Are we all doing it wrong — or is the theory in need of updating and repair?
I think MPT died 30 years ago,” says Jeffrey Saut, chief investment strategist at Raymond James. “If the theory were correct, Warren Buffett, Peter Lynch and Paul Tudor Jones wouldn’t have their track records.” He says that although 60% of Lynch’s trades resulted in losses, he could manage downside risk precisely because he wasn’t tied to a strategic asset allocation. “Asset allocation-and just about any other model-works in a bull market,” Saut scoffs. “But the driver of returns in a bear or range-bound market is stock selection and risk management.”
So far, no other single method has knocked the Modern Portfolio Theory off its perch as a coherent way of structuring portfolios and pricing assets. But more and more practitioners believe the theory doesn’t deal adequately with today’s world.
Poor Harry Markowitz. Every time investors get whipped in the financial markets, they take it out on his Modern Portfolio Theory (MPT).
Investors don’t kick Markowitz only when they’re down. MPT also came under gleeful attack during the technology boom of the late 1990s, when “risk” was a dirty word. What sense does it make to diversify out of an asset class that’s returning 30%? Plenty, of course-but try telling clients to keep a little money in cash during a raging bull market.
Why does MPT look so good on paper, yet fail so spectacularly every few years?
Are VIX ETFs Breaking Out? originally published at ETFTrends
Some traders have been keeping a close eye on the CBOE Volatility Index as a possible “tell” that the rally in risk assets since March 2009 may be due for a breather.
That’s why the VIX’s move above its 200-day moving average Wednesday drew the attention of investors with a technical bent.
The index, which measures the implied volatility of options contracts on the S&P 500, has been relatively subdued during the market’s recent rocky stretch. The benchmark is known as Wall Street’s favorite fear gauge.
However, the VIX was up 18% in the final hour of U.S. trading Wednesday to its highest level since March.
The largest exchange traded product following VIX futures, iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX), rose 8%.
In stock ETFs, a Nasdaq-100 fund was pushed below a key indicator in Wednesday’s sell-off. [Nasdaq ETF Lower]
CBOE Volatility Index
Lots of pessimism since QE2 is deemed a failure and no QE3 is coming. Here’s one article that reminds us to ensure we are risk aware and maintain an intelligently adusting protection strategy. Posted at Seeking Alpha by Michael T. Synder http://seekingalpha.com/article/274478-the-next-crash-could-be-a-lot-worse
The Next Crash Could Be Alot Worse
here’s a lot of emotion in this market at the moment, and the conversations among traders are nearly all leaning toward the bear side
So what are some of the signs that this downturn on Wall Street may turn into a full-blown crash?
Well, according to the Wall Street Journal, junk bonds are being sold off at an alarming rate right now. Does the following quote from the Journal remind anyone of 2008 at least a little bit?….
A steep decline in prices of bonds backed by subprime mortgages has spread through the riskiest segments of the credit markets, ending rallies in high-yield corporate bonds and commercial real-estate debt.
Also, many of the big Wall Street banks are already laying off workers. In a previous article I wrote about the potential for Wall Street to go into “panic mode“, I noted that Goldman Sachs (GS), Bank of America (BAC), JPMorgan Chase (JPM) and Morgan Stanley (MS) are all laying people off or are considering staff cuts.
The truth is that the big banks on Wall Street are not nearly as stable as most people think that they are. Moody’s recently warned that it may downgrade the debt ratings of Bank of America, Citigroup and Wells Fargo.
Another major story on Wall Street right now is oil. OPEC recently announced that oil production levels will not be raised, even though the price of oil has been hovering around $100 a barrel.
World oil supplies are very tight right now. In fact, the globe actually consumed 5 million barrels per day more oil than it produced during 2010. This was possible because the difference was apparently made up by drawing down reserves.
But if oil supplies are this tight already, what is going to happen if a major war (as opposed to all of the minor wars that are already happening) erupts in the Middle East?
The world is sitting on the edge of a financial disaster.
We couldn’t agree with some of the commentary from this article in Financial Advisor Magazine. Its why we created SmartStops.
The broader message is that indexing is moving past the standard beta carve-ups, such as small- vs. large-cap equities and value vs. growth stocks. A new era of factor-based indexing is dawning… Among the catalysts for the new indices is the growing use of factor models, says Rolf Agather, director of index research at Russell. “As investors become more sophisticated, they’re using risk factor models to have a better understanding of their risk exposures.” Elevating risk management to a high priority, in other words, is the new new thing. “Many investors are realizing that using a traditional framework built around countries, sectors or styles doesn’t always provide the insights for appropriately managing risk,” he explained in an e-mail. “Investors are looking for new ways to manage their risks more directly.”
Beyond One Beta
A key motivation for targeting multiple risk factors in portfolio design is recognizing the limits of using just one.
The broad market beta does the heavy lifting for explaining the link between risk and return, according to the capital asset pricing model (CAPM). (CAPM is Robert Merton’s invention) . But if CAPM worked as promised, one beta would suffice for explaining risk and return. More exposure to market beta would bring higher return; less exposure would mean lower return.
CAPM’s embedded message: Don’t waste your time with factors other than market beta. It’s an elegant story, and it simplifies portfolio design and management—if it works. But it doesn’t, at least not completely
Even if you have the stomach for sitting tight over ten or 20 years, the risk and return story isn’t as simple as CAPM suggests. Decades of empirical research show that there are other risk factors beyond market beta driving performance. In fact, the risk-return story is teeming with factor narratives. The concept of one dominant beta isn’t dead, but it’s no longer alone.
Kevin Depew, editor of Minyanville posted an interesting article today at: http://www.minyanville.com/businessmarkets/articles/collapse-financial-collapse-economic-collapse-depression/6/1/2011/id/34883
And we at SmartStops ask the same question – have people become immune to all the potential downfalls awaiting them? Is that what causes them to try to ignore the risk around them? As if they don’t acknowledge it , it doesn’t exist? How do we get investors to feel that risk management is second nature to them when investing in the stock markets? So they can invest wisely and with less “fear”.
…..” It’s been 11 years since the dot-com crash. Our 2006 gloom no longer feels misplaced; it feels comfortable, safe. Yes, there are times to prepare for the worst.” He ponders if we shouldn’t thus also have white swan focus, in seeing this Bloomberg ad:
“Preparing for the Next Black Swans”
Bloomberg Money Managers Conference
When 14-Jun-2011 (Tue) 07:45 – 13:00
Where State Room, 60 State St., 33rd Floor
Boston, MA, United States
Entry Fee USD 695.00
“I have to believe that perhaps the notion of a black swan has not been fully explained? Or if it was, then the concept itself not wholly grasped?”
The event description:
“Preparing for the Next Black Swans”: The year 2011 will most certainly be remembered for its Black Swan events, including the spreading unrest in the Middle East and the earthquake in Japan. Money Managers need to be prepared for unexpected events as they position their investments across asset classes. The Bloomberg Money Managers conference will bring together mutual fund, hedge fund and private equity investors to consider events that could rock the markets, portfolio strategies for managing the unforseen and the future of actively-managed investing.”
“Can you see the shift that has occurred? If you have not participated in or observed the financial services and money management industry throughout the 1990s and before, perhaps not. Prior to 2000, the very concept of a black swan — an unexpected event that has an outsized impact and which endures post-impact rationalization as wholly expected (a la dot-com crash, subprime collapse, debt crisis, etc.) — was anathema. The models accounted for all possibilities. Math and science, financial engineering had permanently eliminated tail risk. This is not overstating things. Fast-forward a full decade, black swans are everywhere, their ubiquity serving as a sort of psychic balm. Today, every unpredicted event is black swan-worthy.”
‘Many Baby Boomers and Gen Xers face a significant retirement income shortfall,’ writes Alicia Munnell , director of the Center for Retirement Research at Boston College
According to Munnell, the current crop of retirees are living in a “golden age” that will fade as Baby Boomers and Generation Xers reach traditional retirement ages in the coming decades.
“Many Baby Boomers and Gen Xers face a significant retirement income shortfall,” she writes. “Even before the financial crisis, almost 45% of working households were projected to be ‘at risk’ [of being unable to maintain their pre-retirement standard of living in retirement]; after the crisis, this level increased to 51%.
Moreover, Munnel adds, the percent “at risk” increases with each cohort. Late Boomers show more households “at risk” than early Boomers, and Generation Xers have even larger numbers “at risk.” This gloomy forecast is due to the changing retirement income landscape.
Exchange-traded funds are developing in a similar way to the shadow banking system that almost brought down the world’s financial system in 2008, according to Terry Smith, chief executive officer of Tullett Prebon Plc. (TLPR)
Without owning the underlying assets, ETFs can move in the opposite way to which investors expect, Smith said
“The drivers and implications of the recent wave of financial innovation in ETF markets warrants closer surveillance of potential vulnerabilities by financial stability authorities to ensure that the market grows in a sustainable and safe way,” the FSB said.
ETFs are also vulnerable to unlimited short-selling because of the ease of creating new shares, according to Smith, who said short-selling in some funds has reached 1,000 percent. “The scope for a short squeeze is tremendous,” he said.
Posted on the SmartStops Education Center. http://media.mta.org/videos/2010/educational-web-series/chuck-lebeau/chuck-lebeau.html