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USING MODERN PORTFOLIO THEORY TO IDENTIFY INCREASED

INVESTMENT RISKS IN PRIVATE BANKS

A Project

Presented to the

Faculty of

California State Polytechnic University, Pomona

In Partial Fulfillment

Of the Requirements for the Degree

Master of Science

Economics

Roberto Martinez Suarez

2015

SIGNATURE PAGE

PROJECT: USING MODERN PORTFOLIO THEORY TO IDENTIFY INCREASED INVESTMENT RISKS IN PRIVATE BANKS

AUTHOR: Roberto Martinez Suarez

DATE SUBMITTED: Fall 2015

Economics Department

Dr. Bruce Brown Project Committee Chair Professor of Economics

Dr. Carsten Lange ______Graduate Coordinator Professor of Economics

ACKNOWLEDGEMENTS

Foremost, I would like to express my sincere gratitude to my advisor Prof. Bruce Brown for his continuous support of my graduate studies and research, and for his patience, motivation, enthusiasm, and immense knowledge. His guidance has helped me in all the time of research and writing of this project. I cannot imagine having a better advisor and mentor.

Besides my advisor, I would like to thank my other project committee member Prof. Carsten Lange. His encouragement, insightful comments, and hard questions have been truly appreciated.

My sincere thanks also goes to Dr. Mohammad Safarzadeh for making economics at Cal Poly Pomona so difficult. This forced me to bring my “A” game.

I thank my classmates Justin Niakamal and David Raymundo. They have offered me their guidance, assistance, and friendship throughout the previous two years.

Last, but not the least, I would like to thank my family. I thank my parents Roberto Martinez and Emma Victoria Martinez for giving birth to me in the first place and for supporting me spiritually throughout my life. I thank my younger siblings Erika, Bayron, Alfred, and Denise who have been instrumental in my success as well. A shout-out to my girlfriend Erica Picazo for being very supportive and understanding.

iii

ABSTRACT

In the wake of the Great Recession of 2009, it is little wonder that there has been growing interest in identifying optimal investment strategies that can avoid unnecessary risks while maximizing returns on investment. Despite its constraints, modern portfolio theory has emerged as a viable strategy for this purpose. This paper applies modern portfolio theory to identify indications of increased investment risks in private banks. This paper also explores how those investment risks can in turn affect private markets, particularly in view of potential penalty risks that private investors sometimes incur. An examination of portfolio returns for various levels of risk through an evaluation of a firm’s beta is followed by an analysis concerning the perspective of Warren Buffett on this issue.

Finally, in the conclusion, the paper provides a summary of the research and important findings concerning the application of modern portfolio theory.

TABLE OF CONTENTS

Signature Page…………………………………………………………………………. ii

Acknowledgements……………………………………………………………………. iii

Abstract………………………………………………………………………………... iv

List of Tables…………………………………………………………………………… vi

List of Figures………………………………………………………………………….. vii

Chapter1: Introduction………………………………………………………………… 1

Chapter 2: Review and Analysis……………………………………………………….. 2

Overview of Modern Portfolio Theory………………………………………… 2

Identifying Signs of Increased Investment Risks in Private Banks……………. 6

How Increased Investment Risk Affects Private Markets……………………... 23

Applicability of Beta to Increased Investment Risk in Private Banks…………. 25

Chapter 3: Conclusion………………………………………………………………….. 29

References……………………………………………………………………………… 31

Appendix: Due Diligence Required for Investments in Private Enterprises…………… 34

LIST OF TABLES

Table 1 Variables That Signal Potential Investment Crises……………………... 20

Table 2 Stock Selection Using Beta……………………………………………... 26

LIST OF FIGURES

Figure 1 Share of the investment portfolio dedicated to credit investments: 2007-2011………………………………………………………………. 12

Figure 2 Portion of the securities portfolio classified as credit or spread investments in 2011…………………………………………………….. 14

Figure 3 Increase in credit portfolio assets and liquidity portfolio asset exposures……………………………………………………………….. 15

Figure 4 Minimizing unsystematic risk through portfolio diversification……….. 18

Figure 5 Efficient frontier for Google and Coca Cola stocks……………………. 19

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CHAPTER 1

INTRODUCTION

Today, there is a growing consensus among practitioners that it is possible to identify salient risks and improve returns on investment by applying modern portfolio theory. There is less agreement, though, concerning the optimal approaches to applying modern portfolio theory to identify increased investment risks in private banks and how those investment risks can affect private markets. To determine the facts, this paper uses modern portfolio theory to reveal signs of increased investment risks in private banks.

This paper then explores how those investment risks effect private markets, especially in light of potential penalty risks that private investors sometimes incur. In addition, by appraising a firm’s beta, there can be an examination of portfolio returns for various levels of risk. Beta views risk solely from the perspective of market prices.

Warren Buffett’s opinion on this matter is that some investors shun beta because it implies that a stock that has fallen sharply in value is more risky than it was before it fell.

Finally, a summary of the research and important findings concerning the application of modern portfolio theory in this context are provided in the conclusion.

CHAPTER 2

REVIEW AND ANALYSIS

Overview of Modern Portfolio Theory

The recipient of the 1990 Nobel Prize winner in economics, Harry Markowitz, was responsible for developing modern portfolio theory as well as for participating in additional collaboration with other economists to fine-tune its tenets (Bai, Dow, &

Newsom, 2008). A useful definition of modern portfolio theory is provided by Mangram

(2013) who advises, “[Markowitz’s] innovative work established the underpinnings for

Modern Portfolio Theory -- an investment framework for the selection and construction of investment portfolios based on the maximization of expected portfolio returns and simultaneous minimization of investment risk” (p. 59).

The work by Markowitz was expanded upon in 1964 by William Sharpe whose research into financial asset price formation became known as the Capital Asset Pricing

Model, or CAPM (Mangram, 2013). This expanded conceptualization of modern portfolio theory provides a useful framework for investment analysis that allows practitioners to select and develop investment portfolios that are founded on the optimization of expected returns of the portfolio and the simultaneous minimization of the associated risks of investment (Fabozzi, Gupta, & Markowitz, 2002). The expanded version of modern portfolio theory is frequently referred to as the mean-variance analysis in which the “mean” is used interchangeably with the average expected return and the

“variance” applies to the indicated risk (Mangram, 2013).

The mean-variance analytical approach has since emerged as a fundamental approach to optimizing investment portfolios (Campbell, 2000). There are some

constraints to modern portfolio theory as conceptualized by Markowitz. For example,

Goetzmann and Wachter (1999) note, “As originally conceived, mean-variance calculates a set of portfolio weights across assets that result in the highest expected return for each given level of investor risk. While useful, the procedure is not without drawbacks” (p. 271).

The main drawbacks to modern portfolio theory depend on the viewpoints of the investors, with some viewing some aspects of the model as being suboptimal while others consider other variables more salient for their purposes (Viezer, 1999). Along this same line, Campbell (2000) points out, “This approach usefully emphasizes the ability of diversification to reduce risk, but it ignores several critically important factors. Most notably, the analysis is static; it assumes that investors care only about risks to wealth one period ahead” (para. 2). However, Campbell goes on to explain that a number of institutional and individual investors are more interested in developing a long-term system of consumption.

Moreover, there are also constraints to the mean-variance analytical approach.

These include the manner in which financial wealth and income are treated (Bielski,

2005). Along this line, Campbell (2000) adds, “Mean-variance analysis treats financial wealth in isolation from income. Long-term investors typically receive a stream of income and use it, along with financial wealth, to support their consumption” (para. 2).

Currently, mean-variance analysis is the foundation of modern portfolio selection and optimization (Leung, 2009).

Notwithstanding these constraints, the research to date suggests that the risk factors associated with modern portfolio theory can be determined through the

application of different mathematical formulas and can be analyzed using the concept of diversification. Diversification seeks to optimize a weighted collection of investment assets that, in the aggregate, demonstrate lower risk factors compared to investments in any individual asset or asset class (Mangram, 2013). This concept is derived directly from the earlier work by Markowitz. As Mangram (2013) points out, “Diversification is, in fact, the core concept of modern portfolio theory and directly relies on the conventional wisdom of ‘never putting all your eggs in one basket’” (p. 61, drawn from

Fabozzi, Gupta, & Markowitz, 2002; McClure, 2010; Veneeya, 2006). It is important to emphasize that modern portfolio theory is defined as a “normative theory,” which is defined by Mangram (2013) as “one that describes a standard or norm of behavior that investors should pursue in constructing a portfolio” (p. 60).

By contrast, the expanded version of modern portfolio theory used by the CAPM is considered to be a “positive theory” which posits the manner in which investors behave in real-world settings versus the manner in which they should behave (Mangram, 2013).

Despite some ongoing controversy over details, modern portfolio theory and the CAPM provide a valuable framework in which investment risk can be identified and measured as well as used to distinguish the emergence of any relationships between expected risk and return on investments (Mangram, 2013).

Furthermore, there is a lack of consensus concerning whether the validity of modern portfolio theory is tied to the underlying asset pricing theory (Fabozzi et al.,

2002). From some investors’ perspective, the most significant element of the Markowitz portfolio theoretical model is the focus on identifying the respective effects of a number of portfolio securities and their covariance relationships on the diversification of

portfolios (Megginson, 1996). In sum, the essential element of modern portfolio theory is diversification of investment. The work by Markowitz demonstrated that investors can combine their financial assets in a manner in which the approach increases their return on investment while concomitantly decreasing their risks (Bai et al., 2008).

Many practitioners eschew the use of modern portfolio theory because of the complexity of its application. The application generally involves esoteric, statistics-based mathematical modeling and formulas that are used to support the theory’s primary assumptions (Mangram, 2013). Efforts to simplify the application have met with less- than-optimal results. In this regard, Mangram (2013) reports “Typically, these investigations present their findings utilizing unnecessarily complicated rhetoric and intricate formulaic expressions. In opposite, the less complicated treatments are generally overly simplified, non-comprehensive, and lack the rigor requisite of serious scholars and practitioners” (p. 60).

Despite these constraints, Markowitz showed that it is possible under certain conditions to select an optimal investment portfolio based on two fundamental dimensions: (a) the expected return of the portfolio, and (b) the risk or variance of the portfolio (Mangram, 2013). Although the following assumptions, quoted here from

Mangram (2013), have been the source of significant debate, they form the framework for modern portfolio theory today:

1.) Investors are rational (they seek to maximize returns while minimizing risk),

2.) Investors are only willing to accept higher amounts of risk if they are

compensated by higher expected returns,

3.) Investors timely receive all pertinent information related to their investment

decision,

4.) Investors can borrow or lend an unlimited amount of capital at a risk free rate

of interest,

5.) Markets are perfectly efficient,

6.) Markets do not include transaction costs or taxes,

7.) It is possible to select securities whose individual performance is independent

of other portfolio investments. (p. 61, drawn from Bofah, n.d.; Wecker, n.d.;

Markowitz, 1952)

Taken together, it is clear that modern portfolio theory represents a useful and timely approach to investment risk analysis, and these issues are discussed further below as they apply to investment risks in private banks.

Identifying Signs of Increased Investment Risks in Private Banks

Identifying signs of increased investment risk can be measured by determining deviations from expected historical returns during a specified period of time (Mangram,

2013). It should be noted, though, that the portfolio selection theory propounded by

Markowitz maintained that "the essential aspect pertaining to the risk of an asset is not the risk of each asset in isolation, but the contribution of each asset to the risk of the aggregate portfolio" (cited in Mangram, 2013, p. 61, drawn from Royal Swedish

Academy of Sciences, 1990).

A growing number of private banks have expanded their operations beyond traditional banking services in recent years to include venture capital investments and asset management services (Weiner, 1986). In this regard, Weiner (1986) reports, “As

commercial lending has become more competitive and less profitable, this small but growing group has found venture capital, with ‘the sky's the limit' profit potential, worthwhile despite its risks” (p. 1).

Notwithstanding the seemingly unlimited profit potential for private bank investments, investors should recognize that the corresponding risk is inordinately high, especially given the manner in which many private banks operate (Weiner, 1986). For instance, according to Weiner (1986), “The learning curve can be very expensive for those who are just getting into the business. It's not an easy business to learn. Everybody has not been successful. And the risks cannot be overblown. Any investment that a bank would not handle as a loan is a risk” (p. 1).

Therefore, identifying signs of increased investment risks in private banks can be accomplished by evaluating the aggregate risk involved from all portfolio constituent elements. However, there are other factors involved that should be taken into account as well. For instance, Siedle (2010) cites numerous problems associated with investments in private banks, most importantly including their tendency to manage investor portfolios to maximize the bank’s earnings rather than the investor’s earnings. According to Siedle

(2010):

For those who are unfamiliar with private banking, it seeks to cater to high-net-

worth clients–often those with $10 million or more to manage–by blending menus

of bank, investment management and other financial services. “Private” refers to

the notion that customer service is provided on a highly personalized basis and

delivered by employees who are supposed to be highly trained financial advisors.

(para. 3)

In many cases, however, the investment services that are promoted by private banks fall short of their promises. These shortcomings have been attributed alternatively to the manner in which bank executives are compensated or to a conservative banking culture. Irrespective of the precise reasons, few private banks have achieved their claimed status as high-performing asset managers (Siedle, 2010).

One common practice by private banks is to pad investors’ portfolios with investment assets that are not included due to their strong performance, but rather are included because they are managed by the bank or its affiliates (Siedle, 2010). For example, Siedle says, “In reality, private banking is riddled with conflicts of interests involving the use of proprietary products and cross-sold services” (2010, para. 7).

Some fortunate investors in private banks may actually benefit from these bank- interested blends of assets, but most investors are faced with asset management practices that favor the private bank. As Siedle (2010) notes, “If you opt to let a private bank handle your affairs, you can expect your separately managed accounts to be filled with proprietary products from the bank itself or from affiliated mutual funds, hedge funds and money market funds” (para. 7). These private banking practices are even more insidious than they appear at first blush because these practices also provide the opportunity for private banks to assess multiple fees for portfolio asset management and the management of sub-accounts (Siedle, 2010).

Furthermore, there is a fundamental lack of transparency in private banking investment, and the same practices that apply to other actors in the money management industry are lacking in private banking circles. For example, Siedle (2010) points out,

“Performance information and analysis routinely provided in the money management

industry, meanwhile, is often curiously lacking in the reports private-bank clients receive” (para. 10). In addition, internally managed investment products in private banks do not report their performance levels and can be sold to investors without any meaningful information (Siedle, 2010). In this regard, Siedle (2010) enumerates,

“Among the information that’s often lacking: assets under management in the product; identity, qualifications and even location of portfolio managers; and performance history gross and net of all fees compared to relevant benchmarks” (para. 11).

Rather than concrete information and solid evidence, many investors in private banks receive a pro forma prospectus that contains exaggerated claims of future performance (Siedle, 2010). As Siedle (2010) concludes, “Instead, projected or hoped- for returns are often used to sell proprietary products. Clients who rely solely on bank projections of future returns are usually setting themselves up for disappointment or outright disaster” (para. 11).

More troubling still for investors is the fact that private banks and their employees are not required to be registered with the Securities and Exchange Commission (SEC) as investment advisory representatives or investment advisors (Siedle, 2010).

Consequently, Siedle (2010) warns that investors at private banks do not receive the same level of disclosure as they would from investment advisors registered with the SEC.

Likewise, the same type of information that is routinely provided to investors through the

Financial Industry Regulatory Authority’s BrokerCheck program is not available through private banks (Siedle, 2010).

In sum, private bank asset managers may be lacking in experience and training that are needed to perform timely and effective investment management services (Siedle,

2010). As Siedle (2010) stresses, “Private banks make sense if you’re willing to pay through the nose for the plush carpeting and fine china–but don’t kid yourself into thinking private banks will provide you with world-class fiduciary guidance or superior investment results. Most won’t” (para. 18).

Other authorities have weighed in on the private bank approach to portfolio investment and management. For example, Schellhorn (2011) reports that private banks may have been responsible for jeopardizing the soundness and safety of the financial system as demonstrated recently in the Great Recession of 2009. There are some steps that the federal government could take to help offset these disparities in private banking.

Pertinent to this, Schellhorn notes, “One way to control excessive risk-taking is to strengthen and expand the government’s supervision and regulation to include the investment banks. Similar to commercial banks, investment banks could be subjected to risk-adjusted capital requirements, asset quality standards, and frequent regulatory audits” (p. 112). In addition, the executive compensation packages at private banks should become the focus of increased scrutiny from government officials (Schellhorn,

2011).

Not surprisingly, these trends in private banking together with fundamental changes in the regulatory environment in recent years have resulted in significant changes in the manner in which bank investment portfolios have been managed (Callin & Ayre,

2012). Although proprietary practices remain beyond the scope of analysts, what is known for certain is that private bank investment portfolios increased significantly following the Great Recession of 2009 (Callin & Ayre, 2012).

Despite the potential for high profits from private bank portfolios, the corresponding high risks that are associated with private bank portfolio investments have fueled calls for more transparency in asset management practices (Callin & Ayre, 2012).

Related to this, Callin and Ayre (2012) report that these trends have “prompted some banks to rethink the best way to achieve the primary objectives of the investment portfolio; providing balance sheet liquidity and generating income” (para. 3). In response, some banks have extended their investment portfolio opportunities to include additional asset classes and sectors in an attempt to diversify and improve risk-adjusted returns on investment (Callin & Ayre, 2012). In addition, Callin and Ayre (2012) relate,

“The complexity of this new global environment has also encouraged some banks to outsource, relying on outside investment specialists to complement their in-house capabilities” (para. 3).

Although investment portfolios have assumed new importance to private bank profitability, there have been some fundamental constraints to achieving optimal outcomes. Some of the key challenges, listed in this extensive but important quote from

Callin & Ayre (2012), have included the following:

1. Bank investment portfolios have increased in size relative to total assets, and

thus they have grown in importance to bank profitability. Bank investment

portfolios grew by $900 billion to 21% of total assets at the end of 2011 from

15% four years earlier, according to data from U.S. bank holding companies

(includes available-for-sale and held-to-maturity securities).

2. Although there are signs this trend may be reversing, credit risk has declined

on average across bank securities portfolios from pre-crisis levels, as reflected

in portfolios with higher concentrations in Treasury and agency securities.

Specifically, the share of the investment portfolio dedicated to credit (e.g.,

“spread”) investments declined to 37% at the end of 2011 from 41% at the end

of 2007 (See Figure 1). The end result may be a highly conservative asset

allocation that may not be well aligned with the bank’s risk/return objectives

and liquidity needs.

3. The write-downs and losses that were experienced during the financial crisis,

as well as uncertainty with respect to future liquidity requirements, have

created additional hurdles with respect to re-orienting the investment portfolio

toward optimal risk-adjusted returns. (para. 5)

Figure 1. Share of the investment portfolio dedicated to credit investments: 2007-2011. From "Rethinking best practices for bank investment portfolios," by S. C. Callin and J. J. Ayre, 2012, Insights. Copyright © 2012 by Pimco. Reprinting permission requested.

The background and underlying sources of the disparity between risk objectives and risk exposure has been documented time and again (Callin & Ayre, 2012). For example, a number of banks experienced substantial setbacks following the Great

Recession of 2009 due to the types of risky investments in their portfolios (Callin &

Ayre, 2012). In response, a growing number of banks have opted for less risky investments, but these trends have also served to adversely affect investments in potentially high performance assets and may limit further diversification (Callin & Ayre,

2012).

In spite of numerous challenges, a few banks have been in the vanguard of improving their diversification in recent years as well as developing innovative approaches to investment in assets that were regarded as non-core as recently as 2010

(Callin & Ayre, 2012). Some indication of these trends can be discerned from Figure 2 below that depicts the portion of the securities portfolio classified as credit or spread investments which increased at the top 50 U.S. banks in 2011.

Figure 2. Portion of the securities portfolio classified as credit or spread investments in 2011. From "Rethinking best practices for bank investment portfolios," by S. C. Callin and J. J. Ayre, 2012, Insights. Copyright © 2012 by Pimco. Reprinting permission requested.

As shown in Figure 3 below, this trend became especially pronounced during the fourth quarter of 2011, with a $45.5 billion increase in credit portfolio assets.

Conversely, increases in liquidity portfolio asset exposures were just $3.3 billion (Callin

& Ayre, 2012). According to Callin and Ayre (2012), the increases in credit/spread positions were comprised of the following:

 Foreign debt ($23.5 billion),

 Municipals ($9.7 billion),

 Commercial mortgage-backed securities ($8.6 billion),

 Structured products/asset-backed securities ($8.4 billion), and 14

 Non-agency residential mortgage-backed securities ($6.6 billion)

Figure 3. Increase in credit portfolio assets and liquidity portfolio asset exposures. From "Rethinking best practices for bank investment portfolios," by S. C. Callin and J. J. Ayre, 2012, Insights. Copyright © 2012 by Pimco. Reprinting permission requested.

It is important to note, though, that the expanded diversification of investment portfolio risk exposures does not mean that higher returns will be generated. It also does not guarantee that profitability will be inextricably interrelated with the banks’ ability to leverage their in-house and contracted expertise in ways that minimize risk while optimizing portfolio performance (Callin & Ayre, 2012). Although every private bank’s situation is unique in some fashion, there are some steps that they can take to improve the risk/return profile of their portfolios. These steps, given in a second extensive yet very pertinent quote from Callin and Ayre (2012), include the following:

 Increasing or adding exposure to certain bank-eligible asset classes and

sectors in an effort to enhance returns without compromising (and possibly 15

even reducing) overall portfolio risk. This approach can improve

diversification within the investment portfolio and across the entire balance

sheet.

 Using skilled security selection and sector expertise to uncover relative value

opportunities that can produce additional return. For example, even in highly

liquid markets, such as agency MBS [mortgage-backed securities],

opportunities may exist to achieve higher risk-adjusted return potential based

on an in-depth understanding of different factors that drive returns (e.g.,

sensitivity to extension risk, etc.).

 Recognizing attractive investment opportunities that arise out of a rapidly

changing market environment and associated increases in risk premiums and

volatility. This may be especially effective when coupled with an investment

process that matches a robust and dynamic macroeconomic forecasting

process with bottom-up asset evaluation expertise.

 Improving downside risk management and monitoring. As a case in point,

many of the low-risk (i.e., low volatility and highly rated) portfolios from the

pre-crisis era experienced significant losses, possibly due to limited resources

and insufficient due diligence that went into the security selection and

ongoing risk monitoring process. (“Improving the risk/return profile,” para. 1)

Again, although every bank’s situation is unique, the risk of different types of financial investments is identified in two different ways by Mangram (2013) as follows:

"(1) Stand-alone basis (asset is considered in isolation), and

(2) portfolio basis (asset represents one of many assets)" [list formatting added]

(p.61).

When applied to a portfolio, the risk that is associated with a given security is categorized by Mangram (2013) into two main constituent elements as follows:

"[1] Systematic risk (also known as market risk or common risk), and

[2] unsystematic risk (also known as diversifiable risk)" [numerals and list

formatting added] (p. 61).

The tenets of modern portfolio theory hold that both of these risk types are a commonality shared by all portfolios (Mangram, 2013). In this regard, Mangram (2013) reports, “Systematic risk is a macro-level form of risk -- risk that affects a large number of assets to one degree or another” (p. 62). Some salient examples of systematic risk include prevailing economic factors such as interest rates, gross national product levels, unemployment levels, inflation, and currency exchange rates (Mangram, 2013). All of these factors can have an effect on every kind of securities to some extent, and it is not possible to completely eliminate them, only mitigate them (Mangram, 2013).

Conversely, unsystematic risk is a type of micro-level risk that can impact a single asset or narrow group of assets (Ross, Westerfield, & Jaffe, 2002). Consequently, unsystematic risk is a specific type of risk that is not associated with other types of risk and only affects specific assets or asset groups (Ross et al., 2002). Unsystematic risk can be minimized, though, through diversification of the portfolio as illustrated in Figure 4 below.

Figure 4. Minimizing unsystematic risk through portfolio diversification. Copyright © 2006 by Investopedia.com. Reprinted by permission. Retrieved from http://i.investopedia .com/inv/articles/site/CT_MPT_1r.gif

There is one combination of portfolio investments that provides the lowest possible risk for every level of return. There is also one combination of portfolio investments that offers the highest rates of return (McClure, 2012). These dichotomous views of portfolio investments can be graphed to identify the corresponding efficient frontier as depicted in Figure 5 on the next page which illustrates a high risk/high return technology stock (i.e., Google) and a low risk/low return consumer products stock (i.e.,

Coca Cola).

There are some recent examples of unsystematic risk affecting investments in different ways. For instance, when NetFlix revised its consumer pricing structure to increase rental rates, the exodus of members resulted in diminished earnings and decreased stock prices for the company (Mangram, 2013). The initiative, though, did not affect the company’s overall stock performance (Mangram, 2013). With this, Mangram

(2013) advised, “It did not impact the overall stock performance of the Dow Jones or

S&P, or even that of entertainment and media industry companies for that matter - with the possible exception of its biggest rival Blockbuster Video, whose value increased significantly as a result of NetFlix’ faltering market share” (p. 62).

Other salient instances of unsystematic risk can extend to negative publicity concerning a company’s business practices or labor problems that are adversely affecting its performance (Mangram, 2013). Fortunately for investors and business leaders alike, it

is possible to significantly minimize unsystematic risk through portfolio diversification

(Mangram, 2013). As Mangram (2013) concludes, though, “Since, in practice, the returns on different assets are correlated to at least some degree, unsystematic risk can never truly be completely eliminated regardless of how many types of assets are aggregated in a portfolio” (p. 62, drawn from McClure, 2010; Royal Swedish Academy of Sciences, 1990).

Some potential signs that there is increased risk in private bank investments include those set forth in Table 1 below:

Table 1

Variables That Signal Potential Investment Crises

Category Variables Comments

Capital account Foreign Exchange reserves,

capital flows, short-term

capital flows, foreign direct

investment, and interest rate

differential

Debt profile Public foreign debt, private The debt-profile gives a

debt, short-term debt, debt broad picture of burden of

service, and foreign aid debt-service, liquidity

risks, and the robustness of

a country's foreign

exchange reserves.

Table 1

Variables That Signal Potential Investment Crises (continued)

Category Variables Comments

Current account Real exchange rate, current Current account relates to

account balance, trade the economic

balance, exports, imports, fundamentals. Regional

terms of trade, price of trade links can be used as

exports, savings, investment, proxy variables for

and regional trade links contagion.

International variables Foreign real GDP growth,

interest rates, and price level

Financial liberalization Credit growth, change in the Incomplete and

money multiplier, real uncontrolled financial

interest rates, and spread liberalization is regarded as

between lending and deposit one of the leading causes

rate of moral hazard.

Other financial variables Ratio of bank credit to the These are regarded as

banking system, money minor factors.

growth, bond yields, and

parallel market rate

premium

Table 1

Variables That Signal Potential Investment Crises (continued)

Category Variables Comments

Real sector Real GDP growth, output,

output gap, employment or

unemployment, wages, and

changes in stock prices.

Fiscal variables Fiscal deficit, government

consumption, and credit to

the public sector

Political variable Political stability index This affects agents’

expectations.

Institutional factors Openness, exchange These can relate to any

controls, and duration of the type of model.

fixed-rate periods

Note. Adapted from Private sector involvement and international financial crises: An analytical perspective, by M. Chui and P. Guy, 2005, p. 210. Copyright © 2005 by Oxford University Press. Adaptation permission requested.

In addition, the timely and rigorous performance of due diligence can help identify increased investment risks in private banks as set forth in the Appendix. Taken together, it is reasonable to suggest that modern portfolio theory and the due diligence steps outlined in the Appendix represent valuable tools for investors that can help identify signs of increased investment risk in private banks as well as potential investment

opportunities. These issues are discussed further below as they relate to how increased investment risk affects private markets.

How Increased Investment Risk Affects Private Markets

Increased investment risk can affect private markets in a number of ways. For example, price risk can result from increased volatility in interest rates or exchange rates or in the prices of commodities (Binder, 1997). Price risk became the focus of a growing amount of interest and research during the 1970s when the volatility of financial markets had become especially pronounced due to a number of different variables, which Binder

(1997) lists in the following quote:

[1] Changes in the flow of funds, worldwide, following the first oil crisis in the

1970s;

[2] the collapse of the fixed foreign exchange rate system;

[3] monetarist practices adopted by many central banks;

[4] the development of communications and technology; and,

[5] the acceptance of deregulation of financial systems around the world during

the 1980s. . . .

[6] the development of a 24-hour financial marketplace, and

[7] the rapidly increased application of financial instruments to hedge commodity

price risk. [numerals and list formatting added] (p. 9)

Increased investment risks can affect private markets by creating demand for certain types of investment assets over others, thereby driving prices up while decreasing prices for less desirable investments. For example, investments in equity securities can result in additional risk compared to debt securities because returns are more closely

linked with the issuer’s level of profitability (Goldman Sachs, 2007). If an issuer becomes insolvent, preferred and secured creditors as well as unsecured creditors will take precedence over the claims of equity investments in the distribution of any proceeds from the sale of corporate assets (Goldman Sachs, 2007). In addition, according to

Goldman Sachs, investments in high-risk volatile ventures, such as the penny stocks of smaller companies, can create inordinately high levels of risk. By contrast, investments in debt securities are less risky because returns are only jeopardized if the issuers become financially distressed (Goldman Sachs, 2007).

Further, increased risk in a given geographic region may also affect private investment. For instance, according to Goldman Sachs (2007), “Emerging markets can carry significantly greater risks than those typically associated with investing in more developed markets. The nature and extent of these risks will vary from country to country” ("Emerging Markets Risk Statement," para. 1).

From Diller and Herger (2009), we learn that because private equity assets are not traded as frequently as other types of investments, investors do not have the same level of access to market price data. Moreover, Diller and Herger assert that private equity investors typically engage in financial arrangements that provide for returns during the initial years of the fund, and then, after a period of 5 to 7 years, they sell the investments.

While the investment is active, private equity investors only receive performance data concerning net asset value on a quarterly basis (Diller & Herger, 2009). This is an important issue due to the fact that it applies to how increased investment risk affects private markets. As Diller and Herger (2009) point out, “Empirical analysis shows that the difference of the net asset value of a company and the price of a company – reflected

through the selling price a few months later – could largely differ” (p. 30). In addition, even top asset managers only have limited access to performance data, so calculating the risk of private equity investments becomes problematic (Diller & Herger, 2009).

Applying a Monte Carlo simulation for an investment to a single private equity partnership indicates a variance greater than 30 percent which is high compared to public markets (Diller & Herger, 2009). Yet, Diller and Herger (2009) agree that it is possible, to reduce this variance to as low as 18 percent through diversification of risk. According to Diller and Herger, it is possible to reduce risk even further under optimal conditions.

For instance, these two researchers report, “If another level of diversification is added through vintage year [sic] investors can decrease their variance even further. A portfolio consisting of 30 funds over five vintage years has a variance of 10 percent” (p. 32).

Moreover, the research to date indicates that, because investment risk in private markets can be mitigated, there may be a growing tendency to opt for these investment alternatives compared to public market offerings (Diller & Herger, 2009).

Applicability of Beta to Increased Investment Risk in Private Banks

As noted above, risks can be divided into systematic and unsystematic risks.

Systematic risk is measured by a company’s beta (Iqbal & Brooks, 2007). The Sharpe-

Lintner-Black Capital Asset Pricing Model (CAPM) maintains that the expected return of any capital asset is proportional to its systematic risk as measured by the beta of the firm involved (Iqbal & Brooks, 2007). Other analysts have applied beta to evaluate investment risk in private banks. According to Rizzi (2013), a bank’s beta represents the relative risk of that bank’s share price to the market. Multiplied by the market price of

risk, known as the equity risk premium, this provides a useful indication of volatility. In

2013, the banking sector had a beta of 0.53 (Rizzi, 2013).

A study by Nazliben (2011) examined the applicability of beta to increased investment risk. According to Nazliben (2011), “The beta coefficient of the market model has gained wide acceptance as a relevant measure of risk in portfolio and security analysis. The beta shows the return of a specific stock with respect to the market index.

Generally prices of stocks go up when the market index grows. That is why most betas are positive” (p. 9). The study by Nazliben developed three portfolios as follows: (a) a portfolio with high-beta stocks, (b) a portfolio with low-beta stocks, and (c) a portfolio with stocks having betas near 1. This is depicted in Table 2 below:

Table 2

Stock Selection Using Beta

High beta Low beta Companies having a beta near 1 Aegan Ahold Akzo Nobel

ING KPN Philips

Ranstad Unilever TNT

The results of the calculation of the return and volatility of the three portfolios set forth in Table 2 above are presented below. Each stock had an equal one-third weight in its respective portfolio:

 The return on the high beta portfolio was 0.2363 or 23.36 %, which is rather high

compared to the AEX. Over the last two years, the AEX showed a yearly return

of 21.67 %. The fact that those stocks achieved a higher return than the AEX

sounds logical because the average beta of the three stocks is 1.669. When the

AEX achieves a positive return, this portfolio should achieve a return which is

even 70% higher.

 The return on the low beta portfolio was 0.0720 or 7.2 %, which is lower than the

yearly return of the AEX. This sounds reasonable because those companies all

have low betas and they reacted less strongly to the growth of the AEX than the

companies with high betas. The difference between portfolios with low betas and

with high betas is, generally, much less than assumed. In this case, however, the

difference is substantial.

 The return on the portfolio of companies having a beta near 1 was 0.1922 or

19.22%, which is close to the yearly return of the AEX as expected because of

their mean beta of 0.997.

Taken together, the results of the Nazliben (2011) study support the growing evidence in support of beta and its applicability to increased investment risk in private banks (Iqbal & Brooks, 2007). However, investment gurus such as Warren Buffett tend to focus on other financial measures to identify optimal investment opportunities with minimal risk. For instance, according to Harper (n.d.), “To guide him in his decisions,

Buffett uses 12 investing tenets, or key considerations, which are categorized in the areas of business, management, financial measures and value” (para. 2). Rather than relying on a mean-variance analytical approach to the exclusion of other methods, Buffett prefers to

limit his investment decisions, in general, to industrial sectors. In particular, he chooses enterprises that he understands and can analyze according to his key considerations.

In this regard, Harper (n.d.) adds, “Buffett's business tenets each support the goal of producing a robust projection. First, analyze the business, not the market or the economy or investor sentiment. Next, look for a consistent operating history”

("Business" section, para. 1). Based on this analysis, Buffett makes a determination as to whether the enterprise can be considered as a long-term investment opportunity (Harper, n.d.). In addition, Buffett takes into account other financial metrics, including return-on- capital, debt-to-equity ratio, return on capital employed, and high profit margins (Harper, n.d.).

CHAPTER 3

CONCLUSION

The research showed that modern portfolio theory was developed by Harry

Markowitz, the 1990 Nobel Prize winner in economics. Based on his seminal work, modern portfolio theory has been incorporated into the mean-variance analytical approach. This approach provides a useful framework in which assets can be selected for inclusion in a portfolio in ways that maximize returns on investment while simultaneously minimizing risk.

The research also showed that this modern portfolio theory and the approach drawn from it have some constraints, including a static emphasis on diversification to reduce risk in the short term. In addition, the fashion in which income and financial wealth are treated by the mean-variance analysis means that financial wealth is considered in isolation from income. Despite these constraints, modern portfolio theory was shown to be a viable framework in which to evaluate the constituent elements of a portfolio in ways that can maximize returns while minimizing risk, assuming that the foregoing constraints are taken into account.

By further summary, the research showed that investments in private bank portfolios are fraught with downsides, including the potential for these financial institutions to include their own investment assets in portfolios and to layer charges for managing these and sub-accounts. Private bank investment advisors are also not required to be licensed by the Securities and Exchange Commission. These advisors may lack access to the types of information that their licensed counterparts enjoy, which may make their recommendations and advice less trustworthy.

In the final analysis, it is reasonable to conclude that savvy investors will use modern portfolio theory as part of an overall analytical approach to evaluating the desirability of a given investment for inclusion in an investment portfolio. Those who exercise investing wisdom will follow Markowitz’s axiom to “not put all their eggs in one basket.”

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APPENDIX

DUE DILIGENCE REQUIRED FOR INVESTMENT IN PRIVATE ENTREPRISE

Due Diligence Step Description and Requirements

Competitive It is important to understand how sustainable the target’s

Landscape and Market business model is and where it is positioned relative to its

Position: competitors.

* What is the company’s competitive advantage (e.g.,

product offering, technology, price, premium brand,

distribution capabilities, geographic presence, fully-

integrated solution, etc.)? Is this a disruptive business model

(i.e., one that changes the landscape of how business is done

in this space in some way)?

* What are the barriers to entry into the business? What are

the costs of switching to a competitor’s product?

* Where does the company fit in the industry value chain?

* How has the industry changed over the last 5 years? How

will it change over the next 5 years?

* Who are the main competitors? Where has the company

been gaining/losing market share? What firm is the biggest

threat to the company? What is the biggest share gain

opportunity?

Due Diligence Required for Investments in Private Enterprises (continued)

Due Diligence Step Description and Requirements

* What is the market landscape (e.g. oligopoly, fragmented

market, first-mover, etc.)? How saturated is the market?

Industry Growth/ When evaluating the industry, it is crucial to understand the

Addressable Market: market environment and the external factors affecting the

business.

* What is the historical growth of the market? What is the

projected growth of the market over the next 5 years? How

mature is the industry?

* What is the total addressable market? What segments of

the industry are growing faster than others?

* Describe the key macroeconomic drivers of the business.

What are the trends?

* Have there been any significant changes to the industry

landscape (e.g. disruptive new entrants, consolidation,

vertical/horizontal integration, demand/supply imbalance)?

* What are the regulatory concerns and how can it adversely

affect the business?

Capital Requirements * How capital intensive is the business? What percentage of of the Business: capital expenditures is growth capital vs.

replacement/maintenance capital?

Due Diligence Required for Investments in Private Enterprises (continued)

Due Diligence Step Description and Requirements

* How has that trended over the last 5 years? What kind of

lead-time is needed (i.e. time from purchase order to

delivery) when making a purchase order? How large of a

deposit is customary for new purchases?

* How cyclical is the business? Are there any severe

seasonal changes in demand? What are the factors? How

much visibility do you have in expected sales?

* What percentage of the cost of goods sold cost structure is

fixed vs. variable? What is the breakdown of operating

expenses?

* What is the normal working level of cash to run the

business for a year?

* At what capacity is the company running right now? How

quickly and to what extent can it be reduced if demand falls?

* What would be the biggest concern in a downside scenario? Financial Performance This analysis provides a deeper look into the company’s

(Historical & historical performance in order to understand how realistic

Projected): the company’s forecasted projections are.

* Provide a comparison of the historical performance to the

management budgets for the last 5 years. Describe the

Due Diligence Required for Investments in Private Enterprises (continued)

Due Diligence Step Description and Requirements

methodology behind the budget and the reasons for

beating/missing the budget.

* What are the key performance indicators the management

uses to monitor the business? Describe the trends in these

indicators.

* Break out organic growth over the last 5 years (not

including the impact from acquisitions).

* Provide 5-year financial model and describe the key

drivers in the projections.

* Growth: Describe key assumptions. How does it compare

to expected market growth? Where will it come from

(increase in price, increase in volume, increase in market

share, new products, acquisitions, etc.)?

* Margins: Describe key assumptions. Why (for example)

are margins expected to increase so significantly compared

to historical performance? Where will it come from

(operating leverage, cost efficiencies, higher margins on

products, revenue/cost mix, etc.)?

* Key performance indicators: Describe key assumptions.

Due Diligence Required for Investments in Private Enterprises (continued)

Due Diligence Step Description and Requirements

How do they compare to the industry average and/or the

company’s main competitors?

* What are the primary risks to this forecast (new product

introduction, successful expansion into new geography,

customer concentration, sufficient hiring of employees, R&D

resources, etc.)?