Conservative Growth (DCG), Dynamic Moderate Growth,(DMG), Dynamic Appreciation (DA), and Dynamic Ultra Appreciation, (DUA). Pinnacle analysts are allowed to fill each bucket with any asset class that they believe offers good value to our clients, so we have a go anywhere approach to filling each bucket. However, the containers are buckets of risk (or volatility) so the DC bucket is much smaller than the more growth-oriented buckets like DA or DUA. The analysts get to put more volatile assets in the appreciation-oriented buckets, and they are not allowed to overfill any individual risk bucket. The amount of volatility allowed in each bucket is determined by analyzing the risk or volatility of five asset class benchmark portfolios that have different asset allocations. The benchmarks range from 20% in stocks to 100% in stocks. We have a lot of data about these volatility benchmarks since we track their monthly returns beginning from 1972 through the present. This treasure-trove of data allows us to make some reasonable assumptions about how volatile each of our strategies is likely to be in the future. So when we construct our portfolios, we’re not constrained by what asset classes we’re allowed to own, but by the volatility of the portfolio relative to the volatility of our benchmarks. The past volatility of the benchmark, and the current volatility of the benchmark, determines our risk budget.
I suspect that this is a critical difference between Pinnacle and the risk budgeters mentioned in the article. Managing to a risk budget as described by the authors often involves a predetermined target level of volatility, measured by standard deviation, allowed for a portfolio, and the portfolio managers are constrained to stick to that absolute amount of volatility. We offer client’s something similar, but the differences are important. Pinnacle clients sign a portfolio policy statement constraining us to a range of volatility, not an absolute target for volatility. The range allows Pinnacle analysts to underweight volatility or overweight volatility compared to our risk benchmark depending on our view of the financial markets. The key is that when we have low conviction in our market view our portfolios should have similar volatility to our risk benchmark, and when we have high conviction we can have more or less risk than our volatility benchmark.
A second important difference is that because we measure volatility relative to our benchmark, there will be times when absolute portfolio volatility will drift to the extremes of the range we define in our policy statements. In fact, during the 2008-2009 bear market, Pinnacle portfolios were less than half as volatile as our benchmarks for the period, but more volatile than the benchmark when compared to most historical periods. We think this makes sense. As long as Pinnacle clients are comfortable with their risk benchmarks, and understand the range of volatility that could be experienced over long and short-term time periods, then using a relative approach helps us to incorporate time diversification into our investment process. However, when volatility is floating at the top of our allowed risk budget it can produce short periods of anxiety that would be eliminated if the risk budget was an absolute fixed number.
The third difference between the two techniques involves how you forecast volatility. Pinnacle uses a variety of models to simulate what the volatility of our portfolio is likely to be in extreme market circumstances. For example, when correlations peak between asset classes, portfolio volatility can be much higher than it would be if correlations were low. A simple example would be the historical relationship between stocks and bonds. Investors would expect that in a recession bond prices would rally when stock prices fall. This obviously helps a balanced portfolio to have low volatility. But what happens in an inflationary scare when bond prices sell-off at the same time as the stock market? Portfolio volatility is likely to be higher than the average historical data might suggest. Because Pinnacle uses a relative approach to budgeting volatility, if we own stocks and bonds roughly in proportion to our risk benchmark, we’re likely to get close to our benchmark volatility.
But if you target absolute volatility, you have to be very accurate in your volatility forecast. If you want to target a portfolio standard deviation of 10, then you can use historical data to construct a portfolio that should be a 10 in normal markets. But if you are forecasting a recession, then you need to allow for much higher standard deviations from the stock portfolio and reduce your stock ownership in advance. I suspect that many of these portfolios make adjustments after-the-fact so that market forecasts are not necessary. Using an absolute target could lead to the counter-intuitive problem of adding volatility when portfolio volatility is too low, and selling volatility when portfolio volatility is too high. This is a problem because when markets riot and volatility is peaking, this is a time you would typically be a buyer (not a seller), which would actually add volatility to the mix. Conversely, when investors are complacent and volatility is very low, this would be a time to consider selling and not buying, which could actually reduce volatility and not add to it.
The bottom line is that while I didn’t know this prior to reading this weekend’s Journal, I can now tell clients and prospects with some confidence that we are a Go Anywhere manager that utilizes “Risk Budgets.” That sounds a lot better than being a Go Anywhere manager that fills buckets of risk, doesn’t it?