Handicapping the Economic Recovery
A recent article in the Wall Street Journal by Alan Blinder, professor of economics at Princeton University, did an excellent job of quantifying the risks of the events in front of us in undermining the growth of our economy (see WSJ.com - Opinion: Handicapping the Economic Recovery). Blinder evaluated the possibility of the four major obstacles facing the U.S. economy that could take our country off the path of reaching our much needed recovery. This included the risks of the:
- Japanese earthquake, tsunami, nuclear meltdown – low risk at 5 percent;
- European sovereign debt issue - a “financial implosion”- low risk at 5 percent;
- Inability of the U.S. government to get its deficit in order, the possibility of hitting the debt ceiling, resulting in default on our national debt - low risk at 5 percent;
- Oil market – due to unrest in the Middle East - spikes up to the $150 per barrel range - 25 percent chance.
Adding up these risks brings us to a 40 percent chance of one of these events happening and knocking our economy off its slow, pathetic growth path. Although the odds are in favor of the economy skirting by these events, they are a paltry 60 percent.
The question is: How does one invest the funds in a portfolio in light of these occurrences and the unforeseen events that seem to creep up on us? Alan Blinder suggests the largest risk at 25 percent is that oil goes to $150 a barrel.
How to Prepare for a Spike in Oil Prices
Investors can hedge that risk to some extent by buying a position in their portfolios that will move in tandem with the increase in oil prices.
These possible positions include oil company stocks or crude oil futures.
Either can be bought through an exchange-traded fund (ETF), which tends to be low-cost and convenient. You will find that the oil futures ETFs have not kept up with oil futures themselves. The USO Oil Fund is up 9.2 percent year to date (YTD) versus the futures that are up 14.5 percent. The difference, or tracking error, is due in part to the problems of rolling over the underlying futures holdings. Suffice to call it a tracking error.
However, the Rogers International Energy exchange-traded note (ETN) is up 17 percent YTD. The difference here is threefold. The Rogers ETN is a global ETN versus the USO Oil Fund, which is U.S.-based. Second, an ETN obligates the issuer to track a certain index, therefore the ETN will most likely have less tracking error and better match the performance of the underlying index. And finally, unlike an ETF, an ETN takes on the risk of the issuer’s ability to pay when you choose to redeem your shares. Most ETNs, in fact, all that I have seen, boast excellent credit ratings.
I believe these kinds of global risks will consistently be in front of us and on our mind when investing; be it a budget crisis, the issue of inflation, an al-Qaida attack, or a civil war in far off oil-producing country, to name a few. This has become the new way of our world and we will have to navigate our investing to take advantage of opportunities, but more importantly, to look to the long term and stay the course.
How to Manage Risk in your Portfolio
A recent article in Barron’s caught my attention, “Ways to Turn Volatility into an Asset Class,” by Bill Luby. It discussed the new products that are available to reduce volatility in a portfolio and/or eliminate “tail risk,” which is defined as a decline in your portfolio of more than three standard deviations. For the sake of simplicity, consider “tail risk” as what happened to most of our portfolios in fall 2008.
As advisors, we need to be open to adding new asset classes to client portfolios and always on the lookout for strategies to mitigate tail risk or even just to lower volatility. Not too long ago, the only asset classes were U.S. stocks and bonds. We moved into real estate investment trusts (REITs), international holdings, then emerging markets, commodities and so on. These have all served as great additions to portfolios as they have provided broader diversification and access to high-growth opportunities.
Risk Reduction as an Asset Class
Risk reduction as an asset class is incredibly appealing. It means we can all sleep a bit better at night.
The VIX ETF, which tracks volatility in the market, is one fairly new strategy. This investment gains in value as the market becomes more volatile. An individual investor can buy this ETF for his or her portfolio in hopes of gaining some positive return when the rest of the portfolio is declining. Due to underlying structural problems, these products do not necessarily work in lockstep with the VIX futures index, thereby limiting their value. As more of these strategies are designed, they may provide more protection for less investment, so will be worth watching.
A more common alternative is to determine how much downside you can handle in your portfolio and then purchase a series of put options on those securities or a like index. Ben Johnson, VP of Research from Barclays Global was kind enough to share with me some research on this subject. He offered this example: At a time when the S&P 500 index is at 1,000, an investor seeking to protect $10 million invested in an S&P 500 index fund might buy a six-month put option with a strike level of 900 (10 percent out of the money) at a cost of $300,000, or 3 percent of the value of the portfolio. This will guarantee the investor that the loss on the portfolio over this six-month period will not exceed 13 percent (a 10 percent decline in the index fund plus the cost of the option). The analysis shows that this strategy will yield a lower return over time (Johnson uses January 1986- January 2010), due to the 3 percent drag on return, than a portfolio of 100 percent stocks or one with 77 percent equities and 23 percent bonds. However, this put option portfolio’s worst six-month performance was just -12.12 percent versus the all-stock portfolio’s worst six-month loss of -34 percent. In conclusion, this strategy may reduce downside risk over time, your returns were better if you invested in an all stock portfolio or a portfolio of stocks and bonds.
Risk Management Panel Discussion at DePaul
I will be exploring the subject of managing risk in much greater detail, as I have been asked to moderate a panel on the topic for the DePaul Center of Finance in May. This panel is composed of some experienced and very qualified analysts in the greater Chicago area. I will be sending out an invitation for you to attend as my guest
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If you would like to discuss my comments further or if I may be of assistance to you, please send me an email at stempleton@staffordwellsadvisors.comor call 630-368-1288.
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