March 31, 2009
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In my previous article “Casting Stones,” I discussed how using correct risk and return estimates can assist advisors in auditing their asset allocation decisions, as well as demonstrating their skill and value to investors. By correctly identifying an investor’s goal, as defined by their Minimum Acceptable Return (MAR), and then using downside risk measurements to quantify how their asset allocation behaves, advisors can assist investors in achieving their goals.
The process I described incorporates sophisticated statistical calculations to move beyond “beating the market” as a measure of success. In order to further our profession, we must embrace computational methods that provide greater accuracy and insight, including those that were computationally intractable a decade ago.
In this follow-up, I outline the process of building portfolios (implementing the asset allocation strategy) by conducting manager evaluations customized to an investor’s individual MAR while adhering to the investment policy statement.
One size fits all?
Those traditional Third Party Asset Management Platforms (TAMPs) and due diligence providers that operate under the Capital Asset Pricing Model (CAPM) are guilty of attempting to solve investment problems for all investors simultaneously. CAPM assumes every investor has a singular goal – to ”beat the market,” and the only differentiation among investors is their tolerance to withstand market volatility. Through risk tolerance questionnaires, investors are classified as aggressive, moderate or conservative and placed like lemmings into ”model portfolios.”
For example, assume Investor A needs $60,000 annually after taxes, inflation and advisory fees to meet their goals. For an investor with $600,000 this equates to a 10% MAR. However, for investor B, with $750,000, this would equate to a MAR of only 8%. In this case, investor A would have to be considerably more aggressive than Investor B; although they both may have answered the Risk Tolerance Questionnaire based on CAPM in the same manner.
Advisors must resolve the gap between MAR and financial resources with their skill, competence and ability, are now implicitly linked to the investor’s success. But, the goal of the advisor should be to assist the investor in implementing financial planning strategies to obtain the lowest MAR, not trying to ”beat the market” once they determine the highest risk an investor can tolerate.
From Alpha to Omega
Until now, the industry has defined manager skill in terms of Alpha or excess return relative to an index. But this approach calls into question the appropriateness of the index selected [Ed. Note: See, for example, this letter to the Editor] as well as the time period used for measurement. Comparing every manager to an arbitrary index such as the S&P 500 is clearly not an apples-to-apples comparison of risk. Nor can one rely on short time periods – a single year, five years or even 10 years – as a representative distribution of returns.
In order to solve both risk and time period biases, Frank Sortino at the Pension Risk Institute devised the Omega and Omega Excess functions. (Dr. Sortino’s Omega calculations vary from Keating and Shadwick’s Omega discussed in Part I. I will refer to Sortino’s as OmegaS and Keating and Shadwick’s as OmegaK.)
The first step is to understand the style beta (sβ) of a manager versus his or her benchmark. Style beta identifies whether the manager’s mix of styles is more or less risky than the style to which the manager is ”assigned.” Mathematically:
Style β = riskmanager / riskindex
(where “Risk” is defined as downside risk)
Unlike traditional R-squared, which measures the appropriateness of an index for comparison, sβ uses style analysis to understand how the manager was invested.Display article as PDF for printing.
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