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ETFs and Risk Management

by: Richard Kang posted on: May 16, 2008

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I keep telling myself, and the occasional inquirer, that I’ll get back into serious blogging … or at least publish at a pace similar to when I started back in 2006. Clearly, you will have noticed that that ain’t happening. One of the things that has kept me busier in recent times has been conference speaking. Just earlier this May I was at Connex International’s Public & Private Wealth Group Forum, an institutionally focused event with both a pension track as well as an endowment/foundation track.

To no surprise, there was a lot of content revolving around the use of alternative investments of all sorts, but especially hedge funds. I was most interested in discussions related to emerging markets as, to me at least, it seems like this is an area where in the longer term there would be a fair assumption for double digit returns unlike other broad asset classes and strategies. The downside, of course, is the volatility, but for long-term oriented institutions, that shouldn’t be a problem given appropriate diversification and risk budgets.

However, the overall sense I had from this and other events in recent months was that emerging market investing is still in the early “toe dipping” stage. Never a good time to get in like when it’s nearly too late! I think it’s far from too late … in fact I think it’s still relatively early. But it’s this herd mentality that I believe is hampering the performance of many institutions. Perhaps the people working at conservative institutional funds just aren’t compensated in a way that would allow them to deviate from what would be perceived as “industry norms”.

Of course, the same could be said of the herd mentality of all investors, including retail individuals and their financial advisors. What once was about picking stocks has now moved well past chasing managers with mutual funds to chasing markets via ETFs. Is Kang bashing ETFs?!!! Well, yeah, in a way, but everyone knows that the gold market and other peaky, speculative (pick an adjective) market has likely had its volatility juiced up due to the level of increased participation of everyday investors thanks to ETFs.

Whether it’s good or bad is not for me or anyone to say … in any market that sees more speculators come in versus long-term investors, it’s common to find more instruments to feed the frenzy. Remember all the tech and Nasdaq funds in 2000?

The whole concept of alternative investments is a bit of a conundrum to me. At the one end, it’s a reality that has to happen given the limitations of traditional investments. Having a vanilla portfolio of stocks, bonds and cash can only get you so far. So called “couch potato” portfolios sound good, but when the markets are going against you, the tendency will be to take action at the very worst time. I didn’t even say that the action would be right or wrong; I’m just saying that the timing will likely be off. If the decisions of what to sell, what to buy, what to hold, whatever, are also off … well, no one does well in college or at their job by being a couch potato.

Correlations among asset classes and strategies remain high. The search for low correlated alternatives will evolve in time but this search for the next new market will persist. The frontier markets of today will be the emerging markets and then developed markets of the near future. Technology, high educational standards internationally and the globalization of economies and capital markets will see this transformation process increase pace exponentially.

The low yield environment of today is another reason alternatives are hot. The traditional fixed income market just isn’t enough. And that includes inflation adjusted bonds where we’ve recently seen the TIPS market hit some interesting numbers (zero).

If we’ve now entered something similar to the beginning of the decade (negative returns with low interest rates), then we’re back to the deadliest of combinations for pension plans and their asset/liability mismatch predicament. With low interest rates, the present value of their liabilities increase so that, on paper … well let’s just say, GULP. Not good. The honest knee jerk reaction from some along with, of course, thoughtful debate and consideration by many others will be to increase allocations to all sorts of alternative investments. It would surprise me immensely if hedge funds and real estate did not get the biggest chucks of these new allocations. My hope is that these alternatives, no matter what they are, provide a true “risk reduction” function for portfolios as opposed to simply a “return enhancement” function. I believe the period of early 2003 to mid 2007 was the time for thinking about return enhancement.

With regard to thinking about risk, I now refer you to three videos that were made immediately after an appearance I made in Las Vegas earlier in April. I was speaking on global investing at the 5th Annual Las Vegas Financial Advisor Symposium thanks to the organizers at InterShow and an invitation from the panel moderator and fellow blogger, Tom Lydon. FYI: Equally cool and insightful blogger, Roger Nusbaum, was also a panelist with me on stage. It’s clear that moving from a US-centric portfolio to one that is more international (with a significant dash of emerging market exposure) is key to improving risk adjusted returns for long-term investors. The concern is implementation and keeping intelligent diversification a key directive.

Anyway, the evolution of ETF industry to active management, emerging markets exposure and risk management are the main topics from the three videos. Clicking on the still shots below will lead you to InterShow’s site and the videos.

Evolution in ETF Industry: