Morningstar Advisor - April/May 2013 - (Page 52)

Morningstar Conversation at the short end, and no longer going to be negative in real terms way out in the government-bond yield curve. They’ll go up. Capitalization rates on assets will go up, and that tends to be tough on prices. And we believe that a big fiscal deficit financed by Federal Reserve money creation is a big subsidy to profits. As those fiscal deficits wind down, that subsidy to profits will wind down and could mean that profit growth is attenuated and that profit expectations are too high. Again, that normalization could be tough on asset prices. So, that underlying set of factors is riskier today than was the case, say, pre-financial crisis. On the other hand, there is both apparent risk and risk that people haven’t recognized. Before the financial crisis, there was less apparent risk, but there was much more risk in the financial system due to misunderstood assets and lower levels of capital. Ratner: Joe, what is your view of investment risk and how you think about it? Joseph Davis: Similarly to Dennis’ comments, we view risk in the context of the portfolio and the clients’ objectives, and that’s related with what we perceive as the investor’s risk appetite, what their objectives are, and what they’re trying to achieve with that portfolio. Investment risk is multifaceted. Clearly, there is risk not just in the markets themselves, but also economic risk, growth and inflation, and policy risk. We agree that policy risk in many ways has not been this high in quite some time, certainly in more than a generation. Risk is often associated with volatility or variance, but volatility is the realization of risk. Risk can be highest when volatility is low or when perceived uncertainty is low. Interest-rate volatility by some measures is very low, and yet interest-rate risk could be high. When trying to think through that, I think quantitative analysis is very important. There have been some important developments over the past several decades. Models are just 52 Morningstar Advisor April/May 2013 a start, and I’d view them as simply one tool in a broader portfolio-construction and asset-allocation context. Qualitative judgment is critical, both with respect to what historical episodes are relevant, and also how historical relationships may have changed over time. Risk, in many ways, can be asymmetric, particularly with respect to clients’ aversion to downside risk, especially for those investors who may be drawing down a portfolio. We also do a great deal of analysis both from a broad portfolio-construction context, as well as within actively managed funds. We will try to assess various states of the world. the increased risk-taking with respect to fixed-income investing, as well as the desire for increased yields or income. We have seen moves out of, say, more-conservative fixed-income and money-market vehicles into more-aggressive corporate and municipalbond offerings, even into dividend-paying equity funds. So, whether it’s explicit or unintended, and that will vary by the investor, we’ve clearly seen greater interest and cash flows into higher credit-risk exposure, greater interest-rate risk, and greater equity risk, although it’s generally viewed as just more of an income positioning. Stattman: Coincident with the financial crisis, Dennis mentioned some scenarios. We do similar scenarios, as well, in terms of trying to assess the potential impact they could have—not only on levels of market risk, but the implied risk premiums, which we as investors would be expected to be rewarded if we should bear that risk. So, that’s a key tenet, as well as trying to be realistic, and applying a heavy dose of humility to try to see how much we really know or perhaps do not know with respect to future states of the world. When one applies that framework, one consistently comes back to more balance, rather than less, in part because one’s appreciation not only for risk but for the inherent uncertainty of financial markets comes to the fore. Ratner: Are you finding today that your clients are, by and large, more risk-averse than they were five, six years ago? Davis: We’re seeing two general patterns. In one sense, we have seen some investors shy away from equities in the past several years, although that’s been more from long-only active than it has been from broad, low-cost, index vehicles where investor appetite seems to be very strong. So, in one sense, there’s an increase, at the margin, to risk aversion. At the same time, particularly more recently, and it gives us some pause for concern, there is there was a very large and sudden shock to risk appetites—a shock downward in people’s tolerance for risk within their portfolios. It was effectively a realization of two things: that there was greater risk than previously understood in the environment and that, unfortunately as is the case with human nature, brought out the real as opposed to imagined levels of risk tolerance in investors. In other words, many investors did not understand how much risk they were willing to tolerate until that risk was manifest and wealth was lost. So, there was a very sharp decline in willingness to take risk that we can date to 2008. But since then, as Joe noted, and especially within the past two years, the thirst for yield and income in what has become an extraordinarily low interest-rate environment has led a number of investors who would have preferred lower-risk vehicles to earn their income—those investors have been, in some sense, forced, if they’re going to get income—to take a higher level of risk. Because effectively, very low-risk vehicles provide returns that are inadequate for many investors. An investor who might have been accustomed to earning inflation plus 1% on a Treasury bill now earns inflation minus 2% on a T-bill. Finding that unsatisfactory, they’ve moved from

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013

Morningstar Advisor - April/May 2013
Contents
Contributors
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot

Morningstar Advisor - April/May 2013