Sunday, December 4, 2011

A discussion on Risk

RISK: Deviation from an Expected Outcome!

The current economic climate is the perfect backdrop to an examination of the “four letter word” most likely to scare an investor today! Risk is the most misunderstood word in investing and yet we all seem to believe we know what the word means in most every other context. “Drink & Drive” and you risk injury, death, increased insurance rates, public condemnation and potential fine and jail time. If you do not wear a hard hat on a construction site you risk injury or death. These seem obvious as well they should. So why is it that investing is different? Well there is one very significant reason for this: in the scenarios listed above you cannot imagine a potential profit that would make the risk worthwhile. Is saving a taxi fare worth a death; is saving the cost of a hard hat worth being paralyzed in a construction accident? Of course not! Attaching the concept to “reward” to “risk” causes emotions to become involved. Add a thousand different opinions on “market risk” from a thousand talking heads and it makes your head hurt to even try to quantify risk.

Investing is one of only a very few areas where “risk” is directly associated with “reward”. In economic theory any investment return greater than that of a “90 day treasury bill” is considered “return on risk”. Investment managers measure “risk adjusted return” on a portfolio or security. Investors often act as if the expression “no risk, no reward” was a balanced equation. In fact, taking risk can enhance returns but taking risk does not ensure enhanced returns.  MF Global Holdings is a hedge fund that most recently learnt this tough lesson when it invested in “high risk” Euro bonds and lost billions in a few short weeks. The lesson here is that professional investors quite often ignore risk and the results can be devastating....  not for the investment manager, but for the investors who provided the money! Risk is NOT owned by the “manager” but by those who provide the capital!

Risks are wide and varied when it comes to investments. In fact, there are so many different risks that the mutual fund industry has undertaken a strategy of hiding risk from the investor rather than spend a ton of time explaining the risks. The fund investment industry has lobbied hard to ensure the Point of Sale Disclosure document will report only a singular risk factor to investors. This type of misleading information is based upon the widely held belief by fund executives that investors are too dumb to understand more than one simple thought at a time. Unfortunately the securities administrators who vet the POS document have taken a pro-fund company approach and ignored investor needs. This is not surprising since the securities administrators are a cozy group of insiders who spend significant time with fund executives and next to no time with normal investors.

Risk Factors: The risks listed below are a small sample of what risks lie out there for investors. It is not in any order of importance but is meant to provoke questions when investors are looking to buy securities/funds.

Price volatility: The amount a fund/security varies in price is a measure of the swings you might expect in the value of a fund you invest in. In short, if a fund has a history of values rising or falling by as much as 30% in a given period, then that fund has twice the risk of losses compared to a fund that tends to fluctuate by 15% up or down in the same period. The typical fluctuation for each security or fund is measured by the “standard deviation” of returns and is generally represented by a “bell curve” of probable outcomes. Most of us will remember bell curves being used to standardize test results so that a predetermined average outcome is obtained on test scores. This approach to measuring risk makes a ton of sense if you ignore the warning that comes with every fund prospectus that “past performance is not indicative of future performance”. A simple way to express the short comings of this approach is to look at the past experience of a turkey in the year prior to Thanksgiving. Every morning the farmer feeds and cares for turkey so in the days leading up to Thanksgiving, the turkey would see the farmer as being of no risk to the turkey! For 364 days the performance of the Farmer shows no variance! Like the turkey discovers on day 365, a lot can change in a day even if past history has not prepared us for the change. However, as a general rule it is good to know the volatility of a fund before you invest so long as you do not look at the information in isolation and suddenly become a turkey for the slaughter one day.

a-       A subset of this volatility risk is “event risk”. Like Thanksgiving to the turkey, certain events occur which alter the volatility measure for a security/fund. Since a 1 yr, 3 yr, or 5 yr horizon will not likely capture all the possible or even likely “events”, it is a fact that risk will be understated. This chronic understatement is exposed when a black swan or flat tail event occurs. For example, a tsunami wipes out a Japanese nuclear plant and uranium producers see their stock values plummet as nuclear energy is exposed as having more risk than suggested by the standard deviation in price volatility. While advisor/salespeople will shrug and say you cannot foresee such an event, in fact tsunamis in Japan are a well known fact and both Chernobyl and Three Mile Island accidents had the same effect on uranium markets. These events are plausible but hard to predict accurately over the short term but not over the long term. Most time periods used for standard deviation are very short term and in many cases the time period is manipulated to provide a desired outcome.

Market Risk: Market risk is considered a systemic risk and thus cannot be easily avoided.  In recent times we have learnt a lesson on the importance of correlations. Prior to 2008 we had forgotten that in a terrible recession all securities can drop together and the past price volatility of securities means little or nothing. While diversification can add value in many instances; when the whole market decides to move in unison even the best past price history or quality business model can get trashed. Contrary to market advisors, sometimes a falling knife is dangerous and not a buying opportunity. Interestingly, a group of wise money managers have created a strategy around bucking the market as ‘contrarian investors”. Equally, a different set of wise money managers have created a strategy of buying into market movements as “momentum investors”. Typically one side will guess right and claim they are truly wise and the other side will fail and bide their time until they eventually guess right and can reclaim the status of “wise investors”. Either way, market movement is a real risk for all investors.

a-      “Market risk” is very hard to measure in the short term. A number of managers claim they have the secret formula to understanding market moves and they provide advice based upon “market timing”. This is generally a macro strategy that claims to understand future market moves based upon a series of trends or analytics. In fact, given the number of salespeople who perpetually recommend buying securities in every market it is very likely that market timing is a sales strategy more often than an investment strategy. Guess wrong and the losses can be huge.

Political Risk: Those Canadians that piled money into the expanding income trust markets will know exactly what I mean by political risk. One simple regulatory change can wipe billions in supposed value from the markets. I say “supposed value” because in the case of income trusts, the value being created was not a reflection of a business strategy or performance, but was rather a combination of business value plus a regulatory tax value. Unfortunately investors were sold on the notion that the price was a reflection of simple business value. Something every analyst knew was false. When the tax laws changed many investors claimed the government caused the market losses. In fact the government created the value through poor tax laws and corrected the values by fixing the tax loophole. The decision was clearly political but the risk was financial. Common political risks include countries such as Venezuela nationalizing oil assets or the Congo extorting funds from mining companies. These risks tend to appear suddenly and cause rapid drops in stock/fund prices. Some political events are hard to predict such as the collapse of a government while others are well known risks such as war in the Middle East disrupting oil prices. A more recent political risk was the failure of the U.S. to approve the Keystone XL Pipeline expansion which caused shares in pipeline companies to drop.

a-      A subset of political risk is “country risk”. Certain countries are prone to a combination of regulatory risk, government changes, civil wars and trade embargos that affect securities issued in the country. A rash of kidnappings in a country can result in companies closing down foreign operations and losing revenue streams vital to the company. Whole regions can be affected in some areas such as the Middle East, when a single country has a significant political or military event.

Advisor Risk:

The number one risk to your investment success and often your retirement success is   “advisor risk”. The vast majority of “advisors” are using a title they have not earned and should not be using. Most people who sell securities are licensed as “sales representatives” but utilize the terms “advisor” or “planner” to self describe their functions. In fact, the vast majority of sales people are licensed ONLY to sell Mutual Funds. As such they can sell you a fund managed by somebody else, and typically can offer very basic financial advice. Obtaining a license to sell Mutual Funds is quite easy and requires very little additional education on either financial planning or portfolio management. The typical “planner” is trained by a fund company on how to “sell” funds. The complexity in the job is around issues such as maximizing commission revenue, sales pitches to convince investors that high MER fees are acceptable and that deferred sales penalties are a good way to purchase funds. The fact is that the business is taught to sales people by the companies who benefit from commissions the most. As such many salespeople actually do not understand the damage they can do by selling high cost funds or complex funds. Investors learned this lesson the hard way when the U.S. asset backed commercial paper market became illiquid in 2008. Sales people had unwittingly sold funds holding ABCP as no-risk money market funds or fixed income products. The fact is, that most salespeople are not qualified to make the decision on what was a safe fund and they just sold what their fund firms told them to! Combine that with the fact most are not licensed to sell  alternative products such as exchange traded funds, stocks or bonds, and you can see how the “advisor”/salesperson  has no choice but to believe that the funds they sell are a great solution for every client.

Advisor performance is difficult to determine as, unlike investment counselling firms, the salespeople who sell funds or non-discretionary stocks and bonds do not provide audited performance results for their clients. Typically only “investment counsellors” working on a discretionary basis can do so.  So basically investors choose an advisor based upon the recommendation of other uninformed investors. While that sounds harsh, the other investors are uninformed because the mutual fund firms refuse to inform them. As an example fund firms generally refuse to provide:

-          A clear rate of return for each investor every quarter or year (the return of the fund rarely equals the return received by the investor, which studies show to be consistently lower than the funds stated returns)

-          A measure of how the fund performed against the normal benchmarks used by investment managers (ex. how did your Canadian Equity fund perform against the TSX 60 index?)

-          A monthly, quarterly or annual summary of fees paid to the fund by the investor

-          A similar summary of commissions paid from the MER to the sales person each period

-          An accurate asset allocation for the portfolios held by a fund investor ( mutual funds are not an asset class despite what many statements claim)

Interest Rate Risk:  The values of many securities are sensitive to changes in interest rates. The classic example is Fixed Income securities such as bonds. Once a bond has a set coupon rate (the percent paid out to investors each year), any increase in current interest rates will cause bond values to drop as new bond purchasers will seek the higher current coupon rates/ payouts that are available. Any decrease in current interest rates will cause bond values to rise as investors are willing to pay a bonus rather than accept the lower coupon rates that are the new norm. This risk is measured by “duration” and typically the longer the term of a bond the higher the duration measure is on a bond. Other securities such as preferred shares will often reflect the same general fluctuations since they trade predominantly on the payout levels fixed to the security. On a more macro level, when interest rates are higher or equity prices are extremely volatile, money may move out of the equity markets and into the generally less volatile fixed income markets. In today’s market we are hearing the terms “risk-on” and “risk-off” to reflect capital flows into and out of equity markets respectively. With current interest rates at historic lows, the risk of a significant interest rate increase makes long term bonds susceptible to greater price risk.

Management Risk: Funds are generally managed by a professional portfolio manager. The manager or management team will make the crucial decisions on when and what to purchase in a fund. The track record of the fund manager is often the major selling feature of a fund. When the key decision maker decides to leave a fund the investment decisions are made by a new fund manager. Given the abilities of the fund managers to attract investors, the fund can often lose a large number of investors if the manager changes. This can require funds to sell securities at a bad time and incur losses. Also, the track record of the fund is used in the marketing material even though the new manager has no ownership of the track record. What often makes this even worse is that sales people lock investors into a deferred sales penalty that can prevent them from following the fund manager that they were told was the reason the original investment was made.

Fraud: the risk of an investor being defrauded is higher than it should be in Canada. The reason is that the Canadian securities regulators are ineffective. Billion dollar frauds such as Bre-X and Nortel occur with no significant action by the regulators. Numerous frauds have occurred in Canada over the past decade and many are by firms who operate with no regulatory oversight right under the noses of our watchdogs. The best an investor can do is to confirm the licensing of the investment firm with a regulatory body such as IIROC or IFIC or the OSC. The most recent issue suggesting fraud is the Sino-Forest debacle which happened while the OSC was napping. Expect more frauds until some regulatory action is taken to curb the profits of the fraudsters.

Foreign Exchange Risk: Investors who buy securities in a currency that is different than the currency they use to fund the investment will have foreign exchange risk. In the case of Europe we can see the high risk currently associated with the value of the Euro versus the Canadian Dollar. If I buy a European security denominated in Euros and the Euro drops 5% against the Canadian dollar, then my investment loss on selling the security at the same price I bought it is 5% plus any sales fees. Investors have seen the Canadian dollar fluctuate strongly against the American dollar. A share bought when the Canadian dollar was worth $0.67 required almost $1.5 CDN dollars to buy one US dollar worth of shares. If it was sold when the Canadian dollar was at par the same share returned only $1 CDN dollar. Foreign exchange risk can be removed with currency hedging strategies but it does have a cost in increased expenses for the hedging.

Many investors take a simple view of risk and thus underestimate the consequences. This tends to show up in portfolios in a number of predictable ways: too much equity, too much low quality fixed income products (high yield), too many complex securities, and fees which are far higher than they should be. Many of these risks should be dealt with by a competent investment sales person. Unfortunately there are very few quality investment sales people in the industry and even fewer who do not have a conflict of interest due to the commission structure used in Canada. The above list of risks is not exhaustive. Issues around liquidity and leveraging risk are two more examples of risks that come to mind when I reflect on portfolios I have reviewed. It is difficult to make a comprehensive list that covers everything. In fact it would be overwhelming to read such a risk. In ending I will just say “risk needs to be understood and managed not totally avoided”. It is never the bus you are waiting for that runs you over, it is the one you did not see coming! Demand your sales person better understand the risks in what they sell and ask questions until you are satisfied you understand the whole picture.
sois mike

p.s. Sorry for the long delay between posts!


Anonymous said...

With all due respect to the often-used "in order to get higher returns, you need to take higher risk", I'll refer to Warren Buffett's assertion that this is backwards. He says that in order to get higher returns, you need to take less risk...take for example, a stock with a intrinsic value of $40: If you buy it at $20, your risk is lower and your potential return is higher. If you buy it at $60, your risk is higher and your potential return is lower/probable loss is higher. MF Global's actions demonstrate this very clearly! Buffett also says that "risk is not knowing what you are doing".

He also has remarked that as long as the business schools use their existing methods to teach students how to invest, he will have no trouble beating the markets!

Food for thought!

(By the way, volatility is not risk. "Volatility" being re-defined as "risk" is a way for regulators to use paint-by-numbers paperwork -- which is very easy for them to regulate -- to pretend they are doing their job of protecting investors. The reality is regulators know very little about investing and are ill-equipped to protect investors from risk. I have thought many times about how to best regulate the industry, and unfortunately I don't have the solution is a VERY complex industry.)

Mike Macdonald said...

Thanks for the comment. I think "risk" is a catch all for a large range of factors that can alter the expected outcome of an investment. A history of price volatility is a risk factor to me, as are gaps in knowledge as per Mr Buffet. You are very right in saying regulators are using volatility as their risk definition because it is easy to do. I suspect, however, they know exactly what they are doing. They are not lacking in knowledge...they may be lacking in ethics and backbone however.

Anonymous said...

Mike, when I read your blog comment above that "Canadian securities regulators are ineffective" I have to admit that based on my experiences with a number of front-line investment industry staff here in Canada, I can't think of even one reason to disagree with you!

In fact, after my most recent dealings with a couple of staff from a Canadian investment industry regulator, and seeing their "skills" at regulating and their "knowledge of investing", I could not help remembering these two video clips from two experts in the USA (are Canadian regulators really any different in skill level and investment knowledge than the SEC staff?):

Harry Markopolos, frustrated whistleblower in the Bernie Madoff fraud:

Bernie Madoff himself: