Advanced Personal Portfolio Design Using ERM Principles

Advanced
Personal “State-of-the-Art
Financial Portfolio Design”
Planning an ERM Approach
Conference
Las Vegas, NV

January 17, 2012 Jerry A. Miccolis, CFA®, CFP®, FCAS

800.364.2468 :: brintoneaton.com

Jerry A. Miccolis
Principal, CIO, Senior Financial Advisor
Brinton Eaton

CFA; CFP; Fellow, Casualty Actuarial Society;
Member, American Academy of Actuaries

Portfolio manager, The Giralda Fund

30 years’ experience in risk management

Co-author: Asset Allocation For Dummies®;
Enterprise Risk Management: Trends and Emerging Practices

Towers Perrin’s global Enterprise Risk Management practice leader

Published in The New York Times, The Wall Street Journal, The Star Ledger,
Business Week, The Baltimore Sun, Market Watch, MSN Money, Market Wire

Appeared as an expert commentator on CBS Radio, ABC TV, NPR, and online
at IRMI.com, the website of the International Risk Management Institute

Company confidential 800.364.2468 :: brintoneaton.com 1

The challenge: Our profession needs a
new level of investment risk management
 Risk has been shifting to the individual
 Pension plans: DB  DC
 Social Security
 Longevity

 …and the risks are daunting
 4Q08/1Q09 — the Great Recession
 May 2010 — flash crash
 Late 2011 — debt crises

 More than ever, wealth management is risk
management
 We need to rise to the challenge
 Enterprise Risk Management provides the road map


What is ERM?

 A management discipline
 Devoted to identifying, analyzing, mitigating, financing, and
exploiting risk
 Designed to give the enterprise sustainable competitive
advantage

 ERM dictates that risk is not to be feared, but:
 Clearly identified
 Fully understood
 Rigorously analyzed
 Expertly exploited

 In ERM, risk is made to work for you


How does ERM relate
to wealth management?
 MPT  ERM  MPT
 ERM owes a lot to Modern Portfolio Theory
 It’s time for ERM to return the favor

 Premise: the core principles of ERM can form the
basis for successfully building and protecting
personal wealth
 ERM’s core principles
 Strategic focus
 Natural hedging
 Risk exploitation
 Catastrophe protection


ERM’s core principles
provide the road map
ERM Principle Organizational ERM Individual ERM

Customize risk management around, and in Customize your investment strategy around your
Strategic Focus service to, the organization’s specific own unique long-term financial objectives — which
strategic objectives is the real purpose of your investments

Diversify and allocate investments among
Look across operational silos to find risky
Natural Hedging uncorrelated asset classes — using up-to-date
operations that offset each other
tools

Use the ERM-enlightened view to do Employ informed risk-taking to exploit high-
Risk Exploitation informed risk-taking, exploiting areas performing but risky assets — making volatility
deemed “too risky” by competitors work for you

Use “safety net” portfolio protection as
Transfer only those risks that can’t naturally
catastrophe insurance against major market
Catastrophe Protection be hedged away, and insure those risks
shocks that diversification can’t handle — and in a
only at catastrophic levels
cost-effective way
Brinton Eaton, 2011


Putting ERM’s core principles to work

Strategic
Targeting investment strategy to the right goals
Focus

Natural
MPT, but modernized — shaking off 60 years of rust
Hedging

Risk
Being opportunistic, but less naive
Exploitation

Catastrophe
Tail risk hedging, without giving away the store
Protection
Brinton Eaton, 2011



Strategic
Focus

Natural
Hedging

Risk
Exploitation

Catastrophe
Protection
Brinton Eaton, 2011


Strategic Focus — Recap

 Customize your investment strategy around your
own unique long-term financial objectives — which is
the real purpose of your investments
 Your financial situation has many moving parts
 Financial planning tools can capture these
complexities in a coherent way
 The right investment strategy is the one that best
secures your own financial future
 Further reading:
 “It’s Good to Be Coordinated” Research
Brief, www.brintoneaton.com
 Asset Allocation For Dummies® (Wiley 2009), Chapter 7



Strategic
Focus

Natural
Hedging

Risk
Exploitation

Catastrophe
Protection
Brinton Eaton, 2011


The tools and techniques of Modern
Portfolio Theory need modernization
 Simplifications for computational ease are no longer
necessary — and are unrealistic
 Normal distributions  “fat tails”
 Standard deviation  more real-life measures of risk
 Single period  multi-period projection with “risk drag” and rules-
based rebalancing
 Solving equations  running simulations

 These modernizations are easy and overdue
 The simplifications have failed us, not MPT
 The underlying conceptual framework of MPT is still
valid


…but, it’s still only as good as its inputs

 The 3Rs — Returns/Risk/Relationships
 Returns
 Expected asset-class returns move in cycles
 Valuation matters

 Risk
 Volatility is not constant
 Clustering

 Relationships
 Correlation — does it really measure what matters?
 Do “uncorrelated” assets remain so when most needed?

 The solutions are available


Natural Hedging — Recap

 Diversify and allocate investments among
uncorrelated asset classes — using up-to-date tools
 MPT is still the right conceptual framework
 But, most applications are very much out of date
 The needed tools are available
 The Kitces Report, December 2009 & January 2010
 “What We Should Be Demanding from Our Asset Allocation
Software” white paper, www.brintoneaton.com
 “Next Generation Investment Risk Management: Modernizing
Modern Portfolio Theory” Journal of Financial Planning, January
2012



Strategic
Focus

Natural
Hedging

Risk
Exploitation

Catastrophe
Protection
Brinton Eaton, 2011


Diversification can reduce risk…

1980 - 2009 Results
11.7%

11.6%
S&P 500
11.5%
US Real Estate
11.4% Combined 50/50
Return

11.3%

11.2%

11.1%

11.0%
15.0% 16.0% 17.0% 18.0% 19.0% 20.0%
Risk


…Rebalancing can improve return

1980 - 2009 Results
11.7%

11.6%
S&P 500
11.5%
US Real Estate
11.4% Combined 50/50
Return

Combined w/ rebalancing
11.3%

11.2%

11.1%

11.0%
15.0% 16.0% 17.0% 18.0% 19.0% 20.0%
Risk


Rebalancing puts the inherent
volatility among assets to work for you
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 YTD 9/30/11

Commodities Real Estate Commodities Emerging Market Real Estate Emerging Market Real Estate Emerging Market Fixed Inc Emerging Market Real Estate Fixed Inc
49.7% 12.4% 32.1% 53.8% 30.9% 32.8% 33.2% 39.1% 5.2% 77.6% 28.9% 6.6%

Real Estate Fixed Inc Fixed Inc Small Cap Stocks Emerging Market Commodities Emerging Market Commodities Small Cap Stocks Mid Cap Stocks Mid Cap Stocks Real Estate
27.8% 8.4% 10.3% 38.8% 24.3% 25.6% 31.7% 32.7% -31.1% 37.4% 26.6% -6.4%

Mid Cap Stocks Small Cap Stocks Emerging Market Mid Cap Stocks Small Cap Stocks Mid Cap Stocks Large Cap Stocks Mid Cap Stocks Mid Cap Stocks Real Estate Small Cap Stocks Large Cap Stocks
17.5% 6.5% 1.6% 35.6% 22.6% 12.6% 15.8% 8.0% -36.2% 27.5% 26.3% -8.7%

Small Cap Stocks Mid Cap Stocks Real Estate Real Estate Commodities Real Estate Small Cap Stocks Fixed Inc Real Estate Large Cap Stocks Emerging Market Commodities
11.8% -0.6% -4.5% 35.3% 17.3% 11.2% 15.1% 7.0% -36.3% 26.5% 18.6% -9.3%

Fixed Inc Emerging Market Mid Cap Stocks Large Cap Stocks Mid Cap Stocks Small Cap Stocks Mid Cap Stocks Large Cap Stocks Large Cap Stocks Small Cap Stocks Large Cap Stocks Mid Cap Stocks
11.6% -4.9% -14.5% 28.7% 16.5% 7.7% 10.3% 5.5% -37.0% 25.6% 15.1% -13.0%

Large Cap Stocks Large Cap Stocks Small Cap Stocks Commodities Large Cap Stocks Large Cap Stocks Fixed Inc Small Cap Stocks Commodities Commodities Commodities Small Cap Stocks
-9.1% -11.9% -14.6% 20.7% 10.9% 4.9% 4.3% -0.3% -46.5% 13.5% 9.0% -13.8%

Emerging Market Commodities Large Cap Stocks Fixed Inc Fixed Inc Fixed Inc Commodities Real Estate Emerging Market Fixed Inc Fixed Inc Emerging Markets
-31.8% -31.9% -22.1% 4.1% 4.3% 2.4% -15.1% -17.4% -52.4% 5.9% 6.5% -21.7%


But, rebalancing is naïve and reactive

 Relies blindly on mean reversion
 Unfortunately, mean reversion does not always
occur:
 At regular intervals
 At consistent deviations from the mean
 With consistent force

 Often, momentum delays/weakens mean reversion
 Rebalancing doesn’t often get the timing right
 It doesn’t attempt to
 It’s just approximately right, often enough, to create long-term
benefit


There is
a more proactive way to exploit risk
 Dynamic asset allocation
 Explicitly treats momentum/mean reversion
 Utilizes early warning signals

 Signals can be internal and external
 Moving average algorithms  Leading Economic Indicators
 Valuation measures  Credit spreads/money flows

 DAA reflects the fact that MPT is only as good as its
inputs
 Recognizes that inputs can change dynamically
 Structurally sound way to:
 Test your fundamental inputs
 Nimbly make adjustments as appropriate


Let’s examine a sector rotation
strategy as an example of DAA
 Attempts to directly measure momentum and mean-
reversion
 Calculates simple moving averages (MA)
 Employs “moving average crossover” (MAC)
algorithms
 Goal is to identify when market segments are due for
extended decline
 Doesn’t try to predict trends, but to promptly identify
them as early as possible in their development


The SPDR S&P 500 Total Return ETF
(SPY)
S&P 500
250

200

150

100

50

0


250-day MA
S&P 500
250

200

150

100

50

0


50-day MA
S&P 500
250

200

150

100

50

0


MAC — Short MA vs. Long MA
S&P 500
250

200

150

100

50

0


Our sector rotation strategy
actually has several layers
 Exit/entry signaling
 Trade-offs between stability and responsiveness
 Three “momentum” algorithms
 Each has its own strengths/ weaknesses
 Rules that determine which algorithm to use at different times
 Dynamically move between responsiveness and stability based
on market characteristics

 Filtering
 To avoid too-frequent trading

 Parameters optimized based on 1990-2007 data
 Tested “out of sample” with 2008-2011 data


How does this strategy compare
to the S&P500 Total Return Index?
S&P 500 TR Sector Rotation S&P 500 TR Sector Rotation
500 200

December 1991 - December 1999 175 December 1999 - December 2002
400
150

125
300

100

200
75

50
100
25

0 0
Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-99 Dec-00 Dec-01 Dec-02

S&P 500 TR Sector Rotation S&P 500 TR Sector Rotation
250 175

December 2002 - December 2007 150 December 2007 - September 2011
200
125

150
100

75
100

50
50
25

0 0
Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-07 Dec-08 Dec-09 Dec-10


How does this strategy compare
to the S&P500 Total Return Index?

S&P 500 TR Sector Rotation
3000

December 1991 - September 2011
2500

2000

1500

1000

500

0


Annualized Returns

12/11/1991-12/31/1999 21.0% 21.2%
12/31/1999-12/31/2002 -14.5% 19.9%
12/31/2002-12/31/2007 12.8% 16.3%
12/31/2007-9/30/2011 -4.6% 7.1%

12/11/1991-9/30/2011 7.8% 16.9%


How else did we test this strategy?

 Rolling annual returns
80%

60%

40%

20%

0%

-20%

-40%

-60%

 Maximum drawdowns
 Parameter robustness


This strategy
can be continuously improved upon
 Stable-return investments in lieu of cash
 Tactical moves into volatility
 LEIs and other external signaling
 Expand beyond US large-cap equity sectors
 Global/international sectors
 Commodities and other alternatives


Risk Exploitation — Recap

 Employ informed risk-taking to exploit high-
performing but risky assets — making volatility work
for you
 Rebalancing is the classic way to exploit volatility
 Dynamic asset allocation takes rebalancing to the
next level
 You can capture higher returns than those investors
who have a less enlightened risk perspective
 Dynamic Asset Allocation, Bloomberg Press, 2010
 “Next Generation Investment Risk Management: Dynamic Asset
Allocation” Journal of Financial Planning, February 2012



Strategic
Focus

Natural
Hedging

Risk
Exploitation

Catastrophe
Protection
Brinton Eaton, 2011


Traditional ways
to protect portfolios are not enough

 High allocation to cash /
US Treasuries

 Precious metals

 Annuities

 Puts / collars


We set three stringent criteria
for an effective tail risk hedge
 Sudden appreciation in severe market downturns
 “Severe” denoting sudden, substantial, unexpected decline in
market value across most major asset classes, as in 4Q08 (i.e.,
when diversification doesn’t help)
 Appreciation to a degree sufficient to meaningfully offset the
decline
 No “give-back” during market recovery!

 Very low cost
 Minimize diversion of funds from productive use
 No sacrifice of upside portfolio potential!

 Minimal disruption to portfolio
 Maintain what works in vastly more likely markets
 “Don’t throw the baby out with the bathwater!”


Our criteria helped narrow our search

 Traditional direct protection (e.g., puts, collars)
violate our criteria
 “Black Swan” funds violate our criteria
 Promising idea: Exploit volatility spikes that coincide
with sudden market declines
 But, long-only volatility (e.g., VIX) violates our criteria
 Transitory benefit
 Can’t invest in directly
 VIX futures: Severe negative roll yield  very high carry cost


Does anything meet our criteria?

 Dynamic hedging
 Puts/put spreads/VIX futures opportunistically applied
 Needs constant monitoring
 Potentially high cost

 Correlation plays
 “Call-on-call” strategies
 Not yet well developed

 Long/short volatility plays
 Realized volatility: daily vs. weekly
 Implied volatility: medium-term vs. short-term
 Difference: implied vs. realized

 Combinations


Our criteria in a picture
S&P 500 Total Return Index Ideal Equity Tail Risk Hedge
2600 120

2400
100

2200

80
2000

1800 60

1600
40

1400

20
1200

1000 0
1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011


Some combinations are promising

Implied Vol Strategy Realized Vol Strategy Difference Strategy Combined Tail Risk Hedge
120

100

80

60

40

20

0
1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011

-20


Catastrophe Protection — Recap

 Use tail risk hedging as catastrophe insurance
against major market shocks — but in a cost-
effective way
 Treat only those risks that asset allocation/
rebalancing aren’t designed to handle
 Think outside the box, as traditional risk hedges are
inferior on several levels
 “Does Your Portfolio Have a Safety Net?” survey report,
www.brintoneaton.com
 “Assessing New Tools to Protect Against Tail-Risk Events” Advisor
Perspectives, February 2011
 “Next Generation Investment Risk Management: Enlightened Tail
Risk Hedging” Journal of Financial Planning, April 2012(?)


When you effectively apply
and integrate ERM’s core principles…

Strategic
Focus

Natural
Hedging

Risk
Exploitation

Catastrophe
Protection
Brinton Eaton, 2011


…the cumulative effect
can be game-changing
S&P 500 Sector Rotation Sector Rotation + Combined Tail Risk Hedge

500

450

400

350

300

250

200

150

100

50

0
1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011


How have we made
all this accessible to our clients?
 We needed to wrap these approaches together in an
integrated package
 And efficiently deliver it


How have we made
all this accessible to our clients?


Let’s review…

 Personal wealth management is risk management
 ERM is the natural conceptual framework to build
and protect wealth
 This has certain implications
 Investment strategy needs to be focused on the right goals
 MPT needs modernization
 Asset allocation needs to be dynamic
 Catastrophe protection needs to be creative

 All this is achievable — we’re doing it


The challenge: Our profession needs a
new level of investment risk management
 “Revisiting Modern Portfolio Theory”/“Understanding
Tactical Asset Allocation” (Michael Kitces presentations)
 “…our education as planners does not train and prepare us for this
type of analysis…”
 “…some planners will be better at it than others…”
 “…some firms will choose to outsource…”

 “The New Investment Paradigm: Graham Meets
Markowitz” (Bob Veres, Advisor Perspectives, March 16,
2010)
 “…far more complicated and time consuming…”
 “…risk of getting [it] wrong will be increased dramatically…”
 “…bifurcation in the advisory profession…the New Paradigm may be
adopted broadly, but applied by few”

 Each firm has a choice to make


For more information on these ideas…

 Read:
 AssetAllocationBook.com
 The Kitces Report
 Advisor Perspectives
 Inside Information
 Journal of Financial Planning

 Visit: www.brintoneaton.com
 Research Briefs/white papers
 Client bulletins
 Podcasts/webinars

 Email: info@brintoneaton.com
 Call: 800-364-2468


Advanced Personal Portfolio Design Using ERM Principles

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