Diversification and Discussion of Risk Conference of the County Investment Academy San Antonio June 2019
PFIA 2256.008c Requires Training in: • Investment Diversification 2
Capital Market Theory 12.0% 10.0% 8.0% E( r) P* 6.0% * 4.0% 2.0% 0.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% Std. Dev. 3
Capital Market Theory • Points along the upper half of the curve represent the best risk/return diversified portfolios of risky assets • The straight line represents portfolios obtained by investing in the “optimal risky portfolio” (P*) and either lending or leveraging at the “risk ‐ free” rate. • Points on the line below the curve represent “lending” and points above represent “leveraging” (note increased “risk” as measured by standard deviation of returns!) 4
So in theory….. Key result? An undiversified portfolio yields inferior return for the level of risk! The same, or higher, return could be attained at a lower level of risk with a diversified portfolio. If you are not diversified, you are taking more risk than you can expect to be compensated for! 5
Diversification and Correlation of Returns Correlation, which measures the degree of “co ‐ movement”, ranges from ‐ 1 to +1. When the correlation between returns is less than 1 there are diversification benefits—the risk of portfolio is less than the average of the risks of the individual assets. Which pair of stock returns is more correlated? Chevron, Exxon Chevron, Delta Airlines 6
International Diversification Correlations vs S&P 500: China 0.62 Korea 0.53 Japan 0.73 Germany 0.74 UK 0.73 Brazil 0.29 Chile 0.38 Monthly returns vs corresponding MSCI indexes (US dollar returns) 5 years ended April 2019 Source: FactSet 7
Global Market Capitalization Latin Canada 1% Other UK 3% 1% 5% Japan 8% Asia ex Japan 13% U.S. 54% Euro ex UK 15% 8
Diversification Across Asset Classes Treasuries versus Stocks Inflation vs Deflation Rising vs falling risk premium (changes in market sentiment) 9
S&P 500 vs Long ‐ term Treasuri es 10
12.0% 10.0% 8.0% E( r) 6.0% PFIA says to be here! 4.0% 2.0% 0.0% 0.0% 10.0% 20.0% 30.0% Std. Dev. 11
• The PFIA requires that you invest in very safe assets, generally very short ‐ term assets • Be SLY—Safety, liquidity, yield • Nevertheless, some principles of diversification apply 12
Sources of Risk Security Risk or Credit risk Call/Prepayment Risk Market risk Liquidity risk Reinvestment risk Strategy Risk 13
Security Risk Credit Risk • Default Risk: Risk of delay and/or lack of payment • Spread Risk: Risk of change in credit spread due to change in default risk or market sentiment • Must diversify across large number of issuers to minimize impact of credit risk 14
Sec. 2256.006. STANDARD OF CARE. (b) In determining whether an investment officer has exercised prudence with respect to an investment decision, the determination shall be made taking into consideration: • (1) the investment of all funds, or funds under the entity's control, over which the officer had responsibility rather than a consideration as to the prudence of a single investment; and • (2) whether the investment decision was consistent with the written investment policy of the entity. 14
In other words….. • Prudence will be judged in a portfolio context. An investment that seems imprudent on a stand ‐ alone basis can be justified in a portfolio context. • Corollary: An investment that turns out poorly had better be only a small part of your portfolio! 16
Commercial Paper vs T ‐ Bills 30 ‐ day Yields 7 6 5 4 Yield (percent per annum) Commercial Paper 3 T ‐ Bill 2 1 Source: Federal Reserve H.15 Release 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 17
Commercial Paper Spread Spread: 30 ‐ day Commercial Paper vs T ‐ Bill 350 300 250 200 Basis Points 150 100 50 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Federal Reserve H.15 Release 18
Market Risk Primarily due to interest rate risk. The two dimensions of interest rate risk: Price Risk or Market Risk —due to rising interest rates Reinvestment Risk —exposed to falling interest rates Strategy can help manage exposure to these countervailing risks. 19
Illustration of Interest Rate Risk 4% Coupon, 30 ‐ year Treasury 30% 20% 10% Annualized 0% HPY +200 bps 0 5 10 15 20 25 30 ‐ 10% ‐ 100bps ‐ 20% ‐ 30% Holding Period (Years) Holding period yields computed assuming +200/ ‐ 100 basis point change in yield for the life of the bond. 20
Duration Matching Works! 8.00 16.00 1 ‐ yr. Realized Yield % 5 ‐ yr. Realized Yield % 14.00 7.00 12.00 6.00 10.00 5.00 8.00 4.00 6.00 3.00 4.00 2.00 2.00 0.00 1.00 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 ‐ 2.00 0.00 ‐ 4.00 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 Starting YTM% Starting YTM% Bloomberg Barclay’s U.S. Aggregate Bond Index starting yield versus realized annualized yield over monthly rolling one ‐ year and five ‐ year horizons April 2004 ‐ April 2019. Source: FactSet 21
Strategy Risk • Short investment horizons are subject to “price risk”. (Extension strategy causes market or price risk) • Long investment horizons are subject to “reinvestment risk”. (Rollover Strategy causes reinvestment risk) • Matching Strategy—Match maturities to cash flow needs • Which risk causes more trouble? ‐‐ Price Risk! (see Orange County 1994) 22
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