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SPARTA RISK MANAGEMENT Protect. One Client at a Time.

SPARTA RM: TWO LIVE EXAMPLES OF INVESTMENT RISK FACING PORTFOLIOS TODAY. The term risk is by itself somewhat nebulous partially because it is so far reaching. In the case studies below, we illustrate two specific and currently relevant investment risks that Boards and CFO must manage.

Case Study #1: Many CFOs and Board of Directors falsely think their portfolios are diversified and therefore safer. Investment advisors and consultants have falsely taught investors to believe that a portfolio is diversified False if (a) the assets are diversified across the major asset classes (pension funds commonly allocate Diversification

40% to equities, 40% to debt and 20% to alternative assets) and (b) if within each asset class capital is further diversified across different strategies. However, this type of allocation is proven to be nave. In this case study we will test the commonly accepted diversification strategy by looking at the equity asset class as an example. Today, it is commonly accepted among clients that capital allocated to stocks is safer if it is diversified across different strategies such as: large cap, small cap, growth, value and international. If this old-school method is trustworthy then the data must demonstrate that a diversified equity portfolio is more stable than the overall market. What does the data reveal? In the most recent major sell-off, the S&P500 fell 53% from October 2007 to February 2009 (falling from 1549 to 735, which is precisely when diversification matters most). How did equity sub-strategies do? Did the so-called different equity strategies perform much differently than the S&P500? o Small cap stocks (Vanguard SC): fell 54% o Value stocks (S&P500 value index): fell 57% o Growth (S&P500 growth index): fell 45% o International (MSCI EAFE): fell 58% How much diversification was there? Did even one of these major strategies earn positive returns? As it turns out, diversification is a powerful force but only if it is done right, which it most often is not. Comfort in false diversification can be quite dangerous and hide the potential for much bigger losses. Is it sufficient for the sake of fiduciary duty to rely on the fact that many others are doing the same thing? If you are not clear about how to correctly diversify, how do you know what your real risks are?

Case Study #2: The U.S. Treasury 10 year bond yield has fallen from a high of 15.3% in 1981 to a low of 1.4% in 2012. During this time, the U.S. Federal Debt has exploded from approximately $1tn in 1980 to $16tn in 2013. Bond In addition the U.S. Treasury and the U.S. Federal Reserve have together increased the available credit Risk

to banks and U.S. businesses using various methods of quantitative easing otherwise known as QE. There are several immediate implications for investors that should immediately jump out at them: o First, if interest rates decline, yields will fall even further. Sure, in the short term bondholders benefit from capital gains but with yields at historic lows, capital gains are limited. o Second, if rates remain low, the returns on the fixed-income portion of investors portfolios will decrease significantly since investors will not be receiving much in capital gains (much of bond funds prior year returns have come from capital gains and not interest income). o Given low absolute returns and increasing credit risk, chasing higher yields within the bond markets by investing in riskier credits and debt to earn the same yield is ill advised. o If an institution puts capital in debt funds that average a 1% return going forward (the funds perhaps being spread across a range of shorter durations to reduce risk), and the institution is paying 1.3% in financial advisory fees and consultant fees, and given an inflation rate of 2.7%, then the real return is: +1.0% 1.3% - 2.7% = a guaranteed -3.0% loss per year! o Bond funds have done quite well, even during 2012, due to additional interest rate compression, but sectors such as the 2-year T-bill sector now yield a tiny 0.25%. o Third, in the event interest rates increase, then bond funds will suffer capital losses. o Investment advisors often argue that you do not lose money if you hold the bond until maturity but this is false logic: real interim returns can be negative and in liquidity-adjusted terms, the bonds have in fact lost money and the investor will have to choose between realizing the loss or not deploying that capital in better alternatives (poor choices). What is the real risk or cost of your bond-investments going forward? Have you quantified this risk?

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Stefan Whitwell, CFA, CIPM office: (877) 936-3722 ext. 701 mobile: (917) 214-6833 stefan@empiricalresults.net

Paul Stafford office: (877) 936-3722 ext. 702 mobile: (406) 546-8410 paul@empiricalresults.net

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