Locally based CPA firm since 1956

By Chris Williams, Partner

This month we decided to address risk from two very different perspectives. First a look at managing risk within a portfolio and second a look at a very real risk to how the stock market functions. There have been several factors that contributed to the recent volatility in the market. The Russia/Ukraine situation, the increased violence in the Middle East, and the approaching mid-term elections are all contributing factors that have caused investors to be nervous. The counter balance to all that has been the solid reports from the recent earnings season. In fact 75% of the companies that reported earnings in July either met or beat their expected numbers.

With the recent volatility in the stock market we thought we would first touch on portfolio risk management. In isolation, risk is neither good nor bad. Finance 101 teaches that the market must offer higher expected returns as an asset’s probability of declining in value or the potential magnitude of losses increases. Otherwise, given the choice between two investments, no one would hold the riskier one. Investors tend to compete away high-return, low-risk opportunities, so that risk is usually the primary source of investment returns. This is why risky asset classes, such as stocks, have historically offered higher returns than Treasuries over the long run. But large drawdowns at inopportune times, coupled with investors’ tendency to buy high and sell low, can create a significant challenge for wealth accumulation. Managing risk effectively is one of the most important aspects of successful investing. There are several ways to do this.

The first step is to avoid or eliminate unnecessary sources of risk–those that the market does not reward. On average, investors should not receive any compensation for risk that they can eliminate through diversification. This was the central insight of the capital asset pricing model, which predicts that assets’ sensitivity to market movements (measured by beta)–a risk that investors cannot diversify–is the only type of risk that the market rewards. As long as assets are not perfectly correlated, combining them in a portfolio reduces risk relative to the weighted average risk of the individual holdings. Because it is easy to diversify, only an asset’s contribution to a diversified portfolio’s risk should determine its expected return. While a portfolio’s risk is less than the sum of its parts, its return is simply the weighted average of its holdings’ returns. Therefore, to the extent that assets are uncorrelated, investors can reduce risk through diversification without sacrificing return.

It is still possible for a diversified portfolio to offer an unfavorable risk/reward profile. Contrary to the predictions of the capital asset pricing model, experience tells us there is little, if any, relationship between an asset’s sensitivity to market movements (beta) and its returns. In fact, assets with the highest betas have historically offered the lowest returns relative to their volatility. This might create an opportunity for investors to reduce risk without sacrificing much return by overweighting low-volatility stocks. Low-volatility stocks tend to lag during bull markets. Investors who are unwilling or unable to use leverage to boost their performance may be drawn to riskier stocks, causing them to become overvalued relative to their risk. Investors may also overpay for volatile stocks because they could offer a small chance of a large payoff–much like a lottery ticket.

Here at WCM Wealth, we attempt to manage risk by choosing to build diversified portfolios with exposure to multiple asset classes through the use of various professional managers who represent multiple styles of investing. Our goal is to create the opportunity for our clients to capture a reasonable amount of the upside the market provides while, at the same time, trying to reduce the amount of downside capture.

Recently certain high profile mutual fund managers such as PIMCO’s Bill Gross have mentioned their fear that the regulatory environment is causing the “REPO” market to dry up. This is a very real risk to how the markets function. Mutual Fund, Hedge Funds, and other institutional investors create the liquidity that we all need for our markets to function efficiently. These large institutions employ a tactic referred to as the “REPO” in order to maintain their liquidity needs and meet certain regulatory requirements. If this market ceases to function it could create the next crisis of the magnitude in size and scale of the Lehman failure which was the catalyst for the 2008 meltdown. We have recently read several articles that attempt to explain the risk we all face if this market ceases to function. I have included excerpts from an Bloomberg BusinessWEek article by Peter Coy from August 29, 2013 titled “A Treasury Shortage Squeezes the Heart of the Market.” I believe Mr. Coy explains very well. Here are some highlights from his article.

The over-the-counter repo market is now one of the largest and most active sectors in the US money market. Repos are widely used for investing surplus funds short term, or for borrowing short term against collateral. Dealers in securities use repos to manage their liquidity, finance their inventories, and speculate in various ways. The Fed uses repos to manage the aggregate reserves.

Considering the trillions of dollars of Treasury bonds the federal government has been selling to pay for its budget deficits, you’d expect there to be plenty of them for use by dealers in the financial markets. Instead there’s a drought, one that’s likely to get worse before it gets better, and it’s already interfering with the functioning of what an adviser to the Treasury Department in a recent document called “the silently beating heart of the market.”
The shortage is a result of a decline in Treasury issuance as well as banks’ strengthening their balance sheets in preparation for rules designed to prevent a recurrence of the 2008 financial crisis. The rules, likely to take effect next year, will further reduce liquidity in the Treasury market and could have the unwanted side effect of slightly pushing up borrowing costs and making interest rates more volatile. “You could argue that you’ve reduced systemic risk,” says Joseph Abate, a money-markets strategist at Barclays (BCS). “But when liquidity in the Treasury market goes down, that translates into higher mortgages and reduced access to consumer credit.”

Treasury securities play a central role in high finance—the “beating heart” that the Treasury Borrowing Advisory Committee described—because they’re all but certain not to suffer default and are easy to buy and sell in large quantities. A hedge fund or bank that wants to borrow $100 million overnight to make a payment or speculate will pledge some of its holdings of Treasury bills, notes, and bonds as collateral. Technically it sells the Treasuries and buys them back at an agreed-upon price in what’s called a repurchase agreement, or repo. Money-market funds, pension funds, and insurance companies that have excess cash will take the other side of the repo transaction—lending the $100 million and temporarily taking the Treasuries as security. Often they will reuse the collateral they receive by pledging it as collateral for a loan of their own. The big banks serve as middlemen.

Wall Street is frighteningly reliant on short-term borrowing to finance what are often long-term investments—which is why a freeze in the short-term lending markets can be catastrophic. During the 2008 credit crisis, Treasury-backed lending never went away, but there was a dramatic decline in repo loans backed by assets such as mortgage-backed securities because lenders lost faith in the quality of borrowers’ collateral. That abrupt drying up of nonbank credit was a factor in the worst economic downturn since the Great Depression.

U.S. regulators as well as the Swiss-based Bank for International Settlements are tightening standards for repo lending to prevent a repeat of the meltdown. Repo lending and related forms of finance such as commercial paper are known as shadow banking, because they operate in parallel with the deposit-taking and lending that conventional banks do. The new rules covering leverage and liquidity will make it more costly for banks to perform their crucial middleman role by squeezing the profits out of “low-yielding, high-volume activities” such as repo dealing, says Hugh Carney, senior counsel at the American Bankers Association.

Treasuries will be in shorter supply because regulators won’t allow lenders to reuse the securities they receive as collateral to secure loans of their own. What’s more, new rules aimed at making derivatives trading safer will require traders to post hundreds of billions to trillions of dollars of high-quality collateral, further draining the pool. “The banks are the guys who are playing the role of the big shock absorber,” and the new rules will create a “real trade-off between bank safety on one hand and market functioning on the other,” says Gregory Whiteley, who manages government debt at DoubleLine Capital.

Even though the rules have yet to take effect, Treasury bonds have been scarce this year. Repo lenders usually earn interest. But frequently in 2013 they have paid borrowers in their eagerness to get their hands on their Treasury collateral, which they then use for secured borrowing, hedging, speculating, and other varieties of financial engineering. On June 4, for example, the overnight repo rate on 10-year Treasury bonds closed at –3 percent annualized, according to data from ICAP (IAP:LN), a broker. “Unless they want to regularly issue more 10-year notes, which is unlikely, I don’t think there is really much they can do,” Barclays’s Abate said at the time. In government debt auctions, there have been five bids for each six-month Treasury bill for sale, up from a 2-to-1 ratio a decade ago.
The abrupt shrinkage of the budget deficit this year caused the Treasury Department to cut back on issuance of debt in the shorter maturities that are sought after on Wall Street. Foreign demand has been strong, partly because some European government securities that had been used as collateral are no longer considered safe enough. Finally, the Federal Reserve, in its efforts to stimulate the economy, has been soaking up $85 billion a month of Treasuries and mortgage-backed securities. Some market participants argue that the Fed is planning to taper its bond purchases in part to relieve the collateral scarcity.

Shadow banking such as repo lending is too important for regulators to shrink it drastically, says Pete Crane, the president and chief executive officer of Crane Data, which follows money markets. He says regulators are suffering from “ultra paranoia.” Even if they tried to shut down shadow banking, he says, it would reemerge, possibly in more dangerous forms. Carney, the American Bankers Association lawyer, makes a similar point: “There is a fear that a lot of these activities will flee outside the purview of the regulatory agencies.” After seeing what happened in 2008, though, regulators have decided that shadow banking is potentially too destabilizing to be left alone.

© 2013 Williams, Crow, Mask, LLP. All rights reserved.