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I FIRST PRESENTED THE IDEAS CONTAINED IN THIS article at an Institutional Investor conference in January. Before taking the podium I struggled to come up with something that would convey the importance of what was to follow. I decided to inform this audience of professional pension fund and endowment managers that their luck had run out:  They were going to learn about investing in risk, either from me or from someone else, but — not unlike having dinner with the in-laws — it was going to happen, so they would be well served to get it over with. The doors were locked, the audience lost hope, and we pushed forward.

For most of the audience, 2008 had been a shock, characterized by a serious loss of self-esteem and devastatingly poor performance that had been exacerbated by a fundamental lack of risk diversification. But such an outcome was not inevitable. In what follows I describe and substantiate how, through the use of a novel, rational allocation process, investors can achieve significant improvements in portfolio diversification, thereby potentially increasing the return and decreasing the risk of their portfolios.

Post-2008 most investment portfolios have remained one-trick ponies, effectively possessing a single source of variance, a typical proxy for risk. In the case of private investors, with a “standard” 60-40 stock-bond portfolio, roughly 97 percent of the portfolio’s variance can be explained by the equity allocation. Perhaps surprisingly, the typical U.S. pension fund doesn’t fare much better, despite a more broadly diversified asset allocation, full-time investment professionals and, in many cases, externally hired experts — variously referred to as “guys from out of town” or “guys with shiny shoes.” Accordingly, the typical U.S. pension fund has in excess of 90 percent of its variance explained by a single risk factor.

There are three basic reasons for this. First, when the bulk of an investment allocation is directed toward its most volatile component, then the emergence of a single dominant risk factor is a virtual certainty. Second, many investors mistakenly assume that nominal, or apparent, diversification is the same as real diversification. This is, of course, not true. To understand why nominal is not real diversification, we must pause for a moment to consider the three basic allocations in a typical diversified institutional portfolio: equities, fixed income and alternatives. With respect to the equity allocation, when you own every stock on the planet, you have in effect eliminated any sources of idiosyncratic risk and now own a single, rarefied risk factor: systematic equity market risk.

With respect to fixed income, when a typically underfunded U.S. pension plan decides to target a 6 percent rate of return on its bond portfolio in a world where ten-year U.S. Treasuries are yielding an anemic 1.8 percent, it is forced to acquire a potpourri of below-investment-grade bonds. In so doing, it has effectively converted the portfolio of daddy-needs-a-new-pair-of-shoes bonds and its associated duration risk (that is, the sensitivity to changes in interest rates) back into equity risk. Conceptually, this happens because default probabilities on corporate debt are typically calculated by the market using a model developed by Nobel Prize–winning economist Robert Merton. The Merton model structures the problem as a call option on the assets of the company issuing the debt; a decrease in the portfolio’s credit quality, therefore, effectively represents a transformation of fixed-income duration risk back into equity risk.

Then there’s the curious case of so-called alternatives. Spoiler alert: These investments are also highly correlated with equities. As an example, the HFRI Global Hedge Fund Index has been correlated versus the S&P 500 index at greater than 0.9 for approximately the past two years. For those of you now defensively pointing out that you have both real estate and private equity, I say, “Whatever helps you sleep at night.” Were it not for the fact that these assets possess neither frequent nor accurate pricing, they would both correlate above 0.9. The bottom line is that the typical U.S. pension fund is diversified in name only, with the broad equity market representing most of the risk.

The third explanation for concentrated risk factor exposure is the inertial effects of outmoded thinking. Investment professionals have historically been trained to think of portfolio construction as an optimal, sign-constrained (that is, long-only) allocation to a collection of assets; the effect of this is to concentrate portfolio risk within a single factor. The failure of both individual and institutional investors to achieve adequate diversification is a direct consequence of the failure to recognize that, contrary to conventional wisdom, investing should not be a process of selecting assets; rather, it should be a process of selecting and accepting risks.

To understand this distinction, consider the return you would require to hold an asset that is completely devoid of any form of risk — an idealized asset immune to any market or implied volatility, credit exposure or inflation, possessing virtually infinite liquidity. The return required to hold such an asset would be very low indeed, if not zero. Now consider how the required return would vary if the asset were a stock, a bond or a commodity. Such a definitional distinction is irrelevant. For example, if the asset were a commodity, one could simply form a corporation to purchase it, have the company issue equity or debt, and — presto — the commodity would be nominally reclassified without modifying any of the actual underlying economic exposure.

Last, consider how the required return would change as a result of an increase in an identified risk factor. If the idealized asset suddenly became dramatically more volatile, with a significant left-tail skew — that is, if large losses became much more likely than large gains — or more sensitive to movements in the U.S. dollar or yield-curve shifts, how would the expected return change? Clearly, it would have to increase, because investors typically require compensation in direct response to the magnitude of the increase in an identified risk. The bottom line is that you are compensated as a result of the risks you assume and not in any direct or obvious way as a product of the types of assets or classes of securities in your portfolio. Furthermore, if you wish to introduce a productive measure of control into your performance outcomes, you need to identify the risks you are assuming and make your investment decisions accordingly.

Investing in risk is a nebulous and difficult concept for many investors. “How do I buy risk?” “What risks should I be looking to buy?” “What sort of compensation should I expect?” “The last time I looked at the menu of options available for my 401(k), no such choices existed.”

The reality is that investors currently do invest in risk. However, in most cases the risks are not well understood and, as noted above, typically boil down to a single exposure: systematic equity risk.

It should be noted that there is nothing inherently wrong with assuming systematic equity risk. Even under the strictest assumptions of the Efficient Market Hypothesis, one can expect some degree of compensation for investing in a broadly diversified basket of equities; the only theoretical constraint is that predicting the return in any period with any useful degree of precision will be impossible. Those of you facile in the dark arts of stochastic calculus may wish to refer to Nobel laureate Paul Samuelson’s excellent paper, “Proof  That Properly Anticipated Prices Fluctuate Randomly.” Nonetheless, there is pretty solid evidence that, on average, you get compensated for assuming equity market risk; there’s so much evidence that it even has its own name: the equity risk premium.

THE EQUITY RISK PREMIUM, WHICH IS typically defined as the expected excess return of equities over the risk-free rate (while remaining coyly silent on the precise meaning of the term “risk-free rate”), has been well documented as a relatively persistent and positive feature of the equity markets. It has also been established that it is by no means a certainty that one will obtain a positive outcome, and that’s why it’s called a risk premium and not merely a premium. A recent study produced by Robert Arnott, founder of Newport Beach, California–based asset management firm Research Affiliates, revealed that there has historically been an approximately 15 percent chance that the risk-free rate will actually exceed the return on equities even over periods of time as long as 20 years.

There are many competing theories that have been developed to explain why this risk premium exists. They run the gamut from explanations rooted in the Efficient Market Hypothesis — essentially, when you have diversified away all that can be diversified away, you are confronted with a degree of inescapable market volatility that deserves compensation — to far more entertaining explanations rooted in the frailties of human behavior. Most notable among the latter is a combination of myopia and loss aversion. In brief (and, wow, am I paraphrasing), when looking too frequently at investment return data, our “inner punk” (my term, not theirs) has an asymmetric sensitivity to losses versus gains and tends to cause mere mortals to abandon their investments before achieving an appropriate long-run return. An interesting study, reported on a few years ago by the Wall Street Journal, linked significant improvements in trading to the ability to engage in just the sort of risk-neutral decision making common to those with organic brain disorders resulting from blunt-force trauma or chronic alcoholism. It seems that the path to a higher Sharpe ratio may be shorter than you ever imagined.

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