On The Coming Crisis

                                    Dr. Frank Sortino and Dr. Hal Forsey

In the July-August issue of Harvard Business Review, Dr. Robert Merton says; The seeds of an investment crisis have been sown. The only way to avoid a catastrophe is for plan participants, professionals, and regulators to shift the mind-set and metrics from asset value to income. Merton goes on to say, “Investment value and asset volatility are simply the wrong measures if your goal is to obtain a particular income.” We highly recommend you read this article. While we do not agree with his solution, We do believe he makes many cogent observations. What we would like to focus on now is the implication for performance measurement.

Whose performance are you measuring? For too long the performance of money managers has been presented as synonymous with the participant’s performance toward their goal.   Participants are deluged with returns on each manager for the last 3 months, 1 year, 3 years, 5 years…but always with the warning that past returns may not predict future returns.   How about seldom ever predict future returns? Then, to fill up a few more pages of the performance report, each manager is measured against the returns on a benchmark, like the S&P 500 or 50 other irrelevant indexes.  What do any of these returns over some arbitrary time period have to do with showing the participant where they are relative to their goal?  NOTHING!

Forget the moments: Recalling the first moment (the mean), or second moment (the standard deviation) from historic returns to capture a past experience or tell you anything meaningful about future experiences is like  trying to remember the experience of seeing the Grand Canyon for the first time by recalling only the date and time of day you saw it.  Conjuring up an image is what the mind does.  Better yet, take a picture that will capture what you saw and what to expect the next time you go there.

Here is the big picture taken with our special 21st century camera.  Think of it as a financial X-ray camera. Do you have a clue as to what Graphic 1 is portraying?  In addition to the graphic being too small it is not intuitively obvious (Click on the picture).

 Graphic 1

 Slide2

Merton rightly says: to my mind it’s a real stretch to ask people to acquire sufficient financial expertise to manage all the investment steps needed to get to their pension goals. That’s a challenge even for professionals. You’d no more require employees to make those kinds of decisions than an automaker would dump a pile of car parts and a technical manual in the buyer’s driveway with a note that says, “Here’s what you need to put the car together.”

Well, we are not talking to a car buyer.  We are talking to people who have the fiduciary responsibility for seeing to it that the 401(k) buyer is getting her money’s worth.  For that reason, YOU, the fiduciary, need to learn more about how to help your client, your employee, your participant…your beneficiary.  You don’t need to learn how to read X-rays in order to benefit from them, but you do need to know they exist and that you can go to a doctor with the training to read them.

So, let’s get started: the blue image shows the entire range of possible returns for the passive indexes that exactly fill up all those asset allocation boxes at the top of graph 1.  The black image shows what happens when you add those few active managers, out of thousands of possible managers, who could actually add value.  The arrow points to the upside potential ratio that shows the optimal portfolio with active managers has 30% more upside potential than downside risk, where risk is that you will not have enough money at retirement to achieve the payout that Merton says is the true goal.  The totally passive portfolio has 10% more downside risk than upside potential.  There can be no justification for choosing the totally passive portfolio.  PRI has provided empirical evidence[1] that the statistics provided in Graph 1 are better predictors of future performance than the mean and standard deviation of returns (historical, current, or projected).  So, what information should the plan sponsor pass on to their employees?

Relevance:   Merton has this to say on that subject: “The only feedback she needs from her plan provider is her probability of achieving her income goals. She should not receive quarterly updates about the returns on her investment (historical, current, or projected) or about the current allocation of her assets. These are important factors in achieving success, but they are not meaningful input for the choices about income that the customer has to make.” So, we say, the plan sponsor should not require the participant to make those choices, but instead, use the managed account QDIA option to provide the plan participant the following information:

Graph 2

Slide1

The MapVest® report shown above says, in the top left hand corner, “Currently, you are on track to replace 70% of your pre-retirement salary from your retirement account.” There is more, but suffice it to say, what Merton calls for, we can deliver.

Where we differ:

While there is much that we agree with in Dr. Merton’s important article in Harvard Business Review, there are these important differences:

  • Merton’s solutions ignore the return each investor needs to earn on their investment over time to achieve that desired payout at retirement. Instead Merton posits a “safe, risk-free asset,” which, if you had enough money, and it existed, would be an inflation-protected annuity. We do not believe such a thing can be created through a liability-driven investment strategy called “immunization.” I did my doctoral dissertation on immunization strategies. In our opinion, the costs associated with trying to create Merton’s Category 1 or 2 inflation protected income vehicles are not worth the hidden risks.
  • We do not see 401(k) plans as a liability management problem, as Merton claims. We see 401(k) plans as an asset-liability management problem. As we have pointed out for many years, the link between assets and liabilities is the return that discounts all those future payouts after retirement to the present value of the current assets and future contributions. This Desired Target Return® is directly related to what the participant is trying to achieve whereas the mean and standard deviation of historic returns are not, and interest rate risk is not. Therefore, the DTR® is the single most important calculation one can make with respect to any investment whose goal is some future payout.

Conclusion:  If participants are ever to achieve the goal of replacing a percentage of their salary at retirement we are going to have to drastically change the way we measure their performance toward their goal.  It is up to the plan sponsor to demand a solution for participants designed around the Desired Target Return that leads to each participant’s payout goal.  We end with a thank you to Dr. Merton for his important insights and a major point of agreement:

Merton: Clearly, the risk and return variables that now drive investment decisions are not being measured in units that correspond to savers’ retirement goals and their likelihood of meeting them. Thus, it cannot be said that savers’ funds are being well managed.”

 

[1]  Bernardo Kuan’s study, page 30, the Sortino Framework for Constructing Portfolios, El Sevier, Amazon.com

 

 

 

 

 

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The 401(k) Conundrum

Here is the problem: each participant wants to invest part of their salary each month in order to replace a sufficient amount of their salary at retirement.  To help them achieve this, the plan sponsor provides a number of investment vehicles, like mutual funds and/or ETFs for each investor to select from.

Unfortunately, the participant does not know which investment vehicle is best for them because the participant does not know how much money would be sufficient at retirement to achieve the payout.  Kathleen Pender at the San Francisco Chronicle says some pundits  claim participants will need 8 times their final salary while others claim the figure is more like 12 times.  The reason it is a conundrum is because all the solutions being proposed are developed by marketing people with simple solutions to complex problems that usually begin with, “all you have to do is…”

Kathleen Pender then correctly points out, “The real answer, of course, depends on your individual circumstances, including your income, age at retirement, life expectancy, expected return”…WHAT!

I was in full agreement until this point.

The expected rate of return is   the   wrong focal point.   The correct return to focus on is the return one NEEDS to earn on current assets and future contribution in order to achieve the actuarially determined payout.

The expected return is commonly calculated as an average return achieved on some market index over time.  The NEEDED return is the return that discounts the future payout to the present value of the assets (current assets + contributions).  We call this the Desired Target Return or DTR.  It is this DTR that separates the risk of failing to achieve the estimated payout from the potential to exceed that payout.  Returns below the DTR cause failure to achieve the payout.  Returns above the DTR are the reward for taking on the true risk…that you will not have enough money to retire.  The average return is not directly related to the payout, the DTR is.

But who knows how to estimate that DTR and use it to guide participants toward their needed payout even when market corrections occur?

C’est moi!

 

 

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Smart Betas Exposed

I recently received an email with a request to read Bill Sharpe: “Smart beta makes me sick” by Robert Huebscher.  I agree with Bill Sharpe, the “Smart Beta Strategies” listed in this article make me sick also.  Congratulations Bill !  However, I disagree that the market place is divided between “Dumb and Dumber” investors. I believe it is divided between totally ignorant and less ignorant investors.  Theoreticians like Bill and empirical researchers like me are among the less ignorant.  That is because the future is unknowable.  If one believes that the uncertainty we face in the financial markets is best described by a bell shaped distribution of returns generated from a time series and the market is efficient, then holding the 60/40 mix of passive indexes is consistent with those beliefs and better than marketing gimmicks posing as strategies.

However, if the market is not efficient in the strong form sense, in that you have information that is not known by the vast majority of investors but is not subject to the insider trading rule; you might have a legitimate claim for constructing portfolios that differ from the market portfolio and for actively managing it instead of simply rebalancing periodically.  We at PRI have developed such a strategy and while we have published the methodology in journals, books and Pensions & Investments magazine, I know of no other institutions currently using it.  Therefore, I believe it qualifies as an exception to the strong form test of market efficiency.  For example, consider the following:

smart beta 1B smart beta 1A

While the blue line describes future uncertainty as bell shaped, the black line is somewhat different.  Yet both distributions in both graphs are generated from the same asset allocations.  The blue line is from a totally passive mix and the black line utilizes a blend of active and passive managers.  We claim only the totally ignorant would choose the blue line, if our methodology is superior to either Sharpe’s or the Smart Beta folks.  Proof: The black line dominates the blue line by second degree stochastic dominance rules.

Both graphs utilized Bradley Efron’s (Bill Sharpe’s colleague at Stanford) bootstrap procedure instead of calculating the means and standard deviations from a time series of returns.  Also, the graph on the left was generated from a different time period than the graph on the right.  Obviously, something is changing over time and that may be telling you to change the asset allocation.

What is the best known way to describe the uncertainty we face and to manage that uncertainty is the important question; not, who is dumber, less ignorant, better looking, older, wiser, etc.  I have notified Robert Huebscher of this posting in response to his article.

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Peace Nowhere in Our Time

In 1938 Neville Chamberlain returned from Europe with the infamous Munich agreement that promised “Peace for our time” and permitted Hitler to annex the Sudentenland, which was mainly inhabited by Germans.  The world has granted Putin no such authority to annex Crimea.  Nor does he give a damn.  It is tempting to say history is repeating itself.  But today is not the same as 1938…it is worse!  Bombs are exploding in China, set by Uyghur’s.  Bombs are exploding in India, set by Muslims.  Bombs are exploding throughout the middle east set by God knows who.

There is rebellion in the air. Oppressed people are in the streets all over the world overthrowing governments.  Chinese are shutting down plants demanding pension plans.  Even Americans are protesting about high rents and private buses in the public bus lane taking techies to work in Silicon Valley.  And yet, the stock market is blithely coasting along at its all time high.  Does the market know something we don’t know?  The market is all of us and none of us KNOW anything.  We have opinions and beliefs but only fools behave as if they know when or what the next shock will be.

What is needed is a professional way to respond to rather than predict financial shocks that periodically postpone the world’s economic improvement.  Rebalancing is the approach used by most professionals.   However, I believe there is a better way to manage such shocks.  I call it “Portfolio Navigation.” Please watch the January 9th video posted below.

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VWO sell off

Yesterday the S&P was off .5% and small cap ETFs like VWO were off FIVE TIMES as much.  This is happening often across a wide range of small cap ETFs I follow.  This is not the time to batten down the hatches but it is time to trim the sails and head for a safe harbor with small craft.  Daily volume often runs 50% to 150% higher than average and the market cannot handle that volume.  If you are going to venture out in choppy seas, be sure you are on a large (cap) ship.  This is the kind of market where active managers can really add value.

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Defining Risk Video

Many people are talking about risk in a way that has nothing to do with what is at stake.  The myRA  bond introduced by President Obama at his state of the union address is the latest example.  This 3 minute video is my explanation of what is at stake. The 2nd video is a 4 minute video on Portfolio Navigation.  The 3rd video is an interview with the former CEO of The City and County of San Francisco Retirement System and an interview with professor Sam Savage of Stanford University.  The full 30 minute video that covers the research findings of the past 30 years is available at the KMVT link below the interview video.

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Portfolio Navigation Update

Dr. Frank Sortino discusses a better way to make asset allocation changes than either rebalancing or LDI. (SEE Also November 2012 under Archives)

This is a 5 minute clip from a 30 minute video produced at KMVT Studios in Silicon Valley. (For the full video0 (Click on  KMVT Channel.)

Isn’t this just like…(insert phrase) is what we often say when someone describes something new to us.  No doubt Einstein heard, “isn’t that just like Newtonian physics”? when he presented e = mc2 .  After all, physics is physics.   At a much lower level of complexity, we have heard some comparisons that need clarification.  The video explains how Portfolio Navigation is different from rebalancing and LDI but it does not address two other faulty comparisons.

  1. Isn’t this just another form of momentum investing?  Perhaps the most notorious form of momentum investing was called Portfolio Insurance, developed by two professors at U.C. Berkeley.  It involved a mathematical formula for increasing equity exposure as the market went up and decreasing exposure as the market went down.  Yes, Portfolio Navigation does involve mathematics but the underlying methodology seeks to do quite the opposite, i.e., a large rise in the market will cause the DTR to decrease, thus decreasing equity, because you will then need a lower rate of return to achieve your desired pay out.  Whereas Portfolio Insurance failed in 1987 because they were trying to unload positions as the market crashed, Portfolio Navigation would be increasing equity exposure after a decline sufficient to increase the DTR.  The market place could not accommodate all sellers and no buyers but it would have welcomed our buy orders.

 In the study performed ex ante at P&I magazine in 2000 the high tech mutual funds of 1998 were replaced by  large cap value and Income and growth funds.  With the CIFs managed at Fiserv , the change in the UP ratio and DTR alpha resulted in a decrease in equity in mid 2007.

  1. Isn’t this just doubling down?  A strategy in the Black Jack card game calls for doubling your bet when you lose as a way to recoup losses.  Yes, Portfolio Navigation increases equity exposure as the portfolio value declines,  but only enough to get back on course to obtain a DTR  needed to achieve your desired payout.  Doubling the equity exposure would be a crude and foolish strategy.
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