A few of our clients have called in the last couple of weeks asking why their portfolio had taken a loss in October.  All of the clients cited various media sources that were spewing about how great the markets have been.  They asked, with all of this wonderful news, why did my portfolio take a loss in October?  The answer is rather straightforward, and that is because global equity markets were largely down, and fixed income was relatively flat; but we see deeper issues that we can’t help but address.

Media feeds off of fear mongering and elation.  At least, that’s our take on their cheap magazines and 24-hour “Action News” stream.  I think most of us accept this fact or at least have come to understand how that machine works.  Nonetheless, not all investors are tracking markets very closely.  Rather, they tend to catch the emotional “wind” of the media.

From an investment perspective, one month’s returns is too short of a time span to measure any meaningful metrics.  Reviewing performance over such a short period magnifies the experienced volatility. Below is a graph that shows the returns of the S&P 500, measured on a monthly basis, for the last 30 years. The point of showing this is to illustrate the volatility experienced month over month, for 30-years.

Over the short-term, we expect to see more volatility, and over the long-term we expect for things to be much smoother.  To be a good and disciplined investor, we need have the right expectations and the right understanding of how markets work.  The long-term approach is important for so many reasons.  In today’s blog, a long-term horizon makes for a smoother and more successful investment experience.

*Returns data from Center for Research on Security Prices (CRSP).

Active managers swing and miss, again and again.  Third time’s a charm - so we wish them luck.

Back on September 16th, we posted the “Cost of Volatility,” which discussed a Morningstar study that showed that investors that held specific sector funds tended to do worse than the fund itself - the reason being that investors could not comfortably bear the volatility of the fund. Morningstar has provided some more data, and Sam Mamudi covers the results in his article, “Active Management Loses in Risk Study.”

Mamudi reports that, “The study by Morningstar Inc. found that, over the past three years, while about half of actively managed funds outperformed their respective Morningstar indexes - which cover the nine different Morningstar investment styles -only 37% [outperformed] on a risk-, size- and style-adjusted basis. The numbers are similar for five and 10-year returns.”

In our Inflation Risk and Portfolio Decisions blog, we touch on the danger of managing a portfolio based on a specific risk factor. But what about taking on more risk with the notion of earning greater returns? In theory, increasing risk should mean increasing potential returns (and potential losses). As the “Cost of Volatility” study showed us, investors have a hard time dealing with high volatility. This recent Morningstar study illustrates that not only do actively managed funds deliver more risk, but 63% of them underperform on a risk-, size-, and style-adjusted basis.

Studies continue to show that index funds generally outperform actively managed funds on a significant scale. Also, that index funds tend to take on less risk, and so are easier to digest through a full time-horizon (preferably long-term).  Taking controlled risk is good for a portfolio, and in our view, tilting a portfolio towards small-cap and value funds helps to increase expected returns.

At last year’s conference, Eduardo Repetto, Chief Investment Officer and Head of Research at DFA, presented on cross-sectional dispersion and the decay of volatility. By virtue of the topic name alone, many were left with blank stares upon their faces. Nonetheless, his presentation proved one of the most insightful. This time around, Eduardo, investigated how volatility has fared under present market conditions.

The foundation from which we work is that volatility decays slowly, and high volatility is more correlated to negative returns. Moreover, volatility is also what provides exceptional positive returns. With that said, what is today’s volatility?

There are many measures of volatility. A common metric is the Chicago Board Options Exchange Volatility Index (VIX). This measures the implied volatility of S&P 500 index options. The average VIX from 1/1990 to 7/2009, is about 20%. In the second half of 2008 through the beginning of 2009, the VIX reached as high as 80%. As of 9/28, the VIX was around 24%.

On 9/30/09, we saw the S&P 500 drop over 1%, only to rebound to breakeven by the end of lunch. The other day, we saw the S&P 500 gain 2%. Volatility is still with us, and it is still high, but it is remarkably lower than one year ago. This is not intended to derive some prediction about future volatility; rather, it is intended to show the nature of capital markets.

Managing risk must be a major component of every good investment advisor’s value added. Successful investing involves capturing the natural volatility of capital markets and removing the unsystematic risk of individual companies.

In an article by Dan Richards, “The True Cost of Volatility,” he explores what volatility means (and costs) in a practical sense. If one looks at the growth of a highly volatile asset class, one will see remarkable growth of wealth. There will be lots of ups and downs, but over the long-term, the asset class will show an overwhelmingly positive end result. One might then surmise that making that asset class a larger part of a portfolio is a smart move. Unfortunately, the volatile ups and downs are often overshadowed by that elusive ending value that displays a significant total return over a long time-period. The problem is that volatility is real, and tolerance to downward market swings is thin-skinned.

A study by Morningstar, looking at 10-year annualized returns (ending 2007), that accounts for cash flows in and out of funds, found some interesting numbers.

An investor that held a specific sector fund did worse than the actual fund. How’s that possible? It has to do with the investor not being able to stomach the volatility. In balanced funds, investors captured all of the actual performance of the fund. The reason for this is that the balanced fund produced smoother returns that investors could swallow more easily for the full time-period. With the balanced funds, investors tended not to flee when returns were sub-par. One can see that an annualized 1.13% was given up due to investors’ distaste for higher risk. For all intents and purposes, we could look at this as an explicit opportunity cost associated with investing in specific sector funds for the time period researched.

Morningstar then looked at funds based purely on standard deviation, as opposed to sector funds versus balanced funds. A similar pattern to the above table was uncovered.

A couple of valuable takeaways result from this article. First, discipline and diversification are critical to successful investing. Second, risk can be increased beyond a tolerable state; at which point, more harm than good is often the result. Having a well-constructed portfolio means having a palatable portfolio that is naturally diversified, where the risk is just right, unforced errors are mitigated, and discipline requires little action.

The full article is here.