An array of new investment products that arrived on the market in recent years have highlighted a perennial risk for advisors.
Dispersion risk — also known as tracking error — occurs when an asset’s actual return deviates from an expected return profile or benchmark. Clients, of course, are usually perfectly comfortable with upside surprises, but unwelcome news on the downside has become a stealth issue for advisors, who may have to explain underperformance when a managed fund underperforms the index or loses money during a downturn.
“There are always new products coming along, and they often produce disappointments,” says Larry Luxenberg, a managing partner with Lexington Avenue Capital Management in New City, N.Y.
Take the smart beta category. Although the vehicles have been around for nearly a decade and a half, the category’s popularity has surged since the 2008 meltdown; it held $452 billion in 417 funds as of Oct. 20, according to Morningstar — up 24% from a year earlier.
Products advertised as low volatility or fundamentally weighted have attracted investors with promises of robust returns and lower risk. These products employ a number of different strategies, with some focusing on high-dividend stocks while others have a value tilt that favors bargain-priced firms, but all aim to produce a better-than-average return with lower-than-average risk.
For example, the PowerShares S&P 500 Low Volatility ETF (SPLV) is described as “a suitable core holding for conservative investors seeking exposure to stocks, with less volatility than a traditional stock portfolio,” according to Morningstar. With roughly $4.6 billion under management, it’s the largest of the low-volatility funds.
That all sounds fine, from an investor’s perspective. But what appears to be a fund geared toward companies with stable earnings and lower drawdown risk has lagged the S&P 500. The PowerShares fund returned only 10% in 2012, trailing the S&P 500 Total Return Index by 6 percentage points. Last year, the fund fell behind the index by more than 9 percentage points.
That creates a potential problem for advisors who recommend these kinds of funds. So one key way to manage dispersion risk is to get accurate profiles of return characteristics.
If you’ve studied the research of behavioral economists like Daniel Kahneman, you know that losses carry much more emotional weight than gains. Even the lost opportunity of missing the upside with a fund can be painful.
Will the current crop of smart beta products deviate much from average returns? They’re engineered to have lower volatility. But while financial engineers now have some idea on how they’ll perform in a sell-off, a majority have little in the way of long-term performance records — and could disappoint clients when they underperform or lose money. Moreover, even when smart beta funds perform as expected, their returns are not likely to equal broader equity market returns.
That’s why it’s critical for clients and advisors to be on the same page regarding risk and return profiles. There’s always a bugaboo lurking when products in a portfolio don’t closely follow a specific index or objective.
“Tracking error is an eternal concern,” Luxenberg says. “There’s always one benchmark or country or product that’s producing huge returns. When it’s on the way up, everyone wants to get in and [wants to know] why you’re not buying; on the way down, people make you feel like a fool if you own it.”
A recent example, he notes, is gold — which was on a tear from 2008 to 2011 and then nosedived; GLD, the most popular gold ETF, lost 28% last year. “I try to explain to clients that a diversified portfolio is highly likely to produce the best risk-adjusted returns over time,” Luxenberg adds. “But that message frequently needs to be reinforced and many investors never learn.”
Indeed the best way to avoid tracking error risk may be to focus on “disciplined index and asset class products.” That’s what Mark Willoughby, chief investment officer with Modera Wealth Management in Atlanta, says his firm does: “We have never encountered an issue with tracking error to a relevant benchmark, certainly none material enough to cause us to discontinue use of an indexed investment product.”
The firm has tried other strategies, he says, but dumps them if they don’t make the grade. One recent example was a liquid hedge fund strategy, “for which we set an absolute return target of 4% to 6% annualized over a five-year period. … We began using one of these liquid hedge funds in late 2008,” he adds — “and after it did not meet our return target, we eliminated it from all our client portfolios in early 2014.”
Then there’s the behavioral component that deals with managing expectations. To head off the possible letdown involving products that may promise much and deliver little, advisors prescribe education and counseling.
“As an advisor,” Luxenberg notes, “I always have to educate clients ... Just as smart beta is gaining popularity now, one product or another always is looking especially good,” he cautions. “We keep in mind that dispersion risk or tracking error is always part of the equation in structuring portfolios.”
Luxenberg’s hand-holding involves a detailed explanation of possible outcomes. “I always talk to clients about the potential for long-term returns, show them the actual numbers, including the year-to-year returns for decades,” he says. “A few charts and graphs can get these concepts across.”
Hype can be a problem as well, particularly with new or trendy investment products that fail to deliver immediate satisfaction. That means advisors must help clients avoid the temptation to dump holdings during downturns. “Many years of strong returns can be destroyed quickly by a simple behavioral mistake,” Luxenberg notes. “Overselling a new product like smart beta can heighten this risk.”
Willoughby says the unpleasant surprise of dispersion risk can be avoided by basic financial planning. “How’s [the investment mix] going to impact the chance of success?” asks Willoughby, who relies upon Monte Carlo simulations to project possible investment outcomes. Will the asset mix match the client’s goals on retirement?
As with many advisors, Willoughby walks clients through possible outcomes. “I get [clients] to sign off on drawdown possibilities,” Willoughby adds, “so they understand the worst-case scenario.”
Ultimately, managing expectations is always going to be a delicate balance, and dispersion risk is part of the calculation. This is where research and education go hand in hand. How likely is a product to show tracking error? Will your clients accept returns that lag a benchmark? How will you educate them on the quirks of some of the newer products?
Within the framework of a comprehensive financial plan, return projections are important, but need to be accompanied by solid education — a planning component that never loses currency.
John F. Wasik, author of Keynes’s Way to Wealth, has contributed to The Wall Street Journal, The New York Times and Forbes.
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