How to Do a Better Job Helping Clients Manage Risk
In the bear market's wake, "risk management" has become the most over-used phrase in the financial lexicon. You can't read an investment brochure these days without several references to how risk is being monitored, managed or controlled.
Part of this trend is positive, because it caters to investors who are more cautious and risk-conscious. Also, financial advisors have developed more skill in applying risk metrics - such as Beta and standard deviation.
But the flipside of the trend bothers me. In some instances, I believe Beta and standard deviation are being misapplied or miscommunicated. In this article, I'll suggest two other risk-monitoring metrics that may help you serve your clients better in today's dynamic markets.
The Limits of Risk Metrics
Let's begin with a basic truth that few advisors will dispute, yet many don't want to discuss. In regard to mutual funds and variable portfolios, virtually all risk metrics are inaccurate in real time. That includes Morningstar risk/return ratings, Morningstar Beta and standard deviation calculations, and scatterplot graphs constructed with risk/return axes. All of these calculations attempt to measure risk in portfolios that existed several months ago - not as they stand today. They don't measure the risk of a current portfolio (or even the manager's current strategy), because mutual funds and variable portfolios don't report holdings transparently, on a timely basis. If you're evaluating a fund with 100% annual turnover, and the risk metrics you're quoting were calculated six months ago, then your numbers may be at least 50% wrong.
Even when Beta and standard deviation are applied to real-time transparent portfolios, they have weaknesses as risk-monitoring tools. For starters, Beta doesn't really assess portfolio risk. It measures the relative volatility of an investment or portfolio compared to a benchmark, such as the S&P 500 Index. Beta can be relatively low in very risky investments that don't track the S&P 500 - such as emerging market equities. So, it's neither accurate nor helpful to tell clients that low-Beta investments are always low in risk.
Standard deviation is a statistical tool that was borrowed by the mathematicians who invented Modern Portfolio Theory (MPT) to explain characteristics that financial markets have in common with random events. For financial analysis purposes, the most common way that standard deviation is calculated is to annualize a set of monthly investment returns from a single investment (or benchmark) over several years. For example, a standard deviation calculation made over a five-year period often evaluates 60 equally-weighted pieces of data (5 years x 12 months). At each monthly interval, the calculation changes as follows: The oldest of those 60 pieces is discarded and replaced by one new piece. The other 59 pieces stay the same. This makes standard deviation a sluggish statistic, always heavily weighted with old data.
If the market suddenly becomes more overvalued and volatile, as occurred near the height of the 1999-early 2000 bull market, standard deviation doesn't detect it, because the calculation only considers one investment at a time and doesn't overweight recent data. It also makes a statistical assumption that investment markets often defy - namely, volatility is symmetrical around a mean. In a deep bear market, investments usually fall farther and faster than they rise in bull markets. Any "momentum" that exists in the markets, the tendency for trends to continue, is virtually ignored by standard deviation.
The most questionable and potentially deceptive applications of standard deviation are appearing in the objectives of some new types of investment products, including fund-of-funds and "lifestyle" or asset allocation portfolios. Typically, these solutions blend together several managers or funds to pursue superior risk-adjusted performance versus a benchmark over time. They may state that they will measure risk by applying standard deviation, but they rarely disclose in advance the specific calculation method to be applied, among several commonly used. This leaves the door ajar to numbers-juggling down the road. In evaluating any such portfolio, quiz your wholesalers to determine how standard deviation and risk-adjusted return will be measured. Ideally, these calculations should be performed and reported by an independent third-party - not the investment manager or product sponsor.
In summary, the acid-test for risk-management came during late 1999 and early 2000, when many investors became over-concentrated in large-cap growth stocks that grew riskier by the day. Both Beta and standard deviation flunked that test with flying colors, as they are likely to flunk when the next big test comes. Today, for example, U.S. government bonds are probably riskier than they were a few years ago. But these metrics don't show it.
Risk = Probability of Loss in Real Time
If Beta and standard deviation aren't the answers for professional risk management, what is?
An outstanding book on financial market risk was written by Peter L. Bernstein and titled Against the Gods: The Remarkable Story of Risk. The author's thesis is that the science of risk-management has always been about assessing the probability of future loss in real time.
For example, just before you roll a pair of dice, what are the odds of throwing "snake eyes?" The answer is 1 chance in 36. But what are the odds of rolling the equivalent of "snake eyes" with an investment portfolio? Few financial advisors currently help clients assess risk in this way, even though the analytical tools to perform such analysis are emerging.
For some time, institutional bond traders have applied a risk metric known as "value-at-risk (VAR)" to define the probability of loss. For a given "confidence level," such as 95% probability, VAR measures the maximum amount of loss an investor should be prepared to absorb. The beauty of VAR is that it can change daily, or even hourly, with financial markets. For example, a trader can go to bed knowing that portfolio VAR falls within risk guidelines, yet wake up to find that the guidelines have been exceeded by overnight market changes. VAR can trigger risk-adjusting trades in real time - a service that can be as valuable to individual investors as to institutions.
VAR is too complex for most individual investors to understand, which makes it difficult for retail financial advisors to apply. But several years ago, one pioneering firm broke through the complexity barrier to implement a VAR-like concept in individual portfolios, in a way that most investors can understand. The firm is RiskMetrics Group, and the tool they developed is a proprietary metric called "Xloss." You can read more about it on their Website here:
http://www.riskgrades.com/retail/rghelp/index.cgi?href=index.html
Xloss looks at a portfolio in real time, daily or even hourly, and assesses the amount of money (in dollars) that a portfolio can be expected to lose, on average, in the worst 5% of trading days. It calculates this amount by looking backward at the same investments' actual performance over the previous year and averaging losses on the "worst case" trading days. This makes Xloss a more sensitive indicator of current portfolio risk than standard deviation. For example, during 1999 and early 2000, Xloss values for Nasdaq stocks and large-cap growth portfolios increased sharply.
Xloss also works well in communicating risk concepts to clients. For example, would it cause the client sleepless nights to experience several daily losses of Xloss size? By tracking changes in portfolio Xloss on a weekly or monthly basis, the advisor can demonstrate that risk-monitoring services are continuous, objective and actionable - which helps to justify ongoing asset-based fees. Separate account managers can be monitored and even replaced for exceeding Xloss thresholds.
RiskMetrics Group has licensed Xloss (along with its other proprietary metrics) to several investment firms through application service provider (ASP) technology linked to separate accounts and brokerage accounts, in real time. Other analytical firms have also begun developing competitive probability-based risk metrics modeled after those of RiskMetrics Group.
Measuring the Probability of Beating a Benchmark
Over the past 3-4 years, a major change has occurred in financial markets that some investment management firms still don't comprehend, because they continue to write legal disclaimers stating that "it is not possible to invest directly in a benchmark."
Through exchange-traded funds (ETF), it has become possible to invest in passive solutions that track benchmarks (single-index or custom-blended) within two or three decimal points of 100%. Since more investors are accepting the convenience and cost-efficiency of benchmark-tracking, it makes sense that a new type of risk metric will emerge to help them assess the probability of rolling "snake-eyes" in an actively managed portfolio-i.e., failing to beat their benchmark on either an absolute or risk-adjusted basis.
Suppose you had the analytical ability to determine that a given lifestyle or asset allocation portfolio has an 85% probability of under-performing its benchmark over the next two years. Would you recommend it to your clients?
Although this ability does not yet exist, it is on the way. Two main variables determine the probability of an active manager's success in beating benchmarks: total costs and the probability that the active management strategy will be successful. Total costs can be determined to a degree, but there is not yet a standard method for evaluating the probability of active management success. However, using other RiskMetrics Group metrics, it is possible to estimate the degree to which an investment strategy is trying to add meaningful diversification or active management value.
One such metric, "Diversification Benefit," compares the risk of a portfolio with the weighted average risk of each component, considered separately. An efficient portfolio should have lower total risk than the sum of its parts. But what if the portfolio owns so many securities, or blends so many managers, that it becomes the equivalent of an "inadvertent index fund" with high fees? In that case, it will have produced "superfluous diversification" that doesn't add active management value and stands little chance of outperforming a benchmark (absolute or risk-adjusted) over time, after costs. The Diversification Benefit metric can be used to evaluate and monitor not only real diversification but also superfluous diversification. Until a better metric comes along, it is among the better tools for helping clients select actively-managed, well diversified portfolios with a good chance of avoiding "snake eyes."
How to Lay the Groundwork for Real Time Risk-Monitoring
Even if you can't apply real time risk metrics to client portfolios now, you can start laying the groundwork in two ways:
- Real time risk metrics can only measure what they can see. So help your clients take advantage of the transparency of separate accounts, fee-based brokerage accounts, folios and multiple-strategy accounts. Accurate and timely risk-monitoring may become one of the most valuable benefits of holding individual securities, compared to opaque funds.
- Accept the fact that part of your job is to help clients assess: 1) the probability of future portfolio loss; and also 2) the chance of failing to beat benchmarks on either an absolute or risk-adjusted basis. Help clients use risk metrics to look forward at dynamic markets - not backwards at ancient history.
Real time risk-monitoring is a valuable service for which you can earn fees on a continuing basis. Start educating your clients about this service now.
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How to Learn About Conversions and Mergers Involving Money Purchase Plans in Your Market
Before retirement plan provisions of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) took effect on 12/31/01, the choice between money purchase and profit-sharing plans was fairly clear. Money purchase plans allowed employers to deduct up to 25% of the aggregate taxable compensation of employees covered by the plan, provided employers agreed to make required annual contributions for all eligible employees. Profit-sharing plans allowed more flexibility in employer contributions. In any given year employer contributions could drop as low as zero, but the maximum deduction was limited to 15% of aggregate taxable compensation.
This made money purchase plans preferable in many companies with steady year-to-year profits and a desire to set aside as much money as possible for owners and other highly compensated employees (HCEs). On the other hand, profit-sharing plans were favored by companies that wanted more flexibility in year-to-year funding.
EGTRRA raised the employer deduction ceiling in profit-sharing plans from 15% to 25% - the same as in money purchase plans. For profit-sharing plans with a 401(k) elective deferral feature, EGTRRA also excluded participants' elective deferrals from the 25% ceiling. Finally, in all defined contribution plans (money purchase or profit-sharing), maximum annual contributions per participant were raised to the lesser of $40,000 (as indexed) or 100% of compensation.
Why More Conversions and Mergers?
As a result of these changes, it appears that profit-sharing plans can now achieve the same goals as money purchase plans, with more year-to-year funding flexibility. Therefore, many older money purchase plans are converting to profit-sharing. Also, some companies that offered both money purchase and profit-sharing plans are merging the two plans into a single profit-sharing plan.
But for companies that are not aware of another provision of EGTRRA, such a conversion or merger could prove costly. This provision involves stringent participant notification requirements under Section 204(h) of ERISA. We covered this matter in detail last November, and you may review that article here:
http://www.freeerisa.com/insight/november_2002.asp
This column summarizes the steps in a procedure that you may find useful for monitoring money purchase-to-profit-sharing plan conversions or mergers in your market, so that you can make plan sponsors aware of notification requirements.
Step 1 - The first step is to monitor FreeERISA's 5310 database for recent "open" listings in your market. You may want to reference our October article on this subject here:
http://www.freeerisa.com/insight/october_2002.asp
The 5310 "open" listings give you the name, address and EIN of a company that has filed for an application of (tax-qualified) determination. In many cases, plans that are converting from money purchase to profit-sharing formats (or merging two plans into one) will seek such a determination and become visible in this database. However, the 5310 data does not explicitly identify a money purchase plan.
Step 2 - To determine that the plan is a money purchase plan, check FreeERISA.com's 5500 database for the same company. On line 8a., a code of 2C indicates a money purchase plan. (A code of 2B indicates a "target benefit plan," which is similar.)
Step 3 - In today's market, a money purchase or target benefit plan that has filed for a determination letter is likely to be involved in converting or merging into a profit-sharing plan. To make this conversion, the money purchase plan is required under Revenue Ruling 2002-42 to provide notice to plan participants prior to adopting a plan amendment authorizing the conversion. The notice must be given at least 15 days in advance in all companies, and companies with 100 or more employees should provide at least 45 days advance notice. If the notice is not given, a federal excise tax is assessed against the plan sponsor at a rate of $100 per participant per day.
Notice is required even if the conversion does not involve a full or partial termination of the money purchase plan. In many cases, a plan that has filed a 5310 and is listed with an "open" status will still have time to provide the required notice to participants, provided the sponsor is aware of this requirement and takes timely action. So, once you have identified a money purchase or target benefit plan that has filed a 5310, you should immediately call the person listed as plan administrator or employer. Offer to inform this person about the details of the required Section 204(h) notification rules, as explained in our November article.
Step 4 - Revenue Ruling 2002-42 indicated that full vesting does not automatically occur on conversion of a money purchase plan into profit-sharing, unless a full or partial termination also has occurred. It also clarified specific conditions under which a full or partial termination would not occur, including: 1) all participants who were covered under the converted or merged money purchase plan must be covered under the continuing profit-sharing plan; and 2) plan assets must retain their characterization; and 3) the same vesting schedule must continue. In a money purchase plan, a spouse of a participant has rights that must be considered, because without the spouse's consent the normal method of paying out benefits is a Qualified Joint and Survivor Annuity. Some analysts have indicated that without a plan termination, the profit-sharing plan into which a money purchase plan converts or merges must adopt this same payout method. Since these requirements may be too burdensome for some sponsors to accept, they may choose to simply terminate the money purchase plan and distribute its assets to participants (with full vesting), with the option of transferring them into the profit-sharing plan. Accepting this choice triggers another required notice to participants, specifying the options for handling plan money. So, you may want to suggest to the employer or plan administrator that a pension specialist be retained, to weigh the advisability of an outright termination of the money purchase plan. (It's a good idea to prospect for plan conversions or mergers with a technical expert on your team.)
In summary, there has never been a better time to help plans in your market effect conversions or mergers involving money purchase and target benefit plans. For many sponsors, these plans now look relatively less attractive, compared to profit-sharing, than before EGTRRA. The 5310 "open" database of FreeERISA.com can be an "early warning system" to help you identify conversions and mergers in your market. Follow the four steps above to generate more profits and new plan relationships.
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