18 Jul 2011 Pzena Investments - White paper: Assessing risk and return ( Portfolio )
In the end, the goal of any investor should be to maximize returns without incurring significant risks of permanent impairment of capital. It is the hallmark of all the great investors. If we can define a process which (1) makes sure we don’t overpay; (2) makes sure we don’t assume too much financial leverage; and (3) makes sure we have the flexibility to offset the cost of inflation – then the individual mistakes that we inevitably make as investors will be offset by the cases where we are positively surprised. Then we won’t have to worry about the inevitable short-term volatility that arises from the ebb and flow of news that creates emotional and not necessarily rational responses.

BONDS - AN ILLUSION OF SAFETY
Whether measured on a short or long-term basis, the bond market has lower volatility than the stock market. But the bond market has a significantly higher probability of real loss (i.e., not earning enough to cover inflation). This is because long-term interest rates have been notoriously poor predictors of future inflation. For equity markets, the average real return for a ten-year holding period over the past 140 years has been 6.9% while for bonds the real ten- year return has averaged 2.5%.

COMMODITIES = INFLATION HEDGE?
An often ill-conceived strategy to hedge the risk of inflation is commodities. But commodities have been notoriously bad at beating inflation, and, with the exception of a handful of periods, have produced negative real returns. Since 1960, commodities (with the exception of crude oil and perhaps a few others) have, on average, produced negative real returns measured on a ten year basis. The probability of a real loss is enormous, and the maximum losses are huge. And although oil has had positive real returns, the variability of outcomes and the probability and magnitude of potential loss makes it hard to consider commodities a low risk strategy or even a valid inflation hedge.

So why are equities so much better than commodities or bonds in protecting against inflation? It stands to reason that businesses have the ability to adapt to their environments. Thus a recession, or a period of rising prices, or the emergence of new competitive markets, are met with a response by the management teams to mitigate or even exploit these changes. This was demonstrated in the recent global financial crisis where unprecedented demand drops were met with management actions which reduced the downside to their businesses. Today margins are back to pre-crisis levels.

HEDGE FUNDS - A POOR RECENT EXPERIENCE
The most recent market experience for hedge fund investors has been less than stellar. If we measure from the market’s recent peak in October, 2007, hedge funds haven’t protected us from the downside scenario in spite of their lower volatility. If we compare the return of the S&P 500 from its peak in October, 2007 to May, 2011, we would have lost 5%. However, the average hedge fund would have lost about 8% over the same period and achieved that result with one-third the monthly volatility. That’s not supposed to happen. The lower volatility is supposed to provide downside protection when the market is declining. Why didn’t it? Well very simple – low volatility and downside protection are not correlated over the long term, only over the short term. Using monthly volatility as the metric of risk really doesn’t do an institutional plan sponsor much good.