The Investment Scientist

Managing Investment Risks

Posted on: November 11, 2010

MZ Capital 60/40 Model

MZ Capital 60/40 model vs S&P 500

Once I asked a prospective client how he managed investment risk.

“Well,” he intoned, “I try to get in before the market rallies and get out before it tanks.”

It is not just lay investors who have this misconception about risk management; many financial advisors equate risk management to market timing as well. One only needs to watch those advisors talking on CNBC to see that many of them are in the fortune-telling business.

So how do I manage risks? There are three steps.

Step one: Identify all investment risks and their characteristics.

I explained this in my previous post; there are nine types of investment risks that can be classified into three groups:

The good: beta risk, small cap risk, and value risk

The bad: idiosyncratic risk, duration risk, credit risk, and inflation risk

The ugly: agency risk and asymmetric information risk

Step two: Determine what risks to take and what risks to avoid.

I observe a simple principle: take the good, control the bad, and avoid the ugly.

Step three: Pick the right vehicles

This requires you to understand the risk loading of each investment vehicle and your desired amount of good investment risks.

For instance, regardless of how good their track record maybe, I don’t put my clients’ money in hedge funds, private equity, or structured products. These vehicles carry huge amounts of agency risk and asymmetric information risk that will blow up in investors’ faces sooner or later.

On the other hand, I like passive asset-class funds. I use them as building blocks for my clients’ portfolios. These funds are very transparent, and they do not have style drift common among actively managed funds. I usually tilt the portfolios toward small cap and value. This has helped my clients recover from the worst bear market a lot sooner. See this 60/40 model portfolio.

Note that the model portfolio also took a tumble in 2008. This shows that risk management can not eradicate risks. To eradicate investment risks altogether, you have to stay out of investment.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

13 Responses to "Managing Investment Risks"

Interesting classification of risks. Asymmetric information is one many investors don’t consider. As Ken Lay was telling Enron employees the company was a great investment he was walking upstairs and selling his stock. Unless you are Warren Buffett and have your people sitting on the board you don’t have all the info.

It’s hypocritical for “passive” advisors, especially from Dimensional, to lay waste to active managers, when they do the exact same thing. They simply buy you an index like this author does, charge you a fee, typically 1% and then what’s the “bogey” you have to overcome? Exactly, you’re always underperforming the index in a plain vanilla 60/40 portfolio you could do at Vanguard for almost free. Do you think this guy’s returns are “audited” by an independent third party net of fees? Doubt it. How long is the track record? uh-huh…probably been doing this a couple of years. Always ask for GIPS verified performance; If not, walk away.

What did I write that tick you off, Mr. Crew?

My chart is to show that small cap premium and value premium exist. No skill on my part at all. One just need to know what risks to take, put in a passive portfolio and rebalance once a year.

My clients don’t pay me 1% for performance. It’s there but it is never my selling point. They pay me for being their personal CFO. They are paying for financial confidence and peace of mind.

Your characterizations of Active Managers in other posts is what upsets me. Your clients pay a fee, likely 1% of Assets on a yearly basis to be their “personal CFO,” as you put it. Nothing wrong with that. But in your other posts, you denigrate Advisors for basically doing the same thing. As an Advisor myself, I find that insulting and I find that many “Dimensional Advisors” market themselves by indulging in this same pathetic tactic.

Basically what you are saying is that managers that select active mutual funds are not worth the fee because they cannot beat the market. First, you don’t know that, and second, most fee only advisors do a lot more than only managing a client’s portfolio. They hand hold; they offer advice on a range of issues important to their clients. In other words, we , too, act as our clients “Personal CFO.”

Listen, you have your “passive” approach and we have an active approach. I don’t market our firm by mocking the approach of Passive Advisors like yourself. Why would you find it necessary to try and build your business by criticizing the hard work of others in your industry who are charged with helping their clients achieve their financial goals? Should you not simply use this website to put forth your expertise without vilifying the hard work of active managers/Advisors? What is so different about what you do than what an active manager or active financial advisor does, for roughly the same fee? A fee-only active Advisor does the exact same thing with one exception-they select active managers or use tactical asset allocation using ETF’s. It’s simply a different investment method. We also act as a “personal CFO” for many of our clients on a number of difficult financial decisions, but we don’t minimize, through websites and postings, the efforts of other advisors to help their clients.

Mr. Crew,

Have you lost some big accounts to passive advisors? I can almost feel your pain reading your comment. I personally have taken many businesses from active advisors.

There are nearly 10000 stocks trading the Us alone, there are 6000 mutual funds. While you active advisors trying to pick the next winning stocks or fund managers, how much time do you have left to understand and service your clients’ financial needs? Think about it, suppose you are super smart and one hour is all it takes to completely analyze a stock or fund, just to go through all of stocks and funds will take you 2000 days.

That would be time well-spent if active advisors can indeed pick winning stocks or funds. Academic research has consistently shown otherwise. Let me quote Barras, Scaillet and Wermers: “Our decomposition of the (mutual fund) population reveals that 75.4% are zero-alpha funds – funds that have managers with some stock-picking ability, but that extract all of the rents generated by these abilities through fees. Further, 24.0% of the funds are unskilled, while only 0.6% are skilled – the latter being statistically indistinguishable from zero.”

TD Ameritrade Institution’s data shows, prior to the market tank, advisors put nearly 75% of their clients money on equity. At the bottom of the crash on 3/9/2009, equity allocation is about 40+%.

What is so wrong about pointing out most advisors are charging 1% to gamble clients’ money and destroy clients’ wealth?

No pain, whatsoever. In fact our asset growth has been stellar over the past four years. We began 2006 with zero AUM and now have over $60MM and we are quite proud of that.

I could give you a myriad of examples of how we not only have managed our clients portfolios effectively and efficiently, and furthermore, have added value with client services. I guess it depends on how you define “client services.” Every Advisor is different.

You justify your fee-and your passive investing, by calling yourself a “personal CFO.” Is that just another way to avoid having to discuss performance with your clients? We justify our fee by not only helping our clients beat the market employing active managers and ETF’s in a tactical way, but by offering ancillary services as well. In fact, unlike yourself, we put our money where our mouth is and have our performance verified by an independent third party twice per year–at our own expense.

Don’t your clients deserve to have your performance verified by an independent third party so you can illustrate to them what your performance has been–or hasn’t been-Net of fees?? That’s after your 1% and Dimensional’s fees. I would be happy to give you the name of a firm that does the audit so you and your clients can see what they’re missing in transparency. And please don’t say you can’t do this because our firm has been doing verifications since our inception in 2006.

The point I take issue with you about is that you lump all Advisors into the same category as if every advisor is on the take unless they have drunk the Dimensional Koolade. Some do well, some do not–much like passive advisors. I have no problem with passive advisors, per se, but the only way to solve the argument is to put your money where your mouth is-and have that performance of yours verified by an independent third party firm. Is that too much for your clients to ask?

We have not had to sacrifice so called “client service” in order to focus on picking the best managers or the best equities/fixed income for our clients. That’s what our relationship managers do. You can burnish your stats all you want, and yes, many active managers do underperform, but there are plenty that do not and unlike your firm, our clients will know if they are underperforming because guess what, we have third party verified results. We like to say “we eat our own cooking.” In fact, Mr. Zhuang, our partners have virturally all our own investable assets in our firm, over $8 Million–just like our clients–can you say the same thing?

Let’s assume that your firm and our firm does about the same client service.

Now,you go get your firm’s performance audited for the past three and five years, or however long you have been in business. Let’s verify your performance, net of fees, and using a blended benchmark with the VT (Vanguard Total World Stock index) as a proxy for your equity component (let’s use 60% equity allocation), and the Vanguard Total Bond market index (BND) for the fixed income component using 40% as the bond allocation. Sounds fair to me. Sounds fair to your clients and if I’m one of your clients, I want to know how well I’m doing–again, net of ALL fees.

Now lets see whether you add any investment value after your fees and those of Dimensional have been deducted.

The proof, they say, is in the pudding…

An interesting debate/argument. Personally, I appreciated Mr. Zhuang’s initial comments and I am enjoying learning more about the difference in a “passive” approach vs. an actively managed portfolio.

I struggle with these investment issues: I love the speculative side and enjoy investing directly in individual equities, but my cognitive side admires the systematic low cost approach of index funds. In the past, I have simply struck a balance of 1/3 direct equities, 1/3 index and value stock mutual funds, and 1/3 cash-fixed income. It’s worked for me, but what the hell do I know about picking stocks, or more importantly, what the hell do I know about when to sell a certain stock.

Regardless, I write in support of Mr. Zhuang, as I do not think his initial comments were truly derogatory towards active managers. If his comments on active managers were the worst things he muttered in a week, then he is closer to sainthood then I am.

Thank you both for your comments and my education.

David,

Being passive while the world is swirling around you is a hard thing to do. That’s why the world has too many active investors and too few passive one.

Mr. Crew,

You surely should be proud of your $60mm AUM. I personally don’t have time to read your long diatribe. As a matter of fact, I used to have time to write one post a week, now I only have time to write one per month. I am not in the business of convincing you to my point of view, my time is much better spent serving my clients.

By the way, I was an active investor as well, as very successful at htat as well. Check out this post:

http://fama-french.net/2010/12/18/the-efficient-market-an-stoppable-march/

While the passive vs active debate has its merits the insane thing is that you guys charge a flat 1% regardless of the asset value. From a pure investment advice standpoint this is nonsense. 100k takes the same amount of work as 100m. You guys have developed a canned allocation given my age and risk profile, yet you charge absurd amounts of money. With mutual funds all you are doing us typing in a few more digits on the buy trade. Big deal. Hand holding? I don’t believe this makes them money … the asset allocation does. So telling your clients not to sell during a crash is worth 1% of assets? Nonsense. Especially when you have all this research that tells you what to do and you just give your money to DFA funds…. 1% of my invested assets? You guys kill yourselves. PS: I’m a huge fan of DFA funds, I just think advisor fee structures are silly.

TR,

I am not ashamed of charging 1%. In fact, I charge 1.2% up to $1mm. The fee is disclosed up front. I don’t receive other compensation from commissions and 12b-1. Maybe the hand holding part is useless to you, for some folks it is extremely important. There are tons of research that shows investor returns lagging investment returns by a huge margin, all due to behavioral quirks of investors. If you can help clients overcome their quirks, we are worth our salt.

I can’t speak for other advisors, but for me, investment management is only a small part of what I do. I watch over my clients’ overall finance, I coordinate a team of fiduciary experts to add their issues that include:

1. tax mitigation
2. asset protection
3. estate planning
4. business succession
5. charitable gifting

I give them the peace of mind to focus on their work and their family. My clients, most of them are successful doctors and businessmen. They are not stupid. If my services are not worth the money, they don’t need you to remind them not to hire me. The most important thing is disclosure upfront, my prospects can make their own judgment.

Good for you for disclosing your fee, kudos. Not ashamed of your fee? For a passive investing low cost advocate you should be. Your fee structure stinks. For the sake of argument lets say I don’t use any of your services (estate planning, taxes, gifting etc) during a given year. DFA’s small cap value fund has an expense of .52%. Add your 1% fee and you get a whopping 1.72%! Suddenly we are into the realm of active mgmt fees. Ridiculous. Contrast that with Vanguards small cap value ETF that charges .14%. So, what you are telling me is that DFA adds (1.72-.14) 1.58% in extra return guaranteed? I say guaranteed because you are guaranteed to take your fee regardless of performance. So lets get back to your other services. Your fee structure suggests that no matter how little I use your other services I get charged a 1.2% fee? Tax mitigation? You think I’m going to use you as my tax accountant if I have millions in assets and complex tax considerations? No, I’m going to a tax professional that does taxes for a living every day. Can you file my taxes? Do you have the resources of a tax firm? Why should I pay twice? And the same goes for the other services. You think you are better at estate planning than my attorney that does this every day? Or charges by the hour? Nonsense. Charge for these services independently or at least by the hour! You think year after year I’m going to pay you for services that you may or may not be doing for me? Lame. At least have a graduated fee schedule that lowers as assets increase. Listen, I really value your advocacy of small cap value and I love your site but I would never pay 1.2% for gatekeeper access to DFA.

TR,

It’s very simple. If you don’t use other of my services, all you need is asset allocation, there is not much value I can add to your financial life, you should not be my client.

I have tried the hourly fee route before. It is not a good arrangement for clients who have complicated financial situation. To deliver great services, I need to know their situation intimately. Hourly fee arrangement is anathema to that. However, hourly fee arrangement is most appropriate for middle class clients who have simpler financial issues. I refer them to a good friend of mine (fee-only hourly planner) who specializes in them.

For my doctor and entrepreneur clients who have substantial wealth and who are extremely busy, watching over their financial big picture is tremendously valuable. For instance, some of them know they need to do something about asset protection, but they don’t understand the subject enough and they don’t have time to do due diligence, so they would have let the situation sit there until someday bad thing happens and it’s too late. Many don’t even aware they have a problem. I make sure all these financial holes are patched up. Are these services valuable to them 10x over the fees i charge? I tell you with confidence they are. I know two very successful businessmen each sold his business for multiple tens of millions, with a few financial mistakes, they are both back in the job market in their 70s. How sad it is. I could have helped them if they were my clients.

You should not pay 1.2% just for the access to DFA, period. People who called me about low cost access to DFA I refer them to Rick Ferri or Evanson.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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