Does Your Investment Plan Consider Risk?

05/25/2012 7:00 am EST

Focus: ETFs

Scott Kubie, MBA, CFA

Chief Investment Strategist, CLS Investments, LLC

The ability to bear risk is an asset that investors can capitalize on, says investment strategist Scott Kubie. He explains how his firm calculates clients’ risk budgets, and why ETFs are his preferred vehicle for achieving optimal portfolio returns.

Kate Stalter: Today’s guess is Scott Kubie, chief investment strategist for CLS Investments.

Scott, you have a long-term strategy for income in any market conditions. We only have a few minutes today, so we can really only talk high level, but maybe you can begin by giving us an overview of the managed income strategy.

Scott Kubie: One of the things we've all experienced is that the Federal Reserve, the Europeans, as well as the Japanese, have kept interest rates at such low levels throughout the globe. Generating income for investors has been very, very difficult.

And so in response to this environment, we tried to find a strategy that would take a little bit more risk. But we also generate a yield that could grow and would be sufficient to meet the needs of income investors.

And so while bonds have gotten very expensive, because your yields have gotten very low, equities—especially dividend-paying equities—are still relatively cheap. And because of that, the yields on those are fairly attractive.

So we’ve assembled a strategy that uses more dividend-paying stocks as well as some preferred stocks, some high-yield bonds, and even just some investment-grade corporate bonds in order to generate yields that are attractive, around 4% for investors, and still be able to sort of meet that objective and the income needs that they’d like to have.

Kate Stalter: One of the aspects of this, as I understand it, is called risk budgeting. Can you tell us a little bit about that?

Scott Kubie: That’s probably a great place to start with where CLS is as a firm. We think that most people, lots of people, use budgets. In fact, if people don’t use budgets, they probably should use budgets.

And the budgets that are most common in our lives are a financial budget. You know, where we allocate our income to our spending. We also have time budgets called schedules.

And what we’ve also found at CLS is that people have a capacity to bear risk, and that’s what we call a risk budget. That’s a term that we sort of borrowed from the institutional space. It’s very commonly used inside pension plans, as well.

So this is an idea that’s got some very common, easy-to-understand parts of it, in that you compare it to a schedule or a financial budget, but it also has all the mass and the depth of it that you would see on the institutional side. What we’ve done is taken the concept and applied it to individuals, and said, “You know, we’re going to try express your risk in terms that we think you can understand.”

They’ve really tightly woven risk and reward together, and so that’s what we’ve done.

Kate Stalter: Can you talk just a little bit about the methodologies, just in terms of the mechanics of how this strategy would work? Say, if I were a new client coming in, how would that discussion go?

Scott Kubie: That’s a great question. So from that standpoint, we have a client profile. I think a lot of client profiles are fairly similar. And we generate a score on it between 1 and 100, and that score is your risk budget.

It represents the percentage in risk that you’re taking of the diversified equity portfolio. So if you score out as an 80, you’re going to take about 80% of the risk of diversified equity portfolio, where if you score a 50, which would be much more conservative, then you’d be only at half the risk of the diversified equity portfolio. Tthat really ties those two ideas together very tightly, the two ideas being risk and reward.

By tying those two together, you really have a great idea of how much return you should have compared to, say the S&P, or even the slightly more diversified equity portfolio. And then what we do is we allocate that risk actively, so we’re going to overweight emerging markets, or we might overweight Germany, or we might overweight small caps, and we just might overweight large-cap US. or high-yield bonds, or any number of different asset classes, depending on the market environment.

And so what we like to do is, we try to spend that risk or invest that risk as efficiently and as effectively as possible, to generate good returns for you in line with your overall risk exposure.

The last thing I kind of add to that is: The ability to bear risk is an asset. That’s ultimately a lot of what we get paid for in the investment market, is that ability to bear risk. And so we make sure we don’t underutilize one of your big assets, and that’s that risk-bearing capacity.

At the same time we know that emotionally, investors can only go so far, and it varies from investor to investor. But over the long haul, we want you to be able to stick with the program and gain the advantage of the returns that markets give you for bearing risk.

But if we overspend it, you’re likely to get off the program, probably at the wrong time, and so that’s really the goal of risk budget: Don’t go too high on the risk standpoint, so you experience things you don’t want to experience, and don’t go too low at the same time, so you don’t lose out on returns that you should have gotten.

Continued…

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Kate Stalter: Now one of the things that our listeners are clearly going to be quite interested in is some of the specific investments. Scott, I know that you have a strategy that uses ETFs. Maybe we could start with that, and talk about some of the ETFs.

Scott Kubie: ETFs are definitely our preferred investment vehicle. As you sort of trace the ideas that we have of risk budgeting, one of the key aspects of that is being able to know what the risk is in the investments you make.

And one of the great things about ETFs are that they list their investments out there every day. They have rule-based strategies, as opposed to active management. They don’t change a lot from day to day.

When they change, they tell you what the new security weightings are, and that makes them very advantageous for us to manage risk. It also helps us manage our asset allocation globally, and allows lots of different opportunities in asset classes in order to do that.

We’ll own, for instance, an iShares S&P 500 (IVV). It's one ETF that we own that’s sort of core diversification. But we also might end up owning the iShares Germany ETF (EWG). That would be a great example where we can take advantage of an opportunity overseas, and in an economy within Europe that’s very, very strong.

Right now, our strongest overweight position tends to be more in the US, and then also some in emerging markets. We tended to be underweight Europe and Japan pretty heavily, because of their just very weak economies, and the strong challenges that they face both politically as well as economically over the long haul.

ETFs have been our preferred investment vehicle really since 2002, so we’ve been doing that for a long time. In fact, managing ETF separate accounts all the way back to the year 2001, so we have a long history with what still is a relatively new and definitely dynamic place to be, as far as an investment manager.

Kate Stalter: Is this the way that you get exposure to different asset classes—equities, fixed income—or are there indeed some other ways, other types of investments that you do use?

Scott Kubie: You know, that’s our primary way. We have different places where CLS might be asked by a financial advisor to manage one of their clients’ monies inside the American Funds, or inside a variable annuity, or something where we’re somewhat constrained to the choices that are available based on that investment policy.

But when we have the choice, we definitely are an ETF advocate. We think that their low expenses and all the other advantages I mentioned, are just a super place to go.

And also, even to head back to that managed-income strategy, we’ve seen that ETFs have gotten more narrow in their focus, but they’re also still stable at the same time. So you can go out and buy a global real estate ex-US ETF that has a very nice yield to it, and know exactly what you’re owning and have access to that. And that’s a great opportunity throughout there.

Or an emerging-market income fund, either a bond or an equity, they all exist. And so the ability to really dial in the exact exposure that you’re looking for is a lot easier in ETFs.

It would be hard for us as a US- based manager to have trading relationships all over the world, and purchase all of those individual securities. And so the ETF is a very, very efficient and effective way for us to do what we want to do.

And then as investment environments change, risk changes, and as opportunity changes, we can move out of those assets or adjust those allocations, and move that money somewhere else where it’s likely to earn a better return for investors for the risk that they’re able to bear.

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