The markets currently look “resilient,” a condition that should give investors confidence to pursue aggressive risk-seeking strategies with little chance of a shock exposing them unprepared for loss, according to Mark Kritzman.
“The conditions seem to be relatively stable,” said Mr. Kritzman — CEO of Windham Capital Management LLC, Boston, and senior lecturer in finance at the Sloan School of Management, Massachusetts Institute of Technology.
Mr. Kritzman bases his view on a model he helped develop after the financial crisis to predict the financial safety or stress of the U.S. markets, an approach that is gaining recognition among institutional investors, which are just starting to use it.
Called the absorption ratio, it predicts the systemic risk in the markets or particular investment portfolios by measuring the concentration of risk. It shows when markets are “fragile” and vulnerable to loss and when markets are resilient.
Using the ratio, asset owners and other institutional investors can anticipate shifts in their portfolio volatility and exposure to loss or opportunity for gain, Mr. Kritzman said in an interview.
With the use of the tool, asset owners and other institutional investors could do away with their rigid strategic asset allocation and adopt a flexible investment policy, according to Mr. Kritzman.
Mr. Kritzman advocates a flexible approach to asset allocation instead of the traditional framework of strategic allocation policy set for several years. He contends expectations of returns, risk and correlations fitted to a strategic asset allocation change more frequently than the rigid policy framework provides.
Investors have been reluctant to veer from strategic portfolios because of the expense of implementing allocation changes and a lack of confidence of doing so successfully to enhance investment performance, Mr. Kritzman said.
But the proliferation of low-cost derivatives, index funds and other investment products allow for efficient changes through overlays in allocations, Mr. Kritzman said.
“The absorption ratio provides pretty compelling evidence that by looking at the risk concentrations it does give you a pretty good early warning signal of fragility vs. resilience,” Mr. Kritzman said.
Using a tool that “has investors becoming more defensive when conditions are fragile and more growth-focused when conditions are resilient, I think is perhaps a wise thing to do.”
“I think many institutional investors are looking for ways to intelligently and unemotionally restructure their portfolios in response to regime shifts (in the markets and economy) and new information,” Mr. Kritzman said.
“Do you think it makes sense to have the same policy portfolio when interest rates are at 10% than when they are at zero? That’s sort of what a policy portfolio implies.”
In this (economic and market) environment, it’s hard to get the kind of returns that (asset owner) liabilities imply and avoiding large drawdowns, while participating more full in market upswings. Asset owners “realize they have to become more dynamic” in their strategic asset allocation, Mr. Kritzman said.
Instead of having a strategic asset allocation, Mr. Kritzman contends investors should have a flexible approach.
The absorption ratio quantifies the risk level driving variability of market returns, Mr. Kritzman said. The ratio captures the extent risk is concentrated or a set of assets is tightly coupled.
“When this ratio is high, these few factors explain a large fraction of the variability of returns,” Mr. Kritzman said. “What that tells us is risk is very concentrated and when risk is concentrated, the markets or portfolios, depending on how you apply it, are much more fragile. It’s vulnerable to a shock that travels more quickly and broadly than when risk is not concentrated.”
“If the same few factors explain only a small percentage of the total variability of returns, then what that means is that risk is distributed broadly across many disparate sources and when that’s the case conditions are much more resilient to shock,” signally higher equity returns ahead.
While Mr. Kritzman with three colleagues introduced in 2011 the concept of the absorption ratio as a tool for investors and regulators, the ratio has attracted more attention lately in the publication of “Risk Disparity,” a paper by Mr. Kritzman published in the Journal of Portfolio Management’s fall 2013 issue and winner of a $1,000 Bernstein Fabozzi/Jacobs Levy Award for outstanding article.
The Office of Financial Research, created within the Department of the Treasury by the Dodd-Frank Wall Street Reform and Consumer Protection Act, added credibility to Mr. Kritzman’s research.
The OFR uses the absorption ratio, along with other measures, to identify systemic risk. It noted in its 2012 report that it found in sampling four financial crises, “the tendency for the AR to rise in advance of a crisis event suggests some promise as an early warning measure.”
In its report for 2013, the OFR noted that “the absorption ratio indicator … has declined during the past year, and reflects moderate risk.”
”Lots of institutional investors are including it in their risk dashboard that many of these investors are putting into place,” Mr. Kritzman said, declining to name them.
Investors “have said to me you can’t get the same insight (into market or portfolio risk) by looking at the average correlation across a set of assets,” Mr. Kritzman said. “The average correlations don’t distinguish between high-volatility assets and low-volatility assets. So if you have a drop in correlation in low-volatility assets, that’s not as big a deal than if you have a change in the correlation of high-volatility assets. The absorption ratio takes that into account.” Investors could shy away from this approach “because it conjures up the notion of market timing,” which has a bad reputation, Mr. Kritzman said in the interview.
MSCI Inc., whose focus includes risk management analytics, introduced statistical models in 2012 and 2013 incorporating its equivalent of the absorption ratio, said Kurt Winkelmann, New York-based managing director and global head of analytics research.
“We find it useful,” Mr. Winkelmann said. “We are starting to see clients use this methodology.”
“We read … an earlier version of Mr. Kritzman’s paper,” when we were working on it, Mr. Winkelmann said. But the motivation came from “feedback from our clients, as they expressed an interest in this, and research appetites of our researchers.”
Clients are using it “to get extra insight into what is contributing to overall portfolio risk,” Mr. Winkelmann said. “It helps them better understand how to build and manage the portfolio.”
“It’s relatively new,” the use of the ratio, Mr. Winkelmann said.
“From our point of view, we don’t view this as a substitute” for other risk management tools, Mr. Winkelmann said. A prudent investment manager … should use all aids to navigation (in risk management). So in that context there will be times the insights from … things like the absorption ratio are going to provide one set of insights, and there will be times (other) models will provide a different set of insights.”
”What we are trying to do is get some of (Mr. Kritzman’s) insights in terms of how the time series properties of the absorption ratio can be used in practical investment management,” Mr. Winkelmann said.
Bruce I. Jacobs, principal, Jacobs Levy Equity Management Inc., Florham Park, N.J., which finances the award Mr. Kritzman won, said, “Like any other market-timing rule, if there are enough adopters who use it, it will become a self-fulfilling prophecy in that it will cause its own crashes much as portfolio insurance did but for other reasons.”
For instance, Mr. Jacobs said, “If everyone tries to sell half their equities or less at the same time, the exit would be too crowded and the markets would fall precipitously.”
“There may be an opportunity for earlier adopters,” Mr. Jacobs added.
That issue “applies to all strategies, but not in the sense that copying will cause a crash, but rather that copying will reduce the advantage of the strategy,” Mr. Kritzman said in a follow-up e-mail in response to questions. “My sense is that as more people follow this information, it will become less valuable. … I do think, however, that this information will remain valuable for some time, because it is unlikely that everyone will follow it.”
“I believe that for investors to be successful they must continue to innovate.” Mr. Kritzman added.
Even so, he believes the ratio could transform strategic asset allocation.
In setting traditional strategic asset allocation, “the more you structure a portfolio to grow wealth the more you expose it to drawdowns,” Mr. Kritzman said in the interview. “A policy portfolio is intended to balance these two conflicting goals. But investors don’t really want the particular asset classes that are in the policy portfolios. What they want is the distribution of returns (the policy portfolios) are supposed to be delivering. What investors don’t appreciate is just how unstable that return distribution is” from a strategic policy portfolio “if you adhere to a fixed set of asset weights” for each asset class.
“That (instability) is not what people have in mind when they put in place a policy portfolio.”
Instead, “the return distribution should be the (strategic) policy, not the specific weights across a set of assets,” Mr. Kritzman said.
“So an investor that wants a, say, 8% annual return and a standard deviation of 12%, sometimes will get them by having a 60/40 mix and other times by a 50/50 mix or whatever,” Mr. Kritzman said.
“People ought to be thinking this way,” Mr. Kritzman said.
“We do need something that’s more flexible … a process whereby to the extent we can anticipate shifts in volatility” and reallocation accordingly.
“So the basic idea is that rather than have a policy portfolio comprising a set of fixed weights that deliver a very unstable risk profile (investors adopt) an investment policy that has more flexible weights that are designed to deliver a more stable risk profile,” Mr. Kritzman said.
To derive the absorption ratio, Mr. Kritzman estimates risk factors “from the covariances of industry returns in the U.S. stock market,” he said in the follow-up e-mail.
“Obviously nothing is perfect,” Mr. Kritzman said of the ratio. “No signal or system is going to be correct all the time.”
“The risk is being overreliant on something that is capturing just one aspect of market conditions. What this (ratio) is capturing is risk concentrations. On average, when risk is concentrated you should be defensive; when risk is diffused you are safer (and) it’s good to be more aggressive” in investing.
“I certainly wouldn’t describe (the ratio) as a holy grail” for asset allocation, Mr. Kritzman said “It does provide insights that are not often obtainable from other measures of risk concentrations.”
