Insight May 2013 Vol. No. 3 No. 2 www.ipexusa.com Modern Portfolio Theory Statistics and What They Mean Given the events of the last several Beta: Although alpha precedes beta in years, investors have become more the Greek alphabet, beta is a Mission attuned to the risk characteristics of necessary precursor to understanding Statement investments. As volatility in the alpha. Beta can generally be defined market continues, investors are as the risk factor of a portfolio to the To provide paying more attention to the market, which is usually achieved independent relationship between the and objective potential for reward and the likelihood of experiencing investment losses. Modern Portfolio consulting Theory (MPT) is used by services to many investment not-for-profit professionals to help organizations. investors make appropriate investing and asset allocation decisions. MPT is rooted in the assertion that there is no free lunch, as investors can only obtain higher returns if Shale P. Lapping they are willing to take on President more risk. Knowledge of MPT statistics through asset allocation. A beta such as alpha, beta, and R-squared number of 1.00 implies that the are useful to understanding and portfolio will perform exactly how the Steven J. Cupchak quantifying this risk/reward landscape. continued on page 3 Vice President IPEX - Investment Performance Evaluation Xperts Kathleen Serafino IPEX is a boutique firm owned by active employees. IPEX advises clients in Vice President structuring, implementing and evaluating their investment programs. IPEX helps clients develop investment policy statements, conduct money manager searches, prepare asset allocation studies and monitor investment 888-IPEX-USA performance. IPEX offers a full range of investment consulting functions. IPEX maintains no affiliation with any money manager or brokerage firm. Our only source of compensation is the fees we receive from our clients. IPEX can work with a client’s existing managers and financial institutions or we can help clients to replace their service providers. The independent structure of our firm enables IPEX to provide objective advice Scan to go to and recommendations, thereby ensuring that clients make informed decisions our website and fulfill their fiduciary responsibilities. Page 2 Insight Investing with a Long-Term Focus It’s easy to follow a long-term investment strategy in good times; the hard part is sticking with it during bad times. What should you do if your organization is a long-term investor sitting in the midst of a bear market? If you are holding a well-diversified “Volatile markets can portfolio, the answer is rather cause investors to straightforward: stay the course. abandon their long- term goals for risky Volatile markets can cause investors to short-term investment abandon their long-term goals for risky short-term investment strategies. strategies.” Volatility can range from a single-day market crash to extended periods of jagged performance. The market has undergone cycles with high and low annual returns from 38% (1995) to - instead of lump-sum purchases, to 37% (2008) over just the past 20 ease into new investments. Dollar-cost years. It can be tough to stay the averaging involves the purchase of course in the face of such fluctuations. securities, usually mutual funds, in fixed dollar amounts at regular The graph illustrates annual stock intervals. This strategy is maintained market performance since 1963. The no matter what direction the market is bull market from 1991 to 1999 lasted moving. Finally, staying focused on a the longest, with an average annual long-term investment plan should help return of 21%. In contrast, a majority your investment program to of the downturns shown in the image participate in recoveries. have lasted for shorter periods of time. “...with a disciplined Despite the ups and downs over the Overall, the stock market has exhibited positive performance in the approach to investing, years, the stock market generated a compound annual return of 9.8% over past, but be prepared for periods of one may be able to this historical time period. underperformance, which can be take advantage of sustained. The fact is no one can market rebounds...” It goes without saying that the market predict market declines with any type will head south at times, but history of certainty. Regardless, with a shows that despite these bumps, the disciplined approach to investing, one market’s long-term trend is upward. may be able to take advantage of market rebounds and enjoy solid A disciplined investment approach is returns in the long run. Don’t be still the best strategy for handling sidelined by (or overreact to) market market downturns. This includes expansions and contractions. Stay the maintaining a well-diversified portfolio course! and using dollar-cost averaging, May 2013 Page 3 Modern Portfolio Theory continued from page 1 market performs. A beta number greater cognizant of the fact that a higher beta than 1.00 implies that the portfolio will does not necessarily equate to a higher perform better than the market when the alpha; a portfolio with a high beta may market is going up, and worse than the well sport a negative alpha. This is due market when the market is going down. to the fact that the greater the risk the “… being able to Conversely, a beta number lower than portfolio assumes, the higher the hurdle generate alpha is 1.00 means that the portfolio is expected the portfolio must overcome in order to touted as the holy to perform worse than the market when outperform the market. grail of investing.” the market is going up, and better than the market when the market is going R-squared: The R-squared value is a down. As Beta can be used to track number that measures the strength of a performance against any market, it is relationship (correlation), important to understand how the market is demonstrating how much a portfolio’s being defined. performance can be explained by the performance of its benchmark. The Alpha: Alpha, a measure of the excess higher the R-squared value, the more return generated by a portfolio that goes closely the portfolio’s performance can beyond the benchmark, is the residual (or be explained by the index it tracks. The skill/luck-based) component of active lower the R-squared value, the more management, allowing money managers likely the portfolio doesn’t behave much to display their value. The benchmark is like its index. R-squared values can usually a market index that the portfolio range from zero, meaning there’s no can be compared against to assess its degree of performance correlation “Investors trying to performance relative to the market. If between a market benchmark and a understand or alpha is positive, it means that the given portfolio, to 100, meaning that a portfolio returned more than its expected portfolio is highly correlated with the interpret these return from the market (after taking the index. More importantly, a higher R- MPT statistics are portfolio’s Beta into consideration), squared number validates the relevance best advised to whereas a negative alpha indicates that of the alpha and beta numbers. seek Professional the portfolio returned less. investment Alpha and beta are the heart of advice...” Should investors be impressed if a money traditional performance (risk and manager is generating positive alpha for return) analysis, although they do their portfolio? In general, yes, being able come with their own caveats and to generate alpha is touted as the holy limitations. Investors trying to grail of investing; it’s an indication that understand or interpret these MPT your money manager has been able to statistics are best advised to seek generate an above-average return relative professional investment advice to to the risk that he or she is taking on. ensure they are allocating risk However, before investors put too much appropriately. A better understanding stock in the statistic, it’s important to of these statistics can go a long way in know what these statistics mean, and why making better investment decisions. they are important. Investors should be www.ipexusa.com Page 4 1st Qtr 2013 Returns Fixed Income Domestic Stocks +2.8 High Yield Bonds +13.2 Small Cap Growth -0.1 Investment Grade Bonds +12.9 Mid Cap Core -0.5 Treasury Inflation Protected Bonds +12.3 Large Cap Value -1.6 Emerging Market Bonds +11.6 Small Cap Value -3.5 Developed Market Bonds + 9.5 Large Cap Growth International Stocks Alternatives +8.4 International Small Cap +8.4 Real Estate +5.4 Asia/Pacific Region +5.0 Long/Short Funds +5.1 International Large Cap +3.2 Global Macro Funds Quarterly Market Barometer Market Quarterly +2.4 European Region +0.4 Market Neutral Funds -1.6 Emerging Markets -1.1 Commodities .