Letter from
the CIO
Morningstar Investment Management LLC
Q12017
Daniel Needham CFA
President and Chief Investment Officer
The Downside of Downside Risk Management: Valuation Matters
2016 was a decidedly volatile year for markets despite the robust returns for U.S. equities. With
heightened market volatility came increased discussions around risk management. This is a common
response, and the popularity of risk-focused approaches and products has been high since the
Great Recession.
I take issue with most risk-management approaches and risk-based products (for example, controlled
volatility or tail-risk hedging strategies) that stem from modern portfolio theory (MPT), especially for
long-term investors. My disagreement starts with the MPT definition of risk as short-term return
variation, runs through the practice of portfolio diversification, and goes all the way to how risk-based
strategies are managed and marketed.
A long-term investor can benefit from short-term volatility, and can be harmed by over-diversification and
costs from strategies that neither reduce the real risk of losing purchasing power nor improve the
investor’s ability to achieve long-term financial goals. I’ll explore my thoughts on risk in greater detail
below, but let’s start with a look at traditional risk management.
Risk Management MPT-Style
Given investors’ rational desire to maximize the upside and minimize the downside, the definition and
measurement of risk matters. If we’re going to manage risk, we first must know what it is and why it’s
not always good for returns. And if we—or our clients—are long-term investors, the returns we
should think about are long-term ones.
However, risk management in the MPT world (which most professional investors live in) is largely
represented by the management of the movement and comovement of asset returns over relatively
short intervals, such as weekly or monthly, using historical return data. Past relationships are usually
extrapolated into the future, directly or indirectly. The cornerstone of MPT is measuring risk via the
relative movement of market returns to produce metrics such as beta and alpha—terms related to the
defunct capital asset pricing model (CAPM).
These frameworks generally rely on econometric analysis of monthly return series and use various
forms of short-term return variation to measure and attribute risk. More on the pitfalls of a heavy
reliance on these measures later.
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Morningstar Investment Management LLC
Letter from the CIO
Q12017
Page 2 of 8
In short, because of MPT’s focus on short-term variations, generating smooth return has become the
holy grail in our profession. For many investors, this is not only irrelevant but also can be expensive.
The desire for smoothness reduces returns over time while not necessarily reducing the risks the
investor should be worried about.
Early last century, a few investment theorists laid out those risks—namely, the risk of permanent loss
of capital, the risk of being overly or needlessly diversified, and others. Somewhere along the way, the
focus shifted from things that matter to the long-term range of outcomes but that are hard to measure
to things that don’t matter as much to long-term investors but are easy to measure—that is, very
short-term variations in asset returns.
Myopic loss aversion, or the combination of investors feeling more hurt by losses than helped by gains
and constantly reviewing portfolio returns despite having a long-term focus, seems to have been
codified into many investing frameworks and processes.
Practically, this has led to a revealed preference for investment strategies with embedded managed
volatility, downside protection, or variable annuity riders, despite their costs to long-term investors. As
a long-term capital allocator who used these tools a lot early in my investing career, I’m very skeptical.
Some of the best lessons come from your errors—and, as Howard Marks has brilliantly observed,
experience is what you get when you don’t get what you want.
Protection Costs
What I learned was that this type of short-term, volatility-based downside protection doesn’t generally
work for long-term investors because of three main kinds of costs. First is opportunity cost. Every
dollar invested in a protection strategy that accepts lower upside in return for downside protection is
one not capturing the long-term “miracle of compounding” (as John Bogle puts it) of reasonably
priced equity markets or other assets that can be volatile in shorter periods. Short-term smoothness of
returns often comes at the cost of lower long-term portfolio value. To paraphrase Charlie Munger, for
investors with a long horizon it can be better to take a lumpy 12% return over a smooth 9%.
The second cost is a matter of value. My sense is that few downside-focused investors consider the
value they get for the fees paid or how they might accomplish the same goal differently. This is
especially true for downside strategies whose costs vary over time, such as annuities. When the price
you’re paying is high relative to the thing you’re trying to avoid, the implied probability of the bad
thing happening rises—i.e., it costs more to hedge the risk. Often, investors collectively don’t like
these bad things at the same times and the cost can become excessive. But for long-term investors
volatility can create opportunities, as prices tend to move around more than fundamentals. Paying a
fee to remove an opportunity seems illogical.
The third cost relates to how investor demand shifts with recent performance. After steep losses in
late 2008, many investors rushed into downside protection strategies in 2009—akin to shutting the
barn door after the horse has bolted. Investors that enter these strategies likely end up with much
©2017 Morningstar Investment Management LLC. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. Morningstar Investment Management is a registered investment adviser and
subsidiary of Morningstar, Inc.
Morningstar Investment Management LLC
Letter from the CIO
Q12017
Page 3 of 8
lower returns than the returns of the strategies they left behind. This underperformance comes from
the timing of their investments—they’re selling something with a low valuation and buying something that’s probably overvalued. Performance-chasing is usually a destructive behavior for investors.
Meanwhile, some solutions can be cost-free. Continuing Munger’s example above, if you have trouble
stomaching a 12% bumpy return, consider advice from behavioral economist Richard Thaler and
look at your investment statement less frequently. Doing nothing can be a surprisingly effective investment tool.
Diversification
Diversification is at the heart of risk management for many investors, including us. The simplest way
to think about diversification is to picture offsetting gains and losses on investments in your portfolio.
This concept combines with the idea of not putting all your eggs in one basket lest the value of the
investment and all your capital be wiped out. If you’re wrong about one investment’s intrinsic value
this should not destroy all your eggs.
For individual stocks, the industry, products, and management of each company respond differently to
the same economic environment. Diversification comes from owning companies whose risks are
different, if not opposing, such as one company that produces natural gas for revenue and another
that uses natural gas to produce energy, like a gas-powered utility. Renowned economist and
outstanding stock-picker John Maynard Keynes illustrated this in one of his investment tenets: “A
balanced investment position, i.e., a variety of risks in spite of individual holdings being large, and if
possible opposed risks.”
We may replace the word “risks” in the above statements with “fundamental risks,” because if
fundamentals drive long-term returns then risk depends on the robustness of fundamentals,1
especially relative to what is priced in. Fundamentals, then, must also drive diversification in longterm strategies. The stocks of two companies that are fundamentally very similar should not be
relied upon to provide diversification, irrespective of the historical correlation of short-term returns.
Fundamentals also drive diversification at the asset class level. Corporate profits supply the returns
from stocks, as interest rates do for bonds. Stocks provide cash to investors via dividends and
buybacks, while bonds via coupons and repayments of interest and principal. When the economy
falters, corporate profits tend to slip leading to sharp falls in stock prices. Bonds on the other hand
tend to see policy rates fall along with inflation expectations, leading yields to fall and prices to rise.
It is this fundamental linkage that drives the diversification benefits of stocks and bonds. This extends
to commercial property, with cash flows linked to contractual rental income often tied more closely to
inflation. Diversification at the asset class level links back to the cash flows that are generated by the
underlying assets. Provided valuations and ownership levels are not extreme, the offsets come from
this source.
1 Risk more broadly hinges on fundamentals and valuation, however valuation is not linked to diversification. An overpriced investment will not, inherently, benefit a portfolio.
©2017 Morningstar Investment Management LLC. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. Morningstar Investment Management is a registered investment adviser and
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Morningstar Investment Management LLC
Letter from the CIO
Q12017
Page 4 of 8
Because fundamentals matter in the long-run, the short-term comovement and beta are less important than these fundamental linkages. The most important inputs should be valuation and fundamental risks, at the asset and portfolio level. These drive the variation in long-term values and returns.
Diversification helps manage uncertainty, reduces the risk of being wrong (primarily through the
intrinsic value), provides offsetting gains and losses during extreme environments, and helps set the
level of risk consistent with an investor’s tolerance.
Led Astray
Too often, many investors become overly concerned about the smoothness of the return line. Rather
than worrying about the long-term return for risk, shorter-term and relative metrics come into the
picture, such as tracking error and beta.
I believe this shorter-term lens is not as relevant as many practitioners believe and that it distracts
long-term investors from focusing on more important risks relating to the fundamentals and valuations
of asset classes. Again, these are decidedly messy and less easily measured, but that doesn’t make
them less important in my opinion. And some people may think the MPT description is just a technical
definition of risk and that practitioners use a more thorough and quality approach. Unfortunately this
is generally not the case, and tools and strategies are managed, sold and marketed using this concept
of risk quite frequently.
Being on the conference circuit a little more these days, I see a lot of salespeople peddling “silverbullet” systematic strategies or multifactor quantitative approaches that can supposedly solve the
volatility “problem.” Many of these strategies are abstract, with little connection to the underlying
cash flows of the investments. They reduce investments to priced-based statistics, trading them more
like cans of sardines2 than fractions of cash-generating assets. Often this lack of connection is worn
like a badge of honor by the quant.
Within finance, we can slice and dice data and it all appears very scientific. The problem is, investing
is more of a social science—human psychology is integral and irreducible uncertainty limits the value
of historical analysis. Investors with a multiyear horizon should remain skeptical of the physics-like
tools that rely largely on historical price movements and comovements to assess and measure risk. We
invest for the future, after all, not the past.
Much of academic study has moved on from these relics from the 1970s and ‘80s, but I fear
many practitioners have not. We should remember Keynes’ admonition: “practical men who believe
themselves to be quite exempt from any intellectual influence, are usually the slaves of some
defunct economist.”
2 Value investor Seth Klarman, author of “Margin of Safety,” tells a parable of sardine prices rocketing after a supposed shortage of the fish. “One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, ’You don't understand. These are not eating sardines, they are trading sardines.’”
©2017 Morningstar Investment Management LLC. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. Morningstar Investment Management is a registered investment adviser and
subsidiary of Morningstar, Inc.
Morningstar Investment Management LLC
Letter from the CIO
Q12017
Page 5 of 8
A Potentially Better (But Harder) Way
An approach that relies heavily on historical price-based statistics isn’t investing, to our way of
thinking. Benjamin Graham, the father of value investing, would call adherents to that approach
“speculators” instead of “investors.” “Most [speculators] are guided by charts or other largely mechanical means of determining the right moments to buy and sell. The one principle that applies to nearly
all these so-called ‘technical approaches’ is that one should buy because a stock or the market has
gone up and one should sell because it has declined. This is the exact opposite of sound sense
everywhere else,” Graham writes in the introduction to “The Intelligent Investor” (emphasis original).
We, like Graham, prefer to rely on things other than recent price movement when investing—specifically, how the intrinsic value of securities (and asset classes when security cash flows and discount
rates are aggregated to estimate the intrinsic value) compares with their market prices. This is
especially true when making decisions under uncertainty, and there’s always considerable uncertainty
with investing.
Why do we prefer valuation? Valuation assesses a company’s prospects—the heart of a business—so
it must be at the heart of investing. Buying stocks or markets that produce free cash flows and are
available at attractive prices is straightforward, easy to understand, and, we believe, can deliver more
value to the patient investor than most fads, theories, or formulas. The output will be subjective,
qualitative, and judgement-driven. But that doesn’t make it any less rigorous.
A quote often attributed to Einstein3 is apt here: “Not everything that can be counted counts, and not
everything that counts can be counted.” When measurability takes precedence over efficacy there is a
lot of room for error. For an investor with a 10-plus-year horizon operating with no borrowed money
and limited near-term need for these funds, does their sensitivity to market beta matter? Does monthly
tracking error matter? If they have tracking error relative to a benchmark of 3.0% vs. 1.0%, is that
relevant? These questions are not asked enough, in my opinion.
Many investors struggle with uncertainty and turn to these MPT-inspired metrics. These tools seem to
produce tangibility and precision—some certainty out of the uncertainty—but they may be just
adding risk for the long-term investor concerned with the permanent loss of purchasing power over a
multiyear window. The messiness of reality is unavoidable, and, irrespective of how many decimal
points we put on the end of a number, uncertainty is not reduced. One thing that can change is the
confidence in the decision-maker through artificial precision. Buyer beware.
Absurdities in Practice
Now back to the application of this MPT form of risk management. Many strategies that seek to
manage risk by using monthly, weekly, or daily price movements for investors often lead to expensive
smooth return lines but not necessarily to lower risk of the permanent loss of capital. Think of
managed volatility, options, or long-volatility strategies. A popular substitute for options or long
volatility are trading strategies—I reserve use of the word investment for strategies that focus on the
3 The likely source is the 1963 book “Informal Sociology” by William Bruce Cameron, according to quoteinvestigator.com.
©2017 Morningstar Investment Management LLC. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. Morningstar Investment Management is a registered investment adviser and
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Morningstar Investment Management LLC
Letter from the CIO
Q12017
Page 6 of 8
underlying ownership of assets and cash flows they generate for owners. Trading or speculative
strategies are more interested in price appreciation over a relatively short period.
Without going into too much detail, and at the risk of over simplification, these strategies are
designed to sell when markets fall and buy when prices rise. Through attempting to limit downside
risk or match a volatility target, the strategies exhibit strong procyclicality: The more markets fall (or
volatility rises), the more they sell, and vice versa. Central to sound investing is buying low and selling
high, as determined by price relative to intrinsic value. Not only do these trading strategies generally
ignore valuation, they buy when prices are higher not lower.
For leveraged institutions, like banks, insurance companies, and investment banks, with capital
requirements this procyclical strategy is largely unavoidable lest they be stuck with fewer assets than
liabilities in their capital structure. And they pay a price to operate with large amounts of borrowed
money that brings additional benefits—and prudential regulation to boot. However, individual
investors are not leveraged financial institutions.
Voltaire’s brilliant observation is apt here: “Those who can make you believe absurdities, can make
you commit atrocities.” Replace “atrocities” with “irrational capital-destructive decisions” and
we are probably there (although our phrase is clearly not quite as catchy). Investing can be made
overly complex by marketing organizations seeking to bamboozle investors and encourage them
toward absurdities.
To outline the absurdity of the strategy described above, I will use an example from an investment
shop that pursues a “risk-managed” strategy for retirees. Managers of the strategy explained at a
conference with some satisfaction how they navigated the first half of 2016, significantly reducing risk
by the end of the first quarter by something like 50%. And then they increased risk by the end of the
second quarter. So, they had more risk before the U.S. stock market fell over 10%, reducing exposure
right near the recent bottom. But not to worry, by the end of the second quarter the risk level was
back up, likely after the market was back near all-time highs. This is performance chasing and
silver-bullet selling plain and simple.
This pin-the-tail-on-the-market game will likely carry obvious costs. For leveraged institutions that
require liquidity this yo-yo may be essential, but for an unlevered investor you are paying a premium
for something you likely don’t need or could probably be selling for additional return. Beware the
managed risk strategy offering all the upside with none of the downside through the application of
MPT engineering precision.
Pocket The Insurance Premium
What should matter to investors is whether they’ll make money over the long term and that the time
horizon matches their liquidity needs. As Warren Buffett pointed out when defining risk, “the real risk
that an investor must assess is whether his aggregate aftertax receipts from an investment (including
those he receives on sale) will, over his prospective holding period, give him at least as much
purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.” In
other words, risk is a loss of future buying power.
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subsidiary of Morningstar, Inc.
Morningstar Investment Management LLC
Letter from the CIO
Q12017
Page 7 of 8
An unleveraged investor who doesn’t need to sell his assets for many years typically has little need for
a smooth line. Even retirees in the “danger zone,” or the years too close to retirement to recover from
a market crash, usually do not need as smooth a line as is sometimes suggested (the exception being
someone about to purchase an annuity for longevity reasons).
That is not to say bad things can’t happen in markets—they can and do. However, the price one pays
for anything matters. And I fear, as mentioned earlier, that many investors are overpaying for downside protection. The volatility market, or any investment product that “pays” for lower volatility
through upside reduction, is prone to overpricing, and this tends to find its way into various forms of
hedging. We might think of this in terms of car insurance: People typically buy insurance because of
short-term (but justified) fears of having to pay to repair their car. But at a certain ratio of price to car
value, the majority of people would be better off in the long run saving the premium and paying for
repairs out of that savings.
In the same way, investors are potentially better off pocketing the protection costs and either
accepting the short-term swings or taking less risk by accepting lower returns. But this latter approach
still comes at a cost—namely, the opportunity cost of giving up better long-term returns and the risk
of not meeting a financial goal. If insurance is overpriced this may be the next-best path. Insurance or
the reduction of risk costs money and investors must accept this trade-off, despite what those
promoting their silver-bullets might suggest.
Focus on Fundamentals
It’s appealing to think we could generate attractive returns without the pesky downside risk of the
balanced portfolio. But this ignores the fundamental nature of markets. Selling when something is
falling and buying when it is rising doesn’t seem like a rational strategy for a long-term investor.
Above everything else, price relative to fair value is the most important principle.
For some of you, the parallel to the portfolio insurance of the 1980s will be clear. It illustrates that
there really are no new ideas, and that even the bad ideas tend to get recycled. John Kenneth
Galbraith outlined this brilliantly in A Short History of Financial Euphoria when he stated that “the
world of finance hails the invention of the wheel over and over again, often in a slightly more unstable
version.” Let’s hope these prophetic words prove unnecessary for the latest version of portfolio
insurance. Nevertheless, we should always stand guard.
There will certainly be people that disagree with my skepticism on MPT and “risk-managed” strategies. That’s OK, because diversity is healthy in every context, especially intellectually. And in reality,
my major concerns lie not so much with the tools but with their application and interpretation. At
times, though, we lose sight of the bigger picture and slip into handling the question we know the
answer to, even if it is the wrong question.
Instead, I urge investors to remain focused on the long-term and the fundamentals. We need to remember
that the underlying fundamentals drive most long-term investment returns, that price matters, and
that investors’ goals and time horizons should inform strategy. That’s the way we approach investing.
©2017 Morningstar Investment Management LLC. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. Morningstar Investment Management is a registered investment adviser and
subsidiary of Morningstar, Inc.
Morningstar Investment Management LLC
Letter from the CIO
Important Disclosures
Morningstar Investment Management and Morningstar Investment Services do not guarantee that the results of their advice,
recommendations, or the objectives of their portfolios will be
achieved or that negative returns can or will be avoided in any
of their portfolios. An investment made in a security may differ
substantially from its historical performance and as a result,
you may incur a loss. Past performance is not a guarantee of
future results.
The information, data, analyses and opinions presented herein
do not constitute investment advice, are provided solely for
informational purposes and therefore are not an offer to buy
or sell a security, and are not warranted to be correct, complete or accurate. The information contained herein is the
proprietary property of Morningstar Investment Management
and may not be reproduced, in whole or in part, or used in
any manner, without the prior written consent of Morningstar
Investment Management.
The opinions expressed herein are those of Morningstar Investment Management, are as of the date written and are subject
to change without notice, do not constitute investment advice
and are provided solely for informational purposes. Morningstar
Investment Management shall not be responsible for any trading
decisions, damages, or other loses resulting from, or related to,
the information data, analyses or opinions or their use.
Q12017
Page 8 of 8
It is important to note that investments in securities (e.g., mutual
funds, exchange-traded funds, common stocks) are subject to
investment risk, including possible loss of principal, and will
not always be profitable. Foreign securities involve additional
risks, including foreign currency changes, political risks, foreign
taxes, and different methods of accounting and financial reporting. Fixed income investments are subject to interest rate and
credit risks. Investments in common stocks involve risk (e.g.,
market and general economic conditions) and will not always
be profitable. Common stocks are typically subject to greater
fluctuations in market value than other asset classes as a result
of such factors as a company’s business performance, investor
perceptions, stock market trends and general economic conditions. Investing in real estate involves risks including valuation
and appraisal risks, financial risk, market risk, income volatility
risk and foreign investment risks.
Diversification and asset allocation are methods used to help
manage risk, they do not ensure a profit or protect against a loss.
The indexes noted are unmanaged and cannot be directly invested in. Since indexes and/or composition levels may change
over time, actual return and risk characteristics may be higher
or lower than those presented.
©2017 Morningstar Investment Management LLC. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc. Morningstar Investment Management is a registered investment adviser and
subsidiary of Morningstar, Inc.