Investment Risk - The 5 Elements of Out-performance
By Marc Katz
In the same way that an obsolete hand held calculator contains more computing power than an Apollo spacecraft, in pursuit of "out-performance" even novice investors today have at their fingertips a vast amount of information and research unimaginable just a few years ago.
In pursuit of excess returns, rather than suggesting that any one investor can absorb, decipher and prioritize all this information better than another investor, Brian Portnoy, author of the widely-acclaimed book The Investor's Paradox (2014), offers a simple but powerful framework to consider the five sources of not only out-performance, but, symmetrically, "blow up" risk, too.
In Paradox, Portnoy says, "We generate return by taking risk. We outperform by taking risks that are different in size or scope from others." Portnoy suggest there are five ways that investors undertake risk, perhaps unwittingly, in pursuit of out-performance. His Risk Prism illustrates these five risk dimensions:
While it is not inherently wrong to take on any of these investment risks in your portfolio, it is essential to understand that to outperform, an investor will from time-to-time have to take on at least one of these risks and must be cognizant of all of them and their downside potential, too.
The Five Investment Risk Dimensions Are:
Perhaps the most common out-sized risk in portfolios is the scale of one or a few positions. When you choose to put all your money in just one investment or type of investment, that concentration of funds means your risk losing big. Activist funds are great examples of managers making concentrated bets. Investors like Carl Icahn or Bill Ackman of Pershing Square take massive positions in just one or a few securities. Icahn's terrific success with his Apple position and Ackman's spectacular losses on Valeant Pharmaceuticals illustrate the considerable upside and downside of concentration.
Of the five dimensions of risk, perhaps the most intuitive is directionality: Are you long (bullish) or short (bearish) in your target market? A typical mutual fund is 100% long, while an activist fund, a typical hedged equity fund, a market neutral strategy, or a short-only equity fund may range from 75% to -60% long.
But, the amount of actual vs. expected directionality in a portfolio can change suddenly causing unwelcome surprises for complacent investors. A 50% equity / 50% bond portfolio may seem to have half the directionality of a stock-only fund, but that will not at all be the case if the bonds were issued by growth-sensitive companies and the outlook for the health of the economy quickly changes. In that case, those bonds can start to behave a lot like stocks.
Employing leverage, i.e., borrowed funds to increase the size of your position is great provided your portfolio is going up in value, but, leverage magnifies losses. As Portnoy says, "Leverage increases the costs of being wrong. It increases your vulnerability to unforeseen market events as well as the goodwill of your creditors." The more volatility or potential volatility of the investments you choose to lever, the greater both your potential for out-sized gains and the potential to blow up.
As Portnoy says, "Ultimately, liquidity is the ability to change your mind." He compares the liquidity of large cap stocks like General Electric to the illiquidity of your home. Almost all the time, in the case of the former, buyers and sellers are plentiful, at or close to the current market price, execution costs are low, and settlement is quick. Compared to large cap stocks, on any given day there are probably no readily available buyers for your home, it is difficult to establish agreement between the seller and buyers about comparable pricing, transaction costs are high, settlement time is long and contingencies can cause the deal to break-up. Illiquidity is also a feature of many financial assets, including those assumed to be otherwise. We saw this during the financial crisis when even high quality municipal bonds had no bids.
Buy-and-hold investors with resources sufficient to withstand financial setbacks are best equipped to invest in less liquid, higher-potential-return investments, such as real estate and bank loans. These investors are least likely to be forced to sell less-liquid investments on short notice at a steep discount to raise cash. As the economist John Maynard Keynes said, "The market can stay irrational longer than you can stay solvent."
The fifth risk dimension is complexity. Complexity can involve…
- an investment with many moving pieces, the out-performance of the whole depends on certain assumed relationships among the parts. However, as we also saw during the financial crisis and discussed briefly above in directionality, assumed relationships among parts can break down producing large losses rather than out-performance.
- the manager being free to allocate capital among different strategies. While the ability to navigate among best-perceived opportunities can produce out-performance, the flip side is the further afield the manager strays from his or her core competence, the larger the chance for poor performance. Bill Gross - the "Bond King" - once caused quite unexpected losses for his investors when he strayed into municipal bonds with a leveraged strategy while being unfamiliar or unduly sanguine with the valuation convention of less liquid municipal bonds vs. highly liquid Treasury and Agency securities, in which he has invested for decades in very large scale.
- the manager employing innovation. As Portnoy explains, this is "an institutionalized mandate to research in order to identify new ways of extracting value in the market." Ken Griffin, founder of Citadel LLC, made his first great success with an innovative convertible bond strategy. On the other hand, there was Long-Term Capital Management L.P., with Nobel Prize winners in finance among its portfolio managers. After years of massive out-performance with an innovative quantitative absolute-return trading strategy combined with high financial leverage, LTCM blew up in 1998 by losing almost $5 billion when its sophisticated trading strategy went terribly wrong.
Out-performance is by all means a worthy ambition of investors. In order to outperform it is essential that investors are aware that, at least occasionally, they must include at a minimum one of the five investment risk dimensions in their strategy, which means the portfolio, by construction, will also have higher than average risk of loss, and maybe even blow-up risk, too.
About the Author
Marc Katz is a former managing director of Lehman Brothers’ and Bank of America’s debt capital markets risk solutions groups. He has extensive daily experience in the management of complex financing arrangements as well as fixed income trading. Marc also has an inside knowledge of the debt transactions for some of America’s leading companies; including taxable and tax exempt investment, leasing, private placements and hybrid securities.