Erm Symposium Slides
Transcript of Erm Symposium Slides
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Managing Personal Wealth in Volatile Markets
An ERM Approach
Jerry A. Miccolis, CFA®, CFP®, FCASMarch 15, 2011
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By way of (re)introduction…
Principal & Chief Investment Officer, Brinton Eaton Wealth Advisors
Former Principal & ERM Global Practice Leader, Towers Perrin Former Chair, CAS ERM Committee Author/co-author:
Asset Allocation For Dummies® (Wiley, May 2009) Enterprise Risk Management: Trends and Emerging Practices (IIA, June
2001) Related publications
Member of the Financial Planning Association (FPA) and the New York Society of Security Analysts (NYSSA)
35+ years of actuarial, risk management, and investment experience
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A brief overview of today’s discussion
Personal wealth management is risk management ERM is the natural conceptual framework to build
and protect wealth This has certain implications Investment strategy needs to
be focused on the right goals MPT needs modernization Asset allocation needs to be
dynamic Catastrophe protection needs
to be creative
All this is achievable with currently available tools
Ask questions!
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Investing has always been an exercise in taking, and managing, risk
But, the game has changed DB plans DC plans, 401(k)s
Underfunded Social Security
Risk-shifting to the individual investor
Now, more than ever, wealth management IS risk management
And the risks are substantial 2008 — a wake-up call; contagion like never before
It can happen again
Fault lines in MPT have been starkly exposed Something more is needed
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Enter ERM
MPT ERM MPT ERM owes a lot to MPT
It’s time for ERM to return the favor
Premise: the core principles of ERM can form the basis for successfully building personal wealth
Build on four key “pillars” of ERM Strategic focus
Natural hedging
Risk exploitation
Catastrophe protection
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These four pillars support a strong bridge —between corporate and personal best practices
5
ERM Pillar Organizational ERM Individual ERM
Strategic FocusCustomize risk management around, and
in service to, the organization’s specific
strategic objectives
Customize your investment strategy around
your own unique long-term financial objectives
— which is the real purpose of your investments
Natural HedgingLook across operational silos to find risky
operations that offset each other
Diversify and allocate investments among
uncorrelated asset classes — using up-to-date
tools
Risk ExploitationUse the ERM-enlightened view to do
informed risk-taking, exploiting areas
deemed “too risky” by competitors
Employ informed risk-taking to exploit high-
performing but risky assets — making volatility
work for you
Catastrophe ProtectionTransfer only those risks that can’t
naturally be hedged away, and insure
those risks only at catastrophic levels
Use “safety net” portfolio protection as
catastrophe insurance against major market
shocks that diversification can’t handle — and
in a cost-effective wayBrinton Eaton, 2011
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Strategic Focus
6
ERM Pillar Organizational ERM Individual ERM
Strategic FocusCustomize risk management around, and
in service to, the organization’s specific
strategic objectives
Customize your investment strategy around
your own unique long-term financial objectives
— which is the real purpose of your investments
Natural HedgingLook across operational silos to find risky
operations that offset each other
Diversify and allocate investments among
uncorrelated asset classes — using up-to-date
tools
Risk ExploitationUse the ERM-enlightened view to do
informed risk-taking, exploiting areas
deemed “too risky” by competitors
Employ informed risk-taking to exploit high-
performing but risky assets — making volatility
work for you
Catastrophe ProtectionTransfer only those risks that can’t
naturally be hedged away, and insure
those risks only at catastrophic levels
Use “safety net” portfolio protection as
catastrophe insurance against major market
shocks that diversification can’t handle — and
in a cost-effective wayBrinton Eaton, 2011
Call 800.364.2468 :: Visit brintoneaton.com
What’s your situation?
Retirement Objectives
Lifestyle Requirements
IncomeSources
Investable Assets
Risk Tolerance
PlanningHorizon
Charitable Inclinations
Gifting/estate Intentions
Tax Status
Investment Constraints
7
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What’s riskier?
8
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Hard Luck Harry has a choice to make
Risk doesn’t exist in a vacuum
9
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Lifetime Cash Flow Projections – Assumptions
10
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Lifetime Cash Flow Projections – Assumptions
11
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Lifetime Cash Flow Projections – Results
12
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The results can be counter-intuitive
13
AB
CD
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E
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Confidence Level
Beginning Investment Strategy
Ending Investment Strategy
Illustrative Client Example
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Strategic Focus — Recap
Customize your investment strategy around your own unique long-term financial objectives — which is the real purpose of your investments
Your financial situation has many moving parts
Financial planning tools can capture the complexities in a coherent way
The right investment strategy is the one that best secures your own financial future
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Natural Hedging
15
ERM Pillar Organizational ERM Individual ERM
Strategic FocusCustomize risk management around, and
in service to, the organization’s specific
strategic objectives
Customize your investment strategy around
your own unique long-term financial objectives
— which is the real purpose of your investments
Natural HedgingLook across operational silos to find risky
operations that offset each other
Diversify and allocate investments among
uncorrelated asset classes — using up-to-date
tools
Risk ExploitationUse the ERM-enlightened view to do
informed risk-taking, exploiting areas
deemed “too risky” by competitors
Employ informed risk-taking to exploit high-
performing but risky assets — making volatility
work for you
Catastrophe ProtectionTransfer only those risks that can’t
naturally be hedged away, and insure
those risks only at catastrophic levels
Use “safety net” portfolio protection as
catastrophe insurance against major market
shocks that diversification can’t handle — and
in a cost-effective wayBrinton Eaton, 2011
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MPT — the beginning
Conceptual breakthrough Risk/return tradeoff Asset class correlations Efficient frontier Prudent Investor Rule
MVO Single period Everything is Normal Risk is standard deviation Efficient frontier derived via
closed-form solution Can solve equation by hand Useful in the 1950s!
Risk
Ret
urn
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MPT evolves
High-speed computing MVC-based simulation Non-normality Fat tails Multiple periods Compound returns/risk drag Rules-based rebalancing More realistic risk measures
Shortfall risk Conditional VaR
MPT has come a long way…
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…but it’s still only as good as its assumptions
MVC — Mean/Variance/Covariance Mean Expected asset class returns move in cycles
Momentum/mean reversion
Valuation
Variance Volatility is not constant
Clustering
Covariance Correlation — does it really measure what matters?
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-1
-0.5
0
0.5
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-1 -0.5 0 0.5 1
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-0.5
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-1
-0.5
0
0.5
1
-1 -0.5 0 0.5 1
Correlation — it gets the obvious cases right
ρ = +1 ρ = -1
ρ = 0
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Correlation — does it measure what matters?
ρ = 0 ρ = 0
ρ = …you name it! ρ = 0
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Correlation — can it mislead?
ρ = +0.95
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Correlation — what would Scooby Doo say?
“ruh ρ!”
“While the Pearson Rho correlation coefficient serves the limited purpose of quantifying the degree of linear relationship between random variables, the actual relationship among asset classes is sufficiently complex that a measure more robust, observant, relevant, asymmetric, multi-dimensional, and dynamic is needed to capture the deep, imbedded, structural relationship among those asset classes”
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Clearly, improvements in MPT tools and techniques are needed
Correlations copulas
MVC (statistical) models structural models Parameter risk ARMA — momentum/mean reversion GARCH — volatility in volatility, clustering Risk budgeting Regime-based optimization
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ρρ ρρ ρ ρρ ρ ρ ρ
ρρ ρρ ρ ρρ ρ ρ ρ
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Natural Hedging — Recap
Diversify and allocate investments among uncorrelated asset classes — using up-to-date tools
MPT is still the right conceptual framework
But, most applications are very much out of date
The needed tools are available
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Risk Exploitation
25
ERM Pillar Organizational ERM Individual ERM
Strategic FocusCustomize risk management around, and
in service to, the organization’s specific
strategic objectives
Customize your investment strategy around
your own unique long-term financial objectives
— which is the real purpose of your investments
Natural HedgingLook across operational silos to find risky
operations that offset each other
Diversify and allocate investments among
uncorrelated asset classes — using up-to-date
tools
Risk ExploitationUse the ERM-enlightened view to do
informed risk-taking, exploiting areas
deemed “too risky” by competitors
Employ informed risk-taking to exploit high-
performing but risky assets — making volatility
work for you
Catastrophe ProtectionTransfer only those risks that can’t
naturally be hedged away, and insure
those risks only at catastrophic levels
Use “safety net” portfolio protection as
catastrophe insurance against major market
shocks that diversification can’t handle — and
in a cost-effective wayBrinton Eaton, 2011
Call 800.364.2468 :: Visit brintoneaton.com
Diversification reduces risk…
$90
$110
$130
$150
$170
$190
$210
$230
$250
$270
0 1 2 3 4 5 6 7 8 9 10Year
Acc
ount
Bal
ance
Asset A
Asset B
50/50 Mix
26
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…Rebalancing improves return
$90
$110
$130
$150
$170
$190
$210
$230
$250
$270
0 1 2 3 4 5 6 7 8 9 10Year
Acc
ount
Bal
ance
Asset A
Asset B
50/50 Mix
Rebalanced 50/50 Mix
27
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What about in real life?
0
500
1000
1500
2000
2500
3000
3500
4000
S&P 500US RE
28
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Diversification reduces risk in real life too…
1980 - 2009 Results
11.0%
11.1%
11.2%
11.3%
11.4%
11.5%
11.6%
11.7%
15.0% 16.0% 17.0% 18.0% 19.0% 20.0%
Risk
Ret
urn
S&P 500US Real EstateCombined 50/50
29
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…and it also improves return
1980 - 2009 Results
11.0%
11.1%
11.2%
11.3%
11.4%
11.5%
11.6%
11.7%
15.0% 16.0% 17.0% 18.0% 19.0% 20.0%
Risk
Ret
urn
S&P 500US Real EstateCombined 50/50Combined w/ rebalancing
30
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Rebalancing puts the inherent volatility among assets to work for you
31
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The more volatile your assets, the more mileage you get from rebalancing
The more distance your pistons travel, the more powerful your engine
32
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There is a more proactive way to exploit risk
Dynamic asset allocation Explicitly treats momentum/mean reversion Utilizes early warning indicators
Signals can be internal and external Moving average algorithms Valuation measures
DAA reflects the fact that MPT is only as good as its assumptions Recognizes that assumptions can change dynamically Structurally sound way to:
Test your foundational assumptions Nimbly make adjustments as appropriate
Leading Economic Indicators Credit spreads/money flows
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Sector rotation is an example of DAA
0.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00
160.00
34
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Risk Exploitation — Recap
Employ informed risk-taking to exploit high-performing but risky assets — making volatility work for you
Rebalancing is the classic way to exploit volatility
Dynamic asset allocation takes rebalancing to the next level
You can capture higher returns than those investors who have a less enlightened risk perspective
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Catastrophe Protection
36
ERM Pillar Organizational ERM Individual ERM
Strategic FocusCustomize risk management around, and
in service to, the organization’s specific
strategic objectives
Customize your investment strategy around
your own unique long-term financial objectives
— which is the real purpose of your investments
Natural HedgingLook across operational silos to find risky
operations that offset each other
Diversify and allocate investments among
uncorrelated asset classes — using up-to-date
tools
Risk ExploitationUse the ERM-enlightened view to do
informed risk-taking, exploiting areas
deemed “too risky” by competitors
Employ informed risk-taking to exploit high-
performing but risky assets — making volatility
work for you
Catastrophe ProtectionTransfer only those risks that can’t
naturally be hedged away, and insure
those risks only at catastrophic levels
Use “safety net” portfolio protection as
catastrophe insurance against major market
shocks that diversification can’t handle — and
in a cost-effective wayBrinton Eaton, 2011
Call 800.364.2468 :: Visit brintoneaton.com 37
Traditional ways to protect portfolios are not enough
High allocation to cash / US Treasuries
Precious metals
Annuities
Puts / collars
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More creative approaches are needed
Additional portfolio diversifiers Market neutral/absolute return strategies
Commodity momentum plays
Portfolio safety nets Hybrid puts
Correlation plays
Volatility plays
Buyer beware
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Criteria for an effective safety net
Sudden appreciation in severe market downturns “Severe” denoting sudden, substantial, unexpected decline in
market value across most major asset classes, as in 4Q08 (i.e., when diversification doesn’t help)
Appreciation to a degree sufficient to meaningfully offset the decline No “give-back” during market recovery!
Very low cost Minimize diversion of funds from productive use No sacrifice of upside portfolio potential I.e., it is “insurance” we expect not to use
Minimal disruption to portfolio Maintain what works in vastly more likely markets “Don’t throw the baby out with the bathwater”
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The criteria in a picture
50
100
150
200
Nov-98
Nov-99
Nov-00
Nov-01
Nov-02
Nov-03
Nov-04
Nov-05
Nov-06
Nov-07
Nov-08
Nov-09
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Effect on the portfolio
50
100
150
200
Nov-98
Nov-99
Nov-00
Nov-01
Nov-02
Nov-03
Nov-04
Nov-05
Nov-06
Nov-07
Nov-08
Nov-09
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How does it work?
Volatility “swap” “Buys” daily volatility
“Sells” weekly volatility
Published index; transparent formula
Accessed via a structured note 1X exposure to S&P 500
Stock Index
3X exposure to swap index
S&P 500 Total Return Index 9/22/10-9/28/10
1880
1885
1890
1895
1900
1905
1910
1915
1920
1925
9/22/2010 9/23/2010 9/24/2010 9/25/2010 9/26/2010 9/27/2010 9/28/2010
42
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Catastrophe Protection — Recap
Use “safety net” portfolio protection as catastrophe insurance against major market shocks that diversification can’t handle — and in a cost-effective way
Treat only those risks that asset allocation/ rebalancing aren’t designed to cover
Think outside the box, as traditional risk hedges are inferior on several levels
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Have we covered all the bases?
Personal wealth management is risk management ERM is the natural conceptual framework to build
and protect wealth This has certain implications Investment strategy needs to
be focused on the right goals MPT needs modernization Asset allocation needs to be
dynamic Catastrophe protection needs
to be creative
All this is achievable with currently available tools
Ask questions!
Call 800.364.2468 :: Visit brintoneaton.com 45
For more information on these ideas…
Read: AssetAllocationBook.com Visit: www.brintoneaton.com Library
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