Morningstar Advisor - February/March 2011 - (Page 30)

In Practice A New Guardrail Against Risk By Bill Harding and Marta Norton Measuring a portfolio’s equity-market sensitivity leads to informed risk-management decisions. It’s been nearly 22 months since the market’s nadir in March 2009, but advisors continue to ask us, “What did you learn from the credit crisis?” Although the crisis was replete with lessons, it laid bare some of the weaknesses of traditional approaches to risk management. Namely, that correlations are not static but fluctuate, especially amid a crisis. Thus, any risk assessment must consider not just the portfolio’s composition and risk profile, but also the ways that they may change. This has a real-world relevance for us. We manage a variety of diversified portfolios and saw first-hand the impact that dynamic market conditions, and fluctuating correlations, can have. For example, our multiasset-class portfolios were far more sensitive to the equity market amid the crisis than traditional risk models would have suggested. Why? The returns of asset classes such as bonds and commodities became much more correlated with stocks during the second half of 2008 and early 2009 as investors fled risky assets en masse. Consider, for example, the six-month correlation of the Barclays Capital U.S. Aggregate Bond Index to the S&P 500. It rose from a negative 0.49 in June 2008 to a positive 0.63 in December 2008. Investors flooded the Treasury market in search of a safe haven but fled the credit risk found in corporate bonds, mortgagebacked securities, and agencies. Even commodities, touted for their lack of correlation to traditional stocks and bonds, began to move in step with the broad equity market amid the flight to safety. The Dow Jones UBS Commodity Index saw its correlation to the S&P 500 climb from a negative 0.43 in June 2008 to a positive 0.82 in December 2008. These correlations were especially unwelcome given that stock prices were gyrating wildly at that time. Thus, equity-market risk rose synchronously across asset classes. As shown in Exhibit 1, the beta of the Barclays Capital U.S. Aggregate Bond Index rose from negative 0.08 in June 2008 to a positive 0.22 in December 2008, signaling that the investment-grade bond market had become more sensitive to equity-price movements. Similarly, the Barclays Capital U.S. Corporate High Yield Index’s beta rose from 0.44 to 1.09 over the same stretch. The Dow Jones UBS Commodity Index saw its beta spike from negative 0.56 to 0.69 between June 2008 and December 2008. We can illustrate the magnitude of these changes in the beta of Income and Growth TaxDeferred, a balanced strategy that we manage. The portfolio invests about 60% of its assets in stocks and the remainder in bonds and alternatives. As shown in Exhibit 2, the portfolio’s six-month beta shot up from 0.55 in June 2008 to 0.65 in December 2008. Exhibit 2 also shows the contribution that each asset class made to the portfolio’s beta. Surprisingly, the contribution to beta from the portfolio’s equitylike portion was fairly stable; it actually slipped a hair during late 2008 and early 2009. On the fixed-income side, however, the beta contribution shot up from negative 0.001 in June 2008 to 0.12 in December 2008. This is partly due to our decision to increase our high-yield bonds stake in late 2008—high yield tends to be more sensitive to the equity market. But the betas of our other bond funds also contributed meaningfully to the overall portfolio’s higher beta during that time period. For example, the equity beta of our investment-grade bond funds increased from negative 0.01 in June 2008 to 0.06 in December 2008. The moral of the story is that the portfolio’s asset allocation was inadequate in explaining its equity-market sensitivity. Consequently, when stocks tanked in late 2008 and early 2009, it dragged our portfolio down to a far greater extent than either we or our clients expected. Finding the Drivers of Risk Although target asset allocations continue to play a large role in our portfolio-construction process, we’ve incorporated guardrails to help us identify the drivers of market risk and use an appropriate risk/reward profile for the conditions. 30 Morningstar Advisor February/March 2011

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2011

Morningstar Advisor - February/March 2011
Contents
Contributors
Letter From the Editor
First, Do No Harm
Do You Use Active or Passive Investment Strategies?
Best of Both Worlds
How to Build an Index
Accountable Investor
Nice Guys Finish First
Four Picks for the Present
Investment Briefs
A New Guardrail Against Risk
Tech Loosens the Purse Strings (a Bit)
It’s More About Costs Than Active or Passive
Play Your Stars
In Between Active and Passive
Selling Beta as Alpha
The Weighting Game, and Other Puzzles of Indexing
Leaving the Nest
Redefining Credit Risk
Another Vote for Market-Based Credit-Risk Measures
Big Opportunities in Small-Cap Stocks
Benchmarks? What Benchmarks?
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
VA Sales Slide, but Assets on the Rise
Indexing’s Lunatic Fringe

Morningstar Advisor - February/March 2011