Negative Tail risks in 2011 and beyond...

The world will probably not come to an end in 2011 or even in our lifetime for that matter but there is something else that is likely to rock the rest of our lives: "black swan" or "fat tail" events.
They have always existed but, unfortunately, human memory suffers from a bout of short termism, we tend to forget longer term experiences, especially if they are unpleasant. I guess it is an inherited trait of our ancestors which explains why the human spirit tends to be on average optimistic. Because of our short term memory bias, however, we dont realize that "fat tail" events in fact occur more frequently than we think they do. Also I would add that a "black swan" event can also be a pleasant one such as when a major market rally occurs but we like to concentrate on the negative end because that is what needs to be controlled.
For this year, we see several risks that have negative "black swan" potential. The table above summarizes the more important ones.

Can the Eurozone survive?

The more time goes by, the worse it looks. The Eurozone frailty is getting more difficult to manage by the day and to understand why, we need to dwelve into the mechanism behind the Euro. Both Europe and the U.S. are in deep trouble but the source of their troubles and, in turn, the approach to resolve those troubles are very different.

The Euro project, from the very beginning, was meant to unify Europe on the economic front only. By creating a single currency, it was believed, trade would flourish and mobility would increase. A single currency makes it far easier and less costly for industries to plan ahead with production.

What everyone seems to forget is that there is also an implied cost to this, which may not seem evident when things are going well. A single currency without a political overlay can be problematic in certain situations like the one that is currently unfolding in the European continent. By joining a single currency, a country is effectively giving up independence on the monetary front. Without political unification, however, fiscal policy stays local. This is in stark contrast to the U.S. with its federal government in which both monetary and fiscal policy is managed at the federal level. What this means is that a state is unlikely to find itself in a situation like many of the peripheral European countries are facing today, having trouble raising capital to pay for maturing debt. This is because such issues are dealt with at the federal level.

So what actually happens when you lose monetary independence but keep fiscal independence and you are facing the type of challenges that we are seeing today? Well, you get hit by a so called double whammy. Let me explain: The booming years inflated prices and now that the crisis has hit and the asset price bubble burst, costs such as wages need to come back down. For a country with an independent monetary system the solution is rather straight forward. Instead of cutting wages, you just depreciate your currency and the problem is pretty much resolved as it is the equivalent of cutting wages. In a country that does not have monetary independence the only real solution is to cut wages, and if history is any guide, this can be a slow and painful process. Prices tend to be sticky on the downside, producers will wait for wages to come down before cutting prices (to preserve margins) and workers will wait for deflation to hit before agreeing to have their wages cut. This is exactly the problem facing a highly unionized Europe, which, through austerity will have to apply the painful cost cutting process as it is the only possible solution at their hands short of regaining monetary independence or defaulting on their obligations which are unlikely to happen any time soon.

Stagflation in Europe?

The euro zone's annual rate of inflation hit a 2 year high in December, driven by fuel, food, alcohol and tobacco prices at a time when the ECB is dealing with a major sovreign debt crisis.
Consumer prices rose 0.6% from November, pushing the year-to-year rate up to 2.2% from 1.9% the previous month, the highest annual rate since October 2008 when it stood at 3.2%.

A surge in cost price inflation that is likely to be passed on to consumers, just as European governments are embarking on an austerity program limits the ECB's flexibility on the monetary front somewhat. But at the same time it should not be forgotten that price stability (i.e. low inflation) is the primary objective of the ECB, in contrast to the Fed that targets both price stability and unemployment.

Applying the brakes at a time when stimulation is most needed could bring Europe closer to the brink of stagflation. Considering the sovreign debt related uncertainty surrounding Portugal and especially Spain, the austerity measures and a whole lot of other problems, a rate hike might just prove too much to handle.

Risk vs. structure based asset allocations

2008 reminded us that diversification can fail spectacularly when risky assets are clumped together. This is because when panic sets in, there is a sort of hoarding activity in the markets as investors jump ship from risky to less risky assets. By doing so, the correlation between risky assets spike, leading to simultaneous losses from investments of different asset classes. This is why, for example, at the peak of the crisis, high yield and emerging bonds and commodities followed the exact same path as equities at the very moment when the benefits of diversification were most needed. What use to be diversified suddenly becomes concentrated.

How can we avoid or at the least minimize such serious pitfalls? One method would be to implement a risk based asset allocation, grouping together investments according to their risk characteristics.

The traditional approach to asset allocation has been to classify assets according to their structure. Genotype/phenotype are good biological analogies to help illustrate the differences. Genotype describe hereditary characteristics (structure based classification) whilst phenotype are the observed properties (risk based classification). As an example, grouping together fixed income investments comprised of bonds with characteristic cash flow streams that include coupons and a final payment at maturity would belong to a traditional structural classification. The problem with the traditional classification is that the investment landscape has changed substantially over the last decade. The risk spectrum of investments with a similar underlying structure has broadened substantially. Today, for example, bonds can include low risk, short duration treasuries as well as high yield/emerging debt that share risk characteristics that are comparable to that of equities.

There are effectively two ways to tackle this problem:

• Managing the risk internally, within the asset class by implementing strict guidelines
• Defining risk at the asset class level

The first method would involve limiting the choice of underlying investments for more effective risk control. One such approach would be to implement a core/satellite approach in which the "larger" core would comprise of less risky investments in contrast to the satellites.

The second method is best explained as a target based approach in which the asset classes are defined as targeting specific objectives. We could very well imagine, for example, a portfolio comprised of four "asset classes" with the following defined objectives:

1. Longer term high returns (equity like risk/reward characteristics)
2. Hard assets (namely for inflation protection)
3. Liabilities matching (high quality low duration fixed income)
4. Pure excess return (de-correlated to the rest of the markets)

This method has the advantage of providing greater transparency and better risk control, at the same time allowing for a greater degree of specificity in matching investor objectives and constraints. A person close to retirement, for example, would typically allocate a large portion of their wealth to liability matching instruments in contrast to someone at the prime of their career, in which case the attributions would probably be more balanced between the four classes.

The two proposed methods aim for the same objectives, the big difference is in the approach.

Is misery back?

The misery index is an interesting economic indicator, courtesy of Arthur Okin, a famous American economist. The idea behind it was a sort of early attempt to capture or measure the misery that one would supposedly experience when the economy was not doing too well. It is basically a combination of the unemployment rate and the rate of inflation combined into a single measure. The graph above plots the misery index for the U.S. over the past four decades with the blue bar representing unemployment and the red bar the rate of inflation. From its peak levels in the 70's and early 80's (high inflation and unemployment), the misery index has been steadily dropping with the occasional short period spikes in unemployment (91-93). Inflation has been far more tamed when compared to the late 70's and early 80's. On the other hand, we note a sharp rise in the unemployment rate, according to the most up to date figures (09), a somewhat worrying observation in the context of dire economic conditions!

The impact of compounding...

Compounding (reinvesting investment gains) can have a wondrous effect on your wealth over the long term. Assume that you invest $1 million that grows by 5% annually for a period of 30 years. If everything goes according to plan, you should actually end up with a whopping $4,322,000 which over the entire period is an appreciation of 322%.

But what happens if you include fees in the equation? Assuming in the above example a 3% all in fee per annum, the final amount shrinks to $1,733,000, for a total gain of 73% over the 30 years and a startling difference of $2,589,000 when compared to the "no fee" version. If we cut the fees to 1.5% per annum, we arrive to a total of $2,746,000, for a gain over the period of 174% which brings the difference with the "no fee" version to $1,576,000.

To conclude, compounding has a substantial effect on the rate of growth of an investment. Because the effect is so significant, chipping into it also has a materially negative impact on the long term growth rate. In other words, if you wish to achieve a reasonable growth rate for your investments over the long term, it is not only important to be aware of the total amount of fees that you are paying, but also to ensure that these fees are reasonable and competitive for the services that you are obtaining.

Finally, the graph below illustrates these exact same concepts but in a more realistic setting: investing into the S&P 500 over the past 30 years. The results are no less startling!

Investing in emerging markets...

The slower economic growth prospects for both the U.S. and Europe have been prompting a growing number of investors to focus a larger share of the investment allocations to emerging markets where a healthier economic environment and sounder policies ensure that growth rates will remain above average for some time to come.

Whilst there is no denying the relative attractiveness of emerging markets at this particular point in time, there is the traditional tradeoff of greater volatility or risk in return for the expectations of higher returns.

There is, however, an additional risk factor that should not be overlooked. The price / earnings ratio (P/E) of developing markets tend to be higher than those of developed markets and right now the difference is rather important given the growing enthusiasm for emerging market investing. The graph above shows the difference in P/E ratios between the U.S. and China. Trouble with high and expanding P/E ratios is that it may be signaling bubble territory which means that there may be a real risk of a sharp correction sometime down the road.

Considering the degree of globalization and integration of economic markets across the globe, a more effective and less volatile way of investing into emerging markets may be through developed market stocks. Given their lower relative P/E ratios, longer history, corporate culture and growing exposure to emerging markets, a number of developed market firms may in fact provide a more effective manner of gaining exposure to emerging markets at a lower volatility to comparable firms in the region. Food for thought.

Rebalancing relative to market values...

Rebalancing a portfolio can be perceived as a contrarian approach to investing and rightly so because what you are effectively doing is selling the asset that is performing well and buying the one that is not. This strategy can be highly effective in a directionless market and much less so if markets are heading in one direction all the time (as they did between 2003 and 2007).
How less effective it is also depends on a number of factors, one of which is the width of the rebalancing bands that the portfolio manager has defined. If they are too narrow and therefore trigger frequent rebalancing in a directional market environment, the portfolio will be less effective in capturing positive returns than say a portfolio with more generous bands or a buy and hold strategy.
On the other hand, if the markets are directionless (i.e. trendless), a rebalancing strategy is bound to be substantially more effective than a buy and hold strategy.
When constructing a portfolio, one of the main tasks is to define the asset allocation for the various asset classes. The main building blocks of an optimal asset allocation portfolio include historical data for the asset classes, the objectives and constraints of the investor, the impact of economic policy and current market values of assets. Among these variables, only one happens to be backward looking (historical data).
Most of these variables can be plugged into an optimizer to generate an efficient frontier on which an optimal portfolio can be devised as a function of the risk/reward appetite of the investor.
Once the portfolio is fully invested, in order to preserve its "optimal" risk profile, it needs to occasionally be rebalanced . A major drawback with this traditional approach to portfolio construction is that it totally fails to take into account the collective market perception of risk. The market values of the various assets in effect reflect the collective market perception as to the riskiness of those assets. By not taking this into consideration, the portfolio manager may in effect be taking greater or less risk than what was originally planned.
As an example, following the severe stock market correction of 2008, managers that followed a stict rebalancing regimen may have inadvertently increased the risk profile of their portfolios. In other words the portfolio may be overweight stocks relative to the markets.
So what are the lessons to be drawn from all this? If we want to ensure that risk profiles are preserved more effectively, we need to somehow find ways to reflect market values in the portfolio. At a strict minimum one should keep track of the market values of the various asset classes and compare their change through time to the same asset classes in the portfolios.