How to cut your ‘fat tail’ risk

How to cut your ‘fat tail’ risk

Confused about how to manage your portfolio in these increasingly uncertain times? You’re not alone. There are so many diverging views. And it’s easy to panic when fund managers start advising to “sell everything”. But instead of selling, a better strategy to manage risk may be to buy into something else.

There is a lot of conjecture about whether equity markets are cheap or expensive. Who you ask will determine the answer you receive. Some market commentators, experts and other ‘helpers’ use the PE ratio as their measure of fair value, some use charts to show support and resistance levels and some just make an ‘educated’ guess. It is easy to see why many investors become confused and lose confidence in the views of financial professionals, particularly since the aforementioned approaches have such poor reliability.

Recently, Montgomery analyst Daniel Wu questioned the veracity of the Schiller Cyclically Adjusted PE ratio (“CAPE”) noting that not only is the CAPE not much more informative than trailing PE (0.86 correlation), its predictive power is also low, showing only -0.59 correlation with stock returns over the next five years, and a paltry -0.27 correlation with stock returns over the next twelve months.

The problem with the PE may in fact simply be that it is not a valuation of a business.  If price is what you pay, and value what you receive, then a valuation cannot have price as an input because it must stand separate from prices to determine whether value is present or absent.

So the PE ratio may be high but it tells us little about whether the market is expensive or cheap and it tells us little about what returns are likely to be in the future.

The holy grail of course would be an indicator that could tell us when to buy and when to sell but in the absence of such a device it is arguably important to stop thinking in terms of ‘all in’ or ‘all out’.

Before considering an alternative and much more sensible approach it is probably worth discussing briefly my own thoughts on where the market is.  In short, I believe the chance of a correction between now and 2020 is almost certain.

The income recession in term deposits has triggered an investor migration up the risk spectrum and into company shares with lower perceived earnings and dividend volatility.  The problem of course is they tend to be the large cap conventionally-described ‘blue-chips’ or the infrastructure and utility companies.

Here’s the problem with each.  In the case of the big blue chips, the ASX 200 dividend payout ratio has increased from 55% in 2011 to 80% today.  As a result, these companies, in aggregate, are retaining less of their profit for growth.  In other words, investors are buying bond-like returns but taking on equity market risk.

In the case of infrastructure and utility companies, the valuations are high because interest rates are low.  When analysis and investors discount back future cash flows to arrive at a valuation they often use the the weighted average cost of capital.  The WACC is simply the cost of debt multiplied by the proportion of debt plus the cost of equity multiplied by the proportion of equity.  Most of these companies have little or no net equity on their balance sheet so valuations are boosted by them having a high proportion of debt.

So think about that for a moment; The most expensive companies are those with little growth or a lot of debt, or both.  That’s what low interest rates have done but as the mathematician Herbert Stein, once observed; “If something cannot go on forever, it will stop”

Low interest rates have produced some strange consequences including the corruption of the assessment of risk.

The way the PE ratio does work is in terms of explaining how share prices might react if long term interest rates rise.  When interest rates rise, the ‘P’ in the PE must fall.  If the ‘E’ for earnings grows one might compensate for the other and the investor could be relatively safe.  If however the ‘E’ is not growing then the ‘P’ falls and the share price declines.

Elsewhere, art, vintage cars, low numeral licence plates and wine are making record prices in auction rooms characterised by standing room only and frenetic bidding.  Sometimes we don’t need data to tell us of market excesses and an impending turning point.

Legendary bond fund manager Jeffrey Gundlach speaking with Business Insider observed, “The artist Christopher Wool has a word painting: ‘Sell the house, sell the car, sell the kids.’ That’s exactly how I feel – sell everything. Nothing here looks good.” And former Pimco boos and founder Bill Gross has tweeted: “Global yields lowest in 500 years of recorded history. $10 trillion of negative rate bonds. This is a supernova that will explode one day.”

It is of course easy to respond to these aphorisms and sell everything but investors are generally poor at timing their selling and even poorer at timing their re-entries.  Buying and selling requires two prescient decisions, the probability of which is very small.

An alternative approach to ‘selling out’ is to adopt an approach that involves realising there is a small probability of an event that could have significant impact on your portfolio.  We call these fat tails and their risk can be mitigated.  The answer is not selling something but instead buying something else.

That ‘something else’ is generally an alternative investment – what some commentators call a hedge fund.  Now I can hear you screaming ‘that’s high risk and they’ve had such lousy returns’.  Neither is true.  A fund with the ability to profit from falling share prices lowers the risk of your portfolio.  And when commentators talk of the poor returns of hedge funds last year they fail to point out that a hedge fund is a structure not a strategy.  Saying hedge funds have had poor returns is the same as suggesting superannuation has had poor returns.  Superannuation returns depend entirely on where the investor had invested their super.  It’s the same with alternative investments.

In the context of de-risking the fat tails, you may in fact want your hedge fund to lose money – that would mean the rest of the portfolio has done extremely well.  Investing a proportion of your portfolio into an alternative strategy, for example a market neutral or long/short strategy, or a fund that can hold larger amounts of cash, is about insurance.  It’s about eschewing the need or temptation to buy and sell frequently, to remain invested in the high quality companies that will increase in intrinsic value over the years and create a layer of security that might even offer the opportunity to take advantage of lower prices rather than run away from them.

MORE BY RogerINVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.