Are you taking too much risk in the pursuit of return?
A discussion that seldom takes place is how much risk is associated with a rate of return of any given investment strategies. A long-standing theory is that in order to attain a higher rate of return, the investor must take on more risk. The environment for this to happen and be valid has significantly changed for the near future. Anyone still following this mandate will be disappointed; furthermore, this is not a belief we have ever had.
Occasionally, you hear from colleagues that they are getting returns better than anyone else and all the time! But … are they?
History clearly illustrates no one gets great returns all of the time who isn’t cheating (Bernie Madoff, Bre-x, Worldcom, Enron); or the risks being taken are high and will inevitably reconcile (Lehman Brothers, Bear Sterns, Jon Corzine) or worse, they are unaware of the level of risk they are exposed to.
Even investor’s who thought they had conservative balanced portfolios, on average, experienced a decline of 24.9% in 2008, and have yet to return to the account values of pre 2008.
So how can it be that in 2008, 99% of the accounts we manage were positive?
Exchange-Traded Funds (ETF’s)
ETF’s Defined
An exchange-traded fund (ETF) is a security that represents a broad basket of assets similar to an index fund, but trades like a stock on an exchange. ETFs offer individuals with significant assets an easy, efficient way to instantly diversify and customize their investment portfolio, enhancing performance and reducing their overall risk.
Through low-cost ETFs, the individual investor can build into a portfolio diversified investments that reflect the performance of equity indexes in difference geographical markets and sectors, bond indexes, specific commodities or currencies. ETFs equalize the playing field by giving individual investors easy, low-cost access to the kinds of investments that were once only available to large institutional or very wealthy investors.
ETFs are popular with astute investors because they offer some key advantages:
Better Diversification
ETFs allow investors to quickly and easily diversify through a full spectrum of securities in a wide range of domestic and global asset classes and sectors. They offer efficient exposure to a wide variety of markets, including broad-based international and country-specific stock indexes, industry sector-specific stock indexes, bond indexes and commodities. Buying a single ETF allows an investor to spread risk more widely than buying a small basket of individual stocks, bonds or other securities.
Effective Risk Management
ETFs generally have lower price volatility and less risk than individual stocks because of the diversity in the underlying basket of securities. ETFs, like index funds, also help investors avoid the risks of actively managed funds. Many academic and industry studies show that active managers as a group underperform the market, a risk exacerbated by higher fees and expenses.
Low Cost, High Value
ETFs have substantially lower management fees and expenses than actively managed funds, and lower costs than index funds.
Tax Efficiency
ETFs are more tax-efficient than mutual funds because capital gains are only triggered when the investor sells the shares. So taxes can be deferred with ETFs — in some cases, for decades through multigenerational planning. Mutual funds make annual payments on profits realized on stocks or other assets sold by the fund during the year. These distributions are taxable to the investor in the year received even when the investor hasn’t sold any fund units.
Liquidity and flexibility
ETFs can be bought and sold at current market prices at any time during the trading day, whereas mutual funds are only priced at the end of the day. Because of their liquidity, flexibility and low cost, ETFs can be used to rebalance portfolios simply and easily. Like any publicly traded securities, they can also be bought on margin and sold short, and traded using stop and limit orders.
Clarity and Transparency
ETFs report their holdings every day, allowing investors to clearly understand the composition and weighting of the underlying securities in the fund and monitor changes as they occur.
Core and Satellite Investing
Core and Satellite investing is based on the simple, but powerful idea of splitting a portfolio into two key components. The core is the foundation, the first and main part of the portfolio. Core investments use index tracking funds, such as exchange-traded funds (ETFs), to offer broadly diversified exposure to major asset classes and market sectors. The core is designed to provide the returns available from the markets in a low-cost, tax-effective way and control risk.
The second part of the portfolio is a ring of satellite investments added to the core. The satellite component contains more specialized investments that seek superior, better than benchmark returns, improved portfolio diversification, or often both. These can include real estate, commodities, private debt and equity, derivatives, futures and other specialized securities. Satellite investments usually carry higher risks and fees than core investments.
Core Advantages
Broad asset class diversification
Core investments, like ETFs, provide broad diversification in different domestic and international asset classes. They offer efficient exposure to a wide variety of markets, including international and country-specific stock indexes, industry sector-specific stock indexes and bond indexes. Core index investments allow an investor to spread risk more widely than buying a small basket of individual stocks, bonds or other securities, and track the available market return more accurately.
Cost-effective
Index-based core investments have lower management fees and expenses than traditional actively managed funds. ETFs are ideal core investments because the costs are lower than for index funds and they offer a broad range of market exposures.
Tax-efficient
Core investments (ETFs) are generally more tax-efficient because they have a much lower turnover rate than actively managed mutual funds, so capital gains and taxes are deferred. With mutual funds, distributions on profits are taxable in the year received even when the investor hasn’t sold any fund units.
Effective risk management
Core investments reduce volatility risk through broader diversification and the risks of eroding returns as a result of high management fees, expenses and taxes. Core investments help investors avoid the risks of active management, since many studies show that active managers as a group underperform the market. By providing a secure foundation for the total portfolio, core investments also limit the risks associated with the smaller segment of satellite investments.
Liquidity
Core investments are easily accessible in active markets that create liquidity for investors. This makes rebalancing of portfolios simple and inexpensive.
Transparency
Core investments, such as ETFs, report their holdings every day. This allows investors to clearly understand the composition and weighting of the underlying securities in the fund and monitor changes as they occur.
Satellite Advantages
Enhanced performance
The satellite component enables investors to pursue enhanced returns through sub asset classes not available with index funds, such as direct investment in real estate, hedge funds, private debt and equity, and the use of an expanded set of investment strategies. These satellite investments can be customized to an investor’s needs, preferences, and areas of knowledge and expertise.
Improved diversification
The satellite component allows for broader diversification of the total portfolio by providing different return patterns than those of the core investments, which are focused on “long” stock and bond positions. Satellite investments, such as hedge funds, allow investors to enter into both “long” and “short” positions. This provides opportunities to generate positive returns in both up and down market environments.
Conclusion: more value for investors
Core and Satellite investing aims to minimize costs, taxes and volatility while providing an opportunity to outperform the market. This efficient, effective approach offers value to investors with significant assets by allowing them to achieve above-average returns with below-average risk.
Core Overview
Core and Satellite investing is based on the simple, but powerful idea of splitting a portfolio into two key components. The core is the foundation, the first and main part of the portfolio. Core investments use index tracking funds, such as exchange-traded funds (ETFs), to offer broadly diversified exposure to major asset classes and market sectors. The core is designed to provide the returns available from the markets in a low-cost, tax-effective way and control risk.
The second part of the portfolio is a ring of satellite investments added to the core. The satellite component contains more specialized investments that seek superior, better than benchmark returns, improved portfolio diversification, or often both. These can include real estate, commodities, private debt and equity, derivatives, futures and other specialized securities. Satellite investments usually carry higher risks and fees than core investments.
Core Advantages
Broad asset class diversification
Core investments, like ETFs, provide broad diversification in different domestic and international asset classes. They offer efficient exposure to a wide variety of markets, including international and country-specific stock indexes, industry sector-specific stock indexes and bond indexes. Core index investments allow an investor to spread risk more widely than buying a small basket of individual stocks, bonds or other securities, and track the available market return more accurately.
Cost-effective
Index-based core investments have lower management fees and expenses than traditional actively managed funds. ETFs are ideal core investments because the costs are lower than for index funds and they offer a broad range of market exposures.
Tax-efficient
Core investments (ETFs) are generally more tax-efficient because they have a much lower turnover rate than actively managed mutual funds, so capital gains and taxes are deferred. With mutual funds, distributions on profits are taxable in the year received even when the investor hasn’t sold any fund units.
Effective risk management
Core investments reduce volatility risk through broader diversification and the risks of eroding returns as a result of high management fees, expenses and taxes. Core investments help investors avoid the risks of active management, since many studies show that active managers as a group underperform the market. By providing a secure foundation for the total portfolio, core investments also limit the risks associated with the smaller segment of satellite investments.
Liquidity
Core investments are easily accessible in active markets that create liquidity for investors. This makes rebalancing of portfolios simple and inexpensive.
Transparency
Core investments, such as ETFs, report their holdings every day. This allows investors to clearly understand the composition and weighting of the underlying securities in the fund and monitor changes as they occur.
Satellite Advantages
Enhanced performance
The satellite component enables investors to pursue enhanced returns through sub asset classes not available with index funds, such as direct investment in real estate, hedge funds, private debt and equity, and the use of an expanded set of investment strategies. These satellite investments can be customized to an investor’s needs, preferences, and areas of knowledge and expertise.
Improved diversification
The satellite component allows for broader diversification of the total portfolio by providing different return patterns than those of the core investments, which are focused on “long” stock and bond positions. Satellite investments, such as hedge funds, allow investors to enter into both “long” and “short” positions. This provides opportunities to generate positive returns in both up and down market environments.
Conclusion: more value for investors
Core and Satellite investing aims to minimize costs, taxes and volatility while providing an opportunity to outperform the market. This efficient, effective approach offers value to investors with significant assets by allowing them to achieve above-average returns with below-average risk.
Satellite Overview
What Are Satellite Classes?
Satellite Asset Classes encompass various types of securities and strategies, primarily referred to as hedge funds.
The main differentiating factor when comparing hedge funds to traditional mutual funds is hedge funds can enter into both “long and short” positions in a variety of securities and fixed asset classes.
Satellite Asset Classes include Real Estate, Commodities, Private Debt and Equity, Derivatives, Futures, and various other specialized transactions.
This feature, in addition to the strategic use of leverage in some hedge funds, allows managers to capitalize on market volatility by being able to generate returns in both up and down market environments.
Because of this unique ability, hedge funds performance is generally measured on absolute returns rather than in relation to benchmarks, as is the case for traditional mutual funds.
Generally speaking, management fees for hedge funds are typically based on absolute returns with a participation fee above a certain threshold such as 20% of returns over 6% is paid to the manager as an incentive fee.
Satellite Asset Class Strategies?
Equity Long/Short Hedged
The manager will make use of both long and short positions in equity to mitigate total net market exposure. The low net exposure provides downside protection, while the bias in favor of the market’s direction means managers can also deliver significant upside as well.
Equity Market Neural
The manager balances his/her long and short equity positions, leaving a net “exposure” or “beta” to the market of zero.
The employment of stock picking within a hedge fund allows an astute manager to make money from both rising long positions and falling short positions simultaneously, regardless of the market’s direction. Managers will tend to go long positions in companies they feel have solid growth prospects, while going short on companies that are either of low quality, or are overpriced.
The total effect is that returns should be a function much less of the market’s direction, and much more of the manager’s skill in picking stocks, whether going long or short on them.
Convertible Arbitrage
Convertible arbitrage employs arbitrage principles by applying them to convertible bonds, a type of corporate bond for which the investor has the option of converting the bond into equity.
Managers exploit these issues by purchasing them when the equity component is priced in such a way that the manager can go on to acquire company stock at a discount to its present market value, subsequently selling it for a risk‐free profit.
Event Driven
This strategy emphasizes the selection of securities that will experience a change in valuation due to upcoming corporate events, such as leveraged buyouts, the outcome of litigation, and filing for bankruptcy protection, among others. Managers will assess the probabilities of various outcomes, and based on such analyses will take their positions—either long or short—accordingly.
Merger Arbitrage
Merger Arbitrage is a type of Event‐driven strategy that focuses specifically on mergers. Often in a merger, the spread between the prices of the acquiring and target firms’ stocks narrows. If the merger goes through, then the prices will converge; if not, they will diverge once more. A manager will thus make an investment decision on the basis of whether he/she thinks that the merger will ultimately be successful. If the former, for instance, he/she will purchase shares of the target company while shorting the stock of the acquiring company. If the merger goes through, the manager will make money off of both the long and short positions as the stock prices of the respective companies converge.
Fixed Income Relative Value
Similar to its equity counterpart, this strategy takes both long and short positions in fixed income securities, especially those that are particularly sensitive to the credit status of the issuer. One oft‐employed technique in this strategy involves the use of “positive carry,” which exploits opportunities where the cost of borrowed funds is lower than the return earned from a “secure” investment like government bonds.
Global Macro
This strategy, which potentially encompasses all others, makes use of macroeconomic principles to attempt to find mispricing that can be located in markets anywhere in the world. Positions might be taken on equities, currencies, interest rates and commodity markets. Generally speaking, macro traders seek out‐of‐the‐ordinary price fluctuations that leave prices far from their equilibrium.
Commodity Trade Account
The CTA or Managed Futures strategy is based on taking positions in the futures markets, in anything from commodities to currencies to interest rates. Managers will go “long” or “short” on particular positions, depending on their research and sentiment, and will often make use of leverage.
Multi-Strategy
The multi-strategy approach is simply one that makes judicious use of any or all of the above strategies, in accordance with the manager’s outlook. Usually, though, a manager will limit his or herself to a selection of the above hedge fund strategies, particularly to those with which he or she has the most expertise.
Our Approach – Qualitative
At ICON, our focus is to research various combinations of Satellite Asset Class Managers in an effort to try to attain an acceptable risk adjusted rate of return in any market cycle.
The purpose of our qualitative process is to ensure potential managers employ a strategy that not only provides solid returns, but provides them in a repeatable and consistent fashion, and with appropriate risk controls. As a result, we focus on the following.
Investment Process — managers must be able to clearly express, in simple terms, their strategy. We need to ensure that any potential managers are able to provide returns within a reasonable range on a consistent basis with a proven routine and procedure.
Conviction of Strategy — must align their interests with investors. We lean towards managers who invest their own assets in their investment strategies.
Firm Culture — must be entrepreneurial, independent, and continually innovating. We prefer to deal with a firm that has long term employees providing depth and long term wisdom and at the same time, integrates new ideas and fresh approaches.
Risk Management — must have a verifiable risk management processes in place such as limits on allocations, loss limits, suitable liquidity, and the use of appropriate levels of leverage.
Compliance — must have strong compliance procedures to protect investors. There must be a dedicated compliance officer, and written (and enforced) compliance policies and procedures.
Reporting — must have an online reporting system that provides clear, concise and accurate reports. This service is ideally, but not necessarily, provided by an independent third party.
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