A League of Their Own - An Evolutionary Addendum to the Concept of Risk-Parity

They say hitting in baseball is a vision thing. Today, it is not uncommon to see a 6’ 6” pitcher, weighing in excess of 200 lbs., throw a fastball in excess of 100 miles per hour, to a hitter a mere 60’ 6” away, allowing only a fraction of a second to react properly. Ted Williams, the last man to hit over .400 during a regular season[1] had this “vision” thing and he was unsuccessful at hitting 60% of the time in his best year. The legendary Yogi Berra developed it by hitting beer bottle caps with a broom stick in his youth. The very best hitters may be able to see a pitched ball, better than the next guy, measured in hundredths of a second. Whether you are born with it or develop it or both, vision is defining with hitting in baseball. Are there other examples of the importance of vision?

The Investment Management Arena [IMA] is comprised of tens of thousands of extremely intelligent individuals all trying to do the same thing in roughly the same way. Largely because of Modern Portfolio Theory [MPT], posited by Professor Harry Markowitz[2], the joint concepts of risk and return have been discussed in tandem for seventy years or so, having served as key pivot points in the analysis of IMA performance by individual managers. In general, such performance has been checkered at best as a recent report suggested that 66% of large cap active managers failed to top the S&P 500 performance in 2016. On a longer term, 15-year basis, that percentage approached 90%.[3]

The above performance metric has been with us for some time. Investment managers probably aren’t getting dumber so what else could be going on? Is the compartmentalization of investment management painting investment managers into a corner? Largely because of all the financial missteps over the last century or so, we have built into the IMA a variety of “best practices” that are supposedly designed to head off unforeseen events, that is until the next unforeseen event happens. In that venue, it is difficult to think “outside the box” but there are those, e.g., Ray Dalio of Bridgewater Associates[4] who seems to have done this with his thoughts on the concept of risk-parity.

Risk-Parity

Mr. Dalio’s risk-parity protocol adjusts portfolios based on a risk allocation rather than on a more traditional capital asset allocation, each asset therein adding to the volatility mix, as evidenced by Bridgewater’s All Weather fund,[5] where low risk from equities via passive management is achieved via a portfolio of uncorrelated assets. If you devote some thought to this concept, whether you agree with it or not, it clearly plows new ground within the IMA and, potentially, represents a diversion from traditional investment management [TIM].

Valuation professionals often refine the scope of their engagement involving investment or other assets by defining the highest and best use of such assets, i.e., are they being used currently in such a way. Whatever our analysis may suggest about the merits of an investment asset, defining it by risk metrics may serve to help remove a lot of the noise that occurs in the process of investment selection. That may be a collateral benefit, or maybe even the primary benefit of a risk-parity approach. 

From the inception of Dodd-Frank[6] in the early 2000’s until only recently there have been somewhere around 12,000 financial reporting misstatements, as per Audit Analytics, 4,000 or so that have been so egregious as to fail the basic reliance test for such financials.[7] They are currently averaging around 700-800 per year among the current 3,700 or so publicly-traded companies [PTCs]. Is there another way to lower portfolio volatility?

Market Framing

In our lives, we often frame events that are important to us in some way. Two events that are important to fiduciaries, other than following the laws of their particular jurisdiction and their own investment policy statements are the simple duties to diversify and to minimize risk, i.e., the probability for loss, wherever they can. MPT has provided us with some guidelines in achieving same by suggesting that portfolios may be populated from securities positioned along a security market line where various returns and risks, i.e., standard deviation of returns or volatility, intersect. Professor Markowitz has suggested that this efficient frontier is a platform for equity markets.

The concept of efficient markets has become so intuitively pleasing that our court system seems to have finally picked up on it, including the Supreme Court of the United States[8] suggesting that investors have at their disposal all information that is known or knowable about the future prospects of a PTC’s market price. That same court, in Tibble v. Edison Int’l [9]also reinforced the idea that fiduciary responsibility stipulates “that the duty of prudence involves a continuing duty to monitor.” There is just one minor flaw in the thinking here and that is that one has to assume that the “markets” are a fair game.

Equity markets are beset by macro and micro forces, the former consisting of machinations like high-frequency trading, spoofing, etc., and the latter consisting of earnings management, fraud and the like that presents a great deal of investing difficulty for any but the most sophisticated investor, much less the average investor. Market framing mimics the protocol similarly used for corporate insiders who rely on “window periods” in and around the release of earnings to buy and sell their employer common stock [ECS]. If you have to rely on information from PTCs, the safest time to make investment decisions may very well be earnings season. 

A simple analogy would be to compare TIM to a motion picture and the market that we are suggesting as individual scenes within a motion picture. The discussion to follow establishes that such “framing” attempts to dramatically reduce, not only the information risk, but the actual market risk, i.e., price risk, that accompanies the trading of PTC shares in TIM. The market framing approach may very well work in the defined benefit [DB] plan space if you can convince an actuary that it will produce more consistent investment returns over time, which it does, with just a little over one-half the volatility, which it also does. 

A Market Return with Less Risk

For a DB plan, the actuary’s role is to monitor the investment results of such plans in conjunction with other considerations, e.g., salaries, mortality tables, etc., so as to fund a benefit for plan participants past their retirements in keeping with plan documents and state law. Actuaries calculate required contributions by plan sponsors to achieve a certain funded status. The calculation of an unfunded accrued liability may be one of the more important calculations made by an actuary for a DB plan. 

One should remember that actuaries do not do investment analysis in the traditional sense but rather consider such calculations as random variables, i.e., “plug” numbers gleaned from an IMA that has become standardized, so to speak. Actuarial investment assumptions use, in part, the concept of expected return E(R), a longer term metric evidenced in an approximation formula [AF], a key component of which is a standard deviation [volatility] assumption. As the AF backs out the volatility assumption, the lower the standard deviation the higher the E(R) over time.

If risk-parity exists where “…low risk from equities via passive management is achieved via a portfolio of uncorrelated assets” would it be possible to achieve the same portfolio results, at least in part, via market framing by simply reducing the volatility of the equity assets alone? What then would be the affect, if the actuary could rely upon a different investment milieu, one where selection of securities for investment was different from the norm?

Ray Dalio came to his conclusions about risk-parity after considerable thought and experience. He continues to speak out about such matters even after all his success. He apparently enjoys doing it! My guess is that there just aren’t too many of us that are born with the whole “vision thing” like the Splendid Splinter, Ted Williams. To some, it just comes naturally. Others have to work for it maybe like Yogi. In my opinion, it’s a lot more fun hitting bottle caps with a broomstick!

[1] Ted Williams hit .406 in 1941 [see https://www.biography.com/people/ted-williams-9532940]

[2] Put forth by Dr. Harry Markowitz in 1952 with the publication of his paper “Portfolio Selection” in the Journal of Finance. MPT introduced the twin concepts of risk and return into the selection of securities in investment portfolio management.

[3] https://www.cnbc.com/2017/04/12/bad-times-for-active-managers-almost-none-have-beaten-the-market-over-the-past-15-years.html

[4] Ray Dalio, billionaire investor, hedge fund manager and philanthropist, is the founder of investment management firm, Bridgewater Associates.

[5] https://en.wik ipedia.org/wiki/Risk_parity

[6] The Dodd–Frank Wall Street Reform and Consumer Protection Act, signed by President Obama on July 21, 2010 made changes in the American financial regulatory environment that affected all federal financial regulatory agencies and almost every part of the nation's financial services industry.

[7]See https://www.marketwatch.com/story/past-enforcement-suggests-proposed-clawback-rules-lack-teeth-2015-09-28

[8] FIFTH THIRD BANCORP v. DUDENHOEFFER ( ) 692 F. 3d 410, vacated and remanded; SUPREME COURT OF THE UNITED STATES - FIFTH THIRD BANCORP et al. v. DUDENHOEFFER et al. certiorari to the united states court of appeals for the sixth circuit, No. 12–751. Argued April 2, 2014—Decided June 25, 2014

[9] S. Ct. —, No. 13-550, 2015 WL 2340845 (May 18, 2015),