Rain Capital Management Perspectives: General

Mixed Bag

  • Volatility in early October is more likely the result of high valuations and tightening financial conditions, not necessarily a flattening yield curve
  • Trade tensions with China are compounding valuation anxiety and we don’t see an immediate end in sight to these tensions
  • Given the relative health of the US economy and continued strong earnings releases, we view the current volatility as an isolated pocket, not the beginning of a more severe bear market

 

The calm of Q3 was interrupted by severe volatility starting in the first few days of October and continuing through to this writing.  Last quarter, we ...

Turkish Contagion

The spat between the US and Turkey is currently roiling various markets, with the greatest impact being felt by other emerging market economies. While there are fundamental reasons to be concerned about Turkey’s situation, we believe the current contagion to other markets is more a reflection of generalized investor anxiety about high market valuations and less about true economic linkages or similarities to Turkey itself.

At the root of Turkey’s problem is its reliance on foreign countries to finance its soaring current account deficit (a broad measure of a country’s trade with others), now at nearly 6 ...

Cutting Through the Noise

  • Political and economic events are happening at breakneck speeds, making it difficult for markets to fully process information as it comes in
  • The yield curve is a useful tool for cutting through this noise
  • Based on information in the yield curve, we may be approaching a pause in economic growth (at the very least) or a potential recession within the next 18 months
  • Higher equity market valuations and a flatter yield curve warrant caution on the growth side of portfolios and may signal a future opportunity to add longer-term bonds to the defensive side 

If you’re wondering what is ...

Policy Predicament

  • Strong wage growth in January ignited inflation concerns and sent equity markets tumbling

 

  • Talk of tariffs and trade barriers in March further dented already fragile investor sentiment

 

  • The cross currents of greater stimulus from tax cuts and a potentially inflationary labor market have put the Fed in a challenging position and increase the odds of policy mistakes

 

  • Valuations across asset classes remain high, with the exception of certain assets that are sensitive to accelerating inflation, namely commodities and emerging markets

 

 

It should be no surprise that the longest stretch of calm in market history ended as it did in Q1 ...

Uneasy euphoria

2017 was a good year for markets, almost too good in fact.  For the first time in history, the S&P 500 Index had no negative months during the calendar year. 2018 has started off with similar gusto, mostly off the back of year-end tax cuts, but there is a certain self-evident uneasiness about the euphoria this year. After all, how can a market go so high for so long without a meaningful pullback? Credit spreads are testing new lows, valuations across asset classes are stretched, complacency about risk is rampant, and, of course, volatility is at historic lows. The ...

Dissecting the Wall of Worry

  • Equity-market volatility hit an all-time low in Q3
  • Low volatility and strong equity markets were likely the result of improved economic fundamentals during the period
  • On the other hand, policy uncertainty, stretched valuations, excessive risk taking and a slight increase in medium-term recession risk warrant more targeted risk taking in portfolios

 

What does volatility tell us about market risk? If there was ever a quarter to ask that question, it was in Q3 when the CBOE Volatility Index (VIX) hit an all-time low of 8.84. During the same period, the US experienced three major hurricanes, political turmoil, serious doubts ...

Bye, Bye Backstop

  • Trump’s agenda of regulatory rollback, infrastructure spending and tax cuts is all but stuck in Washington’s ideologically fractured environment
  • Strong earnings made up for stalled policy and a lack of improvement on the economic front, with reported earnings for the S&P 500 up nearly 14%
  • The Fed may be moving from a focus on financial stability to one of monetary stability, which has important implications for risk taking
  • In the meantime, valuations remain stretched across a number of different asset classes

In Q2, the economic and political situation in the US began to feel a bit stuck ...

Tough Transition

  • The so-called “Trump Trade” began to lose steam toward the end of Q1 as it became clear that single-party control in Washington wouldn’t necessarily translate into quick results
  • Events abroad in Afghanistan, Syria and North Korea also took the President’s attention away from his aggressive domestic agenda
  • The Fed continued to hike rates during the quarter and shifted its tone from one of patience to one that is markedly more aggressive
  • Comparisons between our current economy and political situation to those of the early 1980s are not supported by the data

 

In Q1, President Trump began an unusually ...

Hard Reset

Markets had a hard reset in Q4 with the election of Donald Trump on November 8th.  Initially global equity markets plunged, but within hours began to recover and rallied strongly throughout the quarter, mostly on speculation that the new president would usher in tax cuts, deregulation and a sweeping fiscal spending program.  Coupled with strong economic data and another hike from the Fed in mid-December, bonds were left in the dust during the quarter reminding investors that old rules of diversification are flawed.  To paraphrase one of our managers, “it’s counterintuitive to suggest that, if one aims to ...

Policy Uncertainty

  • In the wake of “Brexit,” central banks reasserted themselves over markets in a big way in Q3, sending bond yields to historic lows.
  • The recent wave of populism in the developed world is targeting institutions that have been supportive of capital markets for the better part of 70 years.  To the extent these political movements prevail, they would likely carry negative economic consequences.
  • Ultra-low interest rates are increasingly being blamed for contributing to the anemic growth and wealth inequality that may be fueling these populist sentiments, further limiting the Fed’s policy options.
  • Rain portfolios remain positioned at the cautious ...

Mixed Messages

  • Events in Q1 took the Fed off message and “Brexit” further complicated its story
  • Given the limited set of policy tools, the Fed seems to want to play it safe and is reluctant to raise rates until it has strong evidence of inflationary pressures
  • The safe road now means more policy uncertainty later
  • Markets will hinge, in part, on whether the Fed dramatically changes the exit framework it has spelled out so well in recent years

Market Update

Last quarter, we wrote that negative interest rate policy in Japan and Europe signaled a sense of desperation on the part of ...

The Limits of Divergence?

 

  • The smooth December lift-off in rates was derailed in January by a rolling set of concerns that culminated in markets pricing in (at least for now) a more gradual pace of interest rate tightening than previously expected.

 

  • Negative interest rate policy out of Japan in late January gave markets a taste of just how divergent global monetary policies are today and may have signaled that foreign central banks are approaching the limits of their policy tools.

 

  • Credit markets were particularly stressed during the quarter, driven largely by the energy sector, and liquidity became scarce in substantial parts of the high ...

Mind the potholes

  • The Central Bank divergence story – the idea that instability in capital markets would be driven by diverging monetary policy among the world’s largest economies - is alive and well but evolving, with more pain in store for interest-rate sensitive investments
  • Correlations between traditional asset classes increased in 2015, making traditional asset allocation an unreliable way to achieve diversification
  • Recent volatility may be attributable in part to rebalancing by traditional portfolio managers away from risk assets because of the lack of portfolio safety that bonds demonstrated in 2015
  • Rain portfolios experienced less volatility than their respective benchmarks due to a tilt ...

Getting to your Goal

As of this writing, the S&P 500 has gone 1,302 days without a correction of 10% or greater, the second longest run since World War II.  As far as the untrained eye can see, risk appears to have disappeared from markets.  The performance of the S&P 500 seems to dominate investors’ perception of prevailing risk in the market, despite explosive risk events in certain other asset classes - May and June 2013 saw the worst bond market rout in generations, certain commodity and resource assets lost more than half their value in 2014, and on October 15th ...

An Advance in Portfolio Construction

Larry Cao, of the CFA Institute, writes that risk factor diversification - like that used at Rain Capital - is one of the most important advances in portfolio construction techniques in recent decades and is increasingly used by sophisticated institutional investors.  According to Cao, asset classes are simply too correlated with each other for traditional asset allocation to add much to portfolio diversification anymore. Continue reading to see why he thinks risk factor allocation is the most effective approach to diversification:

An Advance in Portfolio Construction

 

 

 

 

Accounting for Inflation

The inflation conundrum dogging the US economy right now has a lot of observers scratching their heads.  The economy clocked 5% real GDP growth in Q3:2014 and an estimated 2.6% in Q4.  Unemployment at 5.6% is at levels that have historically begun to generate wage inflation, but there is little to speak of.  Explanations range from labor market slack to deflationary pressures from abroad, but economists at the Fed are pointing markets to a simpler answer:  zero interest rate policy. 

According to Federal Reserve researchers[1], a basic accounting identity is likely at the root of the ...

Fiduciary Ethics

Regulators are (correctly in our opinion) focusing a great deal of attention on the very different legal and ethical standards that brokers and Registered Investment Advisors (RIAs) are held to.  The SEC’s concern stems from the fact that investors generally aren’t aware of the meaningful differences and their legal implications.  Barry Ritholtz does a nice job summarizing these differences in a recent Washington Post column

The quick and dirty version is that RIAs are held to a fiduciary standard, the highest ethical and legal standard of the land, whereas brokers are held a suitability standard, one that is ...

Surprise!

The market isn’t hearing the Fed’s increasingly hawkish message, according to researchers at the Federal Reserve Bank of San Francisco.  The take away?  The authors reiterate Chairwoman Yellen’s words from earlier this year “. . .investors may underappreciate the potential for losses and volatility going forward.”  This disconnect, they warn, is important because “prices of [most] financial assets.  . .are sensitive to unexpected changes in interest rates because their present values are determined by discounting future cash flows.”  Our clients know this story well as we have prepared portfolios to weather volatility and interest rate risk across asset classes. 

The ...

The Labor Market in One Chart

A flurry of communication has come out of the Fed in recent days – from hawks and doves alike - all focused on the need to change forward guidance on interest rates.  As we’ve discussed, the particular concern the Fed has at this point is how to break from its gradualist language of keeping rates low for a ‘considerable time’ after it ends asset purchases in October.  Should the economy continue to surprise on the upside, this language could only serve to hamstring a central bank that may have to act quickly to bring its policy stance more in line with ...

Mind the Gap

 

“Investors may be underestimating the degree of uncertainty about the future path of policy.”                                

- Jeremy Stein, outgoing member, Federal Reserve Board of Governors, May 16

“Monetary policy ought to be reacting to the data.  We are on a path that says low for long and we have no plans to raise interest rates anytime soon, yet as the data keep telling us, we ought to be raising rates. . .We are closer than a lot of people might think.”                                                                                                                          

- Charles Plosser, President, Federal Reserve of Philadelphia, July 11

“The Fed is closer to its goals than many people appreciate . . .[we] are ...

Liquidity Trap?

A new interest rate cycle is upon us.  The Fed has said – and the market is largely in agreement - that within a year short-term interest rates are likely to rise.  We have already spent considerable effort purging interest rate risk from portfolios.  However, even low duration funds have some exposure to shorter-term interest rates.  In an environment where interest rate exposure will likely be penalized even in the most conservative areas of the bond market, we are inclined to swap out that exposure for the money-certain safety and liquidity of short-term Treasuries. 

With that in mind, we have sold low ...

Operation Twists and Turns

Fed Chairwoman Janet Yellen joked in her speech today at the Economic Club of New York, “if the economy obediently followed our forecasts, the job of central bankers would be a lot easier and their speeches would be a lot shorter.”  The purpose of her discussion, which she reiterated in the Q & A afterward, was “to emphasize that there can be a lot of twists and turns in the economy.”  She said, “We need to be alert to what is happening in the economy and to respond to what we see happening, and not have a fixed idea that we ...

Making and Breaking Promises

 

One perplexed Fed watcher recently observed that “Fed policy. . .is maddeningly disconnected from their [sic] forecasts.”  After all, how can the Fed legitimately be concerned about unemployment and low inflation while simultaneously winding down bond purchases?  How can it promise low and gradual rates well past the end of tapering while internal data show committee members’ expectations for rates past 2016 in the 4% range? (Assuming a mid-2015 start to rate hikes, that implies a 50 basis point hike every quarter for 8 quarters straight!)  The Fed still talks a lot like a dove but is acting increasingly like a ...

From Dove to Hawk?

We have expressed concern for some time that markets have been too sanguine about the eventual ‘lift off’ from zero rates, ignoring a recurring Fed narrative that has attempted to guide toward an earlier exit should economic progress (as narrowly defined by the unemployment rate and inflation) justify it.  And as it turns out, strong progress toward the unemployment threshold over the past year has prompted the Fed to abandon that target in favor of a wider range of qualitative factors.  Nonetheless, when Fed Chairwoman Janet Yellen spoke last week of a lift-off some six months after the end of ...

Yellen's Challenge

Unemployment and inflation generally work against each other.  The Fed was counting on that relationship holding up when it established a dual threshold based on those indicators in late 2012.  The idea was that as the two converged (or diverged), markets would better understand the future direction of monetary policy and adjust accordingly.  As we discussed in depth last year, the unemployment rate has dropped faster than most observers expected (a drop that even Fed economists have told us now was “rather spectacular”), due in some part to a declining labor force participation rate.  Inflation, however, hasn’t cooperated. . .yet ...

Information Days

At Rain we talk a lot about what we call ‘information days,’ brief periods of time that are extremely rich with information.  We find that evaluating narrow time periods of isolated stress (or euphoria) can be just as informative about manager positioning and underlying risks as longer-term statistics, if not more.  The days for instance between May 3 and June 25 yielded a tremendous amount of information about the downside behavior of different assets during a period of fairly extreme interest rate volatility in the middle part of the yield curve. 

The typical correlation relationship that investors had become accustomed ...

What scatters, what sticks together, and why?

From a diversification standpoint, understanding how a hypothetical pair walking down the middle of a street together might be related (or integrated) is enormous; is it a man and his dog tethered by a leash, a husband and wife, two neighbors going to the same yard sale around the corner, or complete strangers?

After all, the correlation between a man and his dog tethered by a leash will be far more integrated and persistent than even that between husband and wife, who may at some point go different directions to run errands only to converge again later at home; or ...

Lurking Variables

After evaluating a great deal of data, a statistician finds that as ice cream sales increase, the rate of drowning deaths increases sharply.  Based on this strong correlation, the scientist concludes ice cream consumption causes drowning.  Even to the untrained eye, it is fairly obvious the analyst failed to take into account weather; during warmer summer months, people swim more and crave cool refreshments like ice cream.  Temperature - not ice cream consumption – is the underlying variable that drives both drowning and ice cream consumption.

Seem obvious?  The same mistake is commonplace among professional investors who still practice asset allocation; they ...

The Risk Elephant

As the data tell us today, interest rate risk has bled across asset classes in a way that resembles how credit began to dominate asset prices in 2007.  The biggest difference is that this time it is the intentional effect of monetary policy, whereas the credit bubble was a much more indirect and unintended consequence of monetary policy.  The core purpose behind quantitative easing is to stoke investment by driving investors out of ‘safer’ government bonds into assets with similar characteristics, such as credit risk and duration.  This has driven investors to buy corporate debt, high yielding equities, and so ...

Asset class creep

The first half of 2013 was a startling reminder of how poorly traditional asset allocation diversifies actual investment risk.  For most, it proved to be an extremely difficult period to make money using the traditional approach because a single risk factor – interest rates – largely drove returns across asset classes.  Risk-factor approaches, on the other hand, fared well throughout the turbulence because of the proactive ability to avoid overconcentration in risks, like interest rates, that may creep across asset classes.

Starting with renewed worries about Europe in March, sparked by an ECB tax on bank deposits in Cyprus, and ending with ...

More on Employment

A quick look at the July employment report seems to reinforce the importance of participation rates in the path to the 6.5% unemployment threshold Fed Chairman Bernanke laid out last December.  As we’ve speculated, meager gains in employment can have a material impact on the unemployment rate because so many people are leaving the workforce due to demographic changes.  Unemployment fell in July by a whopping 0.2%, from 7.6% to 7.4%, on the back of just 162,000 new jobs!  Again, the policy implications of this are clear: we are marching more quickly toward the ...

Chicago Fed Letter

Those of you who have followed our thoughts about evolving Federal Reserve policy here and here and here will appreciate a forthcoming paper by economists at the Federal Reserve Bank of Chicago which concludes that changing demographics have dramatically lowered the number of jobs it will take to impact the unemployment rate in the future.  The Wall Street Journal’s take on the new research should sound familiar to our readers: “the authors’ conclusion is significant for two reasons. First, it has potential implications for Fed policy: It suggests that even if job growth stays at its recent level -— or ...

Unemployment and the Fed

There may be more to unemployment numbers than meets the eye.  Conventional wisdom has it that as the economy rebounds and jobs are created, people begin to reenter the labor force, making the unemployment rate a particularly stubborn number on the way down.  However, changing labor force demographics have upended that wisdom and, we think, the relative stickiness of the unemployment number.  As it turns out, much of the decline in the labor force participation rate has more to do with aging baby boomers and a plateau in the rate of women entering the workforce than any cyclical factors specific ...

Last Call!

Source: Fed Reserve Bank of St. Louis, "Perspectives on the Current Stance of Monetary Policy"

 

The job of the Federal Reserve is ‘to take away the punch bowl just as the party gets going’ as one Fed Chairman once said.  Typically the process has started with a hike in short-term interest rates, a step toward the exit with the punch bowl in hand indicating the economic party was getting raucous.  Never in the past has the Fed sounded a bell or yelled ‘last call!’ before the bar closed.  The concept of exit in a zero interest rate environment is a ...

Low Correlation to the Rescue

 

As part of what one of our managers described as “a bull market in fear,” 2012 was a year in which central banks around the world ganged up against savers and forced them to choose between monetary debasement and navigating a minefield trying to escape it.   Asset classes largely manifested those two extremes and investors who attempted to diversify around asset classes experienced the full brunt of that market volatility.  This was better known as the ‘risk on / risk off’ investing environment that vexed most investors.

Rather than participate in the unpredictable ‘risk on / risk off’ world, RAIN portfolios spent ...

Considerations for 2013

We believe many of the uncertainties that clouded the horizon in 2012 are slowly being resolved or constructively contained.  In fact, we also see domestic economic strength that would indicate an earlier hike in interest rates than is currently priced into the market.  Money velocity (an important measure of money usage) has picked up, inflation is closing in on the Fed’s 2.5% target, growth is increasingly led by robust domestic private investment and monthly job growth (though anemic) is high enough to reach the Fed’s 6.5% unemployment target within 12 to 18 months. 

As a result ...

"The Role of Risk in Asset Allocation"

Investors can often mistake the asset diversity in their portfolios for adequate risk diversification.  Author Jason Hsu, of Research Affiliates, argues many investors who are diversified around investment products may be poorly diversified by risks.  He suggests investors should look beyond asset class "menu" labels to avoid building unintended risks into their portoflios. An investment approach based on risk factors can also achieve more intuitive and perhaps more sensible portfolios.

"The Role of Risk in Asset Allocation"


For Rain Capital’s specific approach to risk allocation, be sure to revisit our December 2011 piece The Asset Allocation Merry-Go-Round: why most ...

The age of improvisation?

It’s been said physics explains 99% of the world with three laws, while economics explains 3% of the world with 99 laws.  We found the data in the table interesting for a number of reasons, but namely for the fact that it would be nearly impossible for a trained economist to make sense of the past five or so years given these snapshots in time.  Central banks are said to have entered the ‘age of improvisation’ and it shows here (though we think there’s some method to the madness):

 

The cost of volatility

The professional investor who is benchmark agnostic, who doesn’t seek to eke out every penny of return at the expense of risk, who focuses on downside protection, and who is not handcuffed by a certain business model – be it active, passive or otherwise – has better odds of controlling for volatility.  Contrary to popular belief, the famed investor Warren Buffet has managed to compound wealth at many times the market index not by shooting for the stars, but by investing in lower-volatility assets.  The annual standard deviation of the Berkshire portfolio since inception has averaged 14.6% versus the S ...

Modern research meets orthodoxy

Of all the experts that we would expect to undermine the basis of passive (index) investing, Standard and Poor’s, the creator of the widely-followed S&P 500 Index, was not high on our list.  However, in a recent piece The Low-Volatility Effect: A Comprehensive Look, the company inadvertently does just that.  The paper is a review of the mountains of academic and industry literature that has emerged bucking some of the widely-held beliefs of Modern Portfolio Theory, including the premise that investors get paid for taking more risk (see our January 2012 commentary on the subject in our article ...

Cheap volatility

Indexing has always been peddled as a cheap, tax-efficient and safe way to get market returns.  While it is unquestionably the cheapest and among the most tax-efficient ways to invest, safe it is not, the research shows.

Here’s why:  while indexing generally allows investors to diversify individual company risk and still get 100% of the market return, it also exposes investors to 100% of the market’s volatility.  And, as we know, volatility is toxic to long-term performance.  What is known as ‘volatility drag’ – the exponential recovery needed to offset losses (e.g. you have to gain 100% to ...

Index distortion

Because of their formulaic nature, many indexes are prone to distortions over time (as we saw in the late 90’s, valuations on tech stocks drove up their market capitalizations and caused the tech weighting of the Russell 1000 Growth Index to hit 50% by 2000.  Again in 2007, high flying financials rose to 36% of the Russell 1000 Value Index the year before delivering crushing losses).  This is the basis of the argument that indexes are prone to “buying high and selling low.”  To the extent market capitalization is driven by excessive leverage (and it almost always is toward ...

Good News, Bad News

 We seem to live in a world where the markets believe bad news is good news.  The worse things get, the more excited markets become about yet another round of stimulus by the Federal Reserve.  Whether it’s uncertainty around Greek elections or weak economic data, markets have supreme confidence in the willingness of the Fed to support financial markets during economic weakness.  Some people think this is bad – they bemoan a Federal Reserve that is overstepping its role, messing with fundamentals, eroding the value of the dollar while supporting risk takers, etc., while others think it is good – in ...

"Same Returns, Less Risk"

During market turmoil, traditional portfolios often decline more than investors expect, due to different, seemingly unrelated, asset classes moving in unison.  As Ben Levisohn and Joe Light of the Wall Street Journal write, traditional asset allocation fails to achieve stable and robust diversification.  As the authors explain, making risk considerations a primary input to portfolio construction, turns 50 years of portfolio theory on its head and may deliver a smoother ride for investors:

"Same Returns, Less Risk"

For Rain Capital’s specific approach to risk allocation, be sure to revisit our December 2011 piece The Asset Allocation Merry-Go-Round: why most ...

"Force Fed"

Today, the Fed has engineered a situation in which the really unattractive asset classes are the ones we have always thought of as low risk: government bonds and cash. And unlike the internet and housing  bubbles, this time it isn’t a quasi-inadvertent side effect of Fed policies, but a basic aim of them. The Fed has repeatedly said that a central part of the goal of low rates and quantitative easing is the creation of a wealth effect by pushing up the price of risky assets.  By keeping rates very low and taking government  bonds out of circulation, the ...

Portfolio construction

Our goal is to grow your wealth with the most robust and stable diversification possible.  Risk limits, stress testing and so on may be very useful tools, but can’t overcome fundamentally flawed portfolio construction any more than a seatbelt can solve the problems inherent in reckless driving.  At Rain, our relentless focus on understanding how to diversify risk is central to portfolio construction.  In previous letters, we’ve discussed our philosophy and market views.  This letter is designed to discuss portfolio construction and review the role of specific investments in your portfolio.

This is an excerpt from our article ...

When markets adapt

Overall, we’re cautiously optimistic about the recovery domestically, with an eye toward the various external macro forces that could disrupt it.  As you know, we believe true diversification is a proactive process that requires looking under the surface of stated asset class objectives to identify underlying performance drivers and risks that could pervade multiple asset classes.  It also happens to be a decent way to identify opportunity.  2011 got a number of issues out on the table that were useful in developing positioning around interest rates, credit, growth, volatility, currencies and liquidity.  These are the core drivers of the ...

Natural selection

In financial markets, equilibrium is a constantly moving target; the textbook “steady state” or “balance” doesn’t exist in an open and global economy.  Some external shock is introduced and markets adjust to find the new balance between supply and demand for different assets.  In the meantime, this sows the seeds of some new disruption elsewhere down the line.  In the investing world, dislocation and volatility create opportunity and, from a risk management perspective, provide valuable real-world stress-test information.  2011 was an important year in this respect and had material implications for portfolio construction that we want to share with ...

The stretch for yield

The renewed strength that the US economy began to show late last year has translated into a number of opportunities in credit and equities domestically.  On the credit side, our managers are tilting away from richer high yield and treasury bonds in favor of mortgage-backed securities and high quality corporate bonds.  This reflects both opportunities in a battered-but-stabilizing mortgage market as well as a continued interest in safer credit given an uncertain global macro backdrop.  A number of our managers have found an unlikely value in “distressed” subprime mortgages; much of what constitutes subprime these days is made up of ...

Capital flight

It is not enough to take a narrow look at “Greece” or “Europe” exposure without exploring the various risk factors and knock-on effects associated with it – it’s impact on liquidity, volatility, growth and so on.  One of the more likely secondary effects the European crisis will be on certain emerging markets investments.  Bank for International Settlements data show a heavy dependence on European banks for lending in these markets; emerging Europe (Poland, Hungary and Romania in particular) shows the greatest vulnerability to capital flight, with Latin America and Asia significantly less so.  European banks will be responding to the ...

Defensive, through and through

At Rain, we decompose strategies by risk factors.  We deliberately select strategies on the defensive end of portfolios that are diversified by those risk factors.  We use tools on the bond side that allow for far greater flexibility to manage exposure to interest rate and credit spread risk as well as non-fixed-income-centric strategies whose returns are largely independent of interest rate risk and safe-haven volatility.  This allows us to build more dependable and truly diversified qualities into the defensive side of client portfolios.

This is an excerpt from our article "What color is your parachute?" January 31, 2012

The longer view on long bonds

There is always a trade-off between the return sacrifice and diversification benefit a strategy brings to a portfolio.  Long-dated bonds and treasuries in particular, have demonstrated strong diversification benefits in portfolio construction because of their negative correlation to other asset classes, like equities.  This is in large part due to two factors: the interest rate factor that is negatively correlated with recessionary forces (including deflation) that drag other asset classes down and the safe haven status that is, well, positively correlated with fear.  However, that correlation characteristic between treasuries and equities has been unstable over longer periods of time, vacillating ...

What you see is not always what you get

The relationship between risk and return is alive and well, even though in the past 10, 20, and 30-year periods (ending December 2011), it has looked more like this:

Widely accepted ways of measuring risk simply do a poor job of showing it.  Risk encompasses the multitude of scenarios an investment could deliver, not the single path that ends up being measured afterward.  In other words, volatility, standard deviation (and the many ways they are sliced and diced in risk management models) tells us what has happened, not what might have happened or could happen in the future. 

In fact ...

The parachutes of the investment world

Bonds are the parachutes of the investment world; they have offered safe, stable income and their prices generally go up when everything else goes down, giving them a nice defensive quality in portfolios.  Falling interest rates are the wind that keeps the parachute open and the greater the duration (interest rate sensitivity), the softer the landing.  However, the very factor that makes them such an attractive hedge against a deteriorating economy and equity market transforms the parachute into a source of instability in a zero interest rate environment. 

The traditional toggle between stocks and bonds to dial up and down ...

Why bonds might not be as defensive as you think

"Investors who fled the perceived risk of equities into the 'safe,' low volatility arms of bonds during the Great Depression. . .experienced a peak-to-trough real drawdown. . .exceeding 67%"

Bonds are exposed to interest rate risk and the greater a bond’s duration, the greater the sensitivity to that risk.  Perhaps more importantly given the current interest rate environment, the more rates fall, the more that risk rises exponentially. In other words, last year’s explosive treasury performance on the back of a relatively small drop in rates (just 1%) reflects the high-octane nature of this relationship and just how dangerously ‘wound ...

Zombie finance

Asset allocation was intended to be a means by which to diversify, not an end in itself.  Despite ample examples of how insufficiently asset allocation diversifies risk – the Fall of 1998, the dot-com crash of 2000, the high yield debt rout of 2003, the credit crisis of 2008, and so on – the industry overwhelmingly continues to use it as the primary means by which to build portfolios.  Part of its persistence as a diversification tool is in its quantitative purity; technically it had been a mathematically correct way to diversify for many years and it conveys a sense of discipline ...

The cart and the horse of portfolio construction

At Rain, we start with the premise that risk considerations should drive capital allocation, rather than letting capital allocation drive portfolio risk.  This means that the building blocks of our portfolio construction are the direct risk factors that drive asset valuation like inflation, economic growth, interest rates, liquidity, volatility, and so on.  The logic is simple: correlations are significantly lower and more stable over time between risk factors than they are between asset classes.   For instance, most asset classes contain primary or secondary exposure to equity risk.  Rather than just using rough proxies of exposure, Rain uses primary risk factors ...

Why most investors are overallocated and underdiversified

The relationships that made asset allocation an effective way to diversify have changed.  Correlations between most asset classes have been creeping steadily upward since the mid-1990s.  By early 2008, most asset classes were moving significantly in step with the S&P 500.  By the fall of that year, at the peak of the credit crisis, correlations spiked further and asset classes of nearly every kind (with the exception of safe-haven treasuries) experienced severe losses.  Many studies have pointed to the fact that in a typical ‘balanced’ portfolio of 40% bonds and 60% equities, more than 90% of the portfolio risk ...

The asset allocation merry-go-round

             

Investors have been told investing across different asset classes (known in the industry as asset allocation) is the best means of diversifying their portfolio, yet they continue to experience violent swings in the value of their wealth with each successive crisis.  The typical prescription is to remain focused on the long term and consider adding more asset classes and sub asset classes to the myriad already in their portfolio, which promises to ameliorate the problem.  But, it doesn’t.  There is a paradox of asset allocation in that uncorrelated assets attract money flows which cause them to become more correlated ...

The poverty of progess

Humankind innovates faster than we can solve the problems our innovations create.  Wall Street is a case in point. What started with simple barter between individuals who produced goods each other wanted, evolved into trading shells, beads, commodities, coins, trade bills and so on ad nauseum.  The Wall Street product machine that now exists creates products faster than risk managers and regulators can control them.  We know this too well from the recent credit crisis and current history being made in Europe.  Financial innovation has created some obvious and other nearly imperceptible distortions in the money management industry that we ...