Some of the toughest compliance and investment teams in the industry have done a deep review of our portfolio risk methodology. Despite the complexity of accurately setting risk and reward expectations for every US stock, ETF, mutual fund, 130,000 VA subaccounts, 10,000 third party money managers and a number of non-traded proprietary strategies, our advisors have benefited from an approach that has valued objectivity and simplicity above all else.
Our methodology uses the actual price history of a security as the underlying basis for our risk assessments. Ideally, that price history encompasses a complete market cycle, including a full bear market. When advisors utilize younger securities that haven’t seen a full bear market, we’ve traditionally used whatever data was available and highlighted the limited history.
However, as time goes on without another bear market on the books, more and more advisors are using younger securities. Traditional industry workarounds, like proxies, loose benchmarks or unproven ratios, seemed like unacceptable band-aids to us. It was time to invent a better solution.
Today, we’re excited to announce Extrapolation, a key addition to our methodology that dramatically strengthens the risk/reward assessment of young securities.
Using sophisticated pattern matching algorithms, Extrapolation uses the actual data of younger securities to find similar securities and fill in the missing history with a close approximation of how the security would have performed during 2008 and 2009.
How do we know it works? Beyond the extensive testing we’ve performed, let’s just use EFA as an example. This fund dates back to Aug 24, 2001. According to the long term consensus data model, Riskalyze assesses its six-month downside risk at -22.2%.
If we remove all of the history prior to June 2010, which includes the 2008-09 bear market, the risk in the security collapses. The six-month downside drops to just -14.7%.
But when we run EFA through Extrapolation (still with only the historical data back to June 2010), the six-month downside goes back to -22.9%…less than a point away from the actual downside risk.
The killer proof point: in a test of 800 mutual funds and ETFs that existed before 2008, Extrapolation got 95.4% of those funds within two points or less of their risk levels using the actual historical data.
No longer will an investment without 2008 “street cred” outshine a tested strategy, and no longer is a young security penalized simply for being the new kid on the block. Extrapolation is a huge step forward in assessing portfolio risk, while maintaining the values of objectivity and simplicity that serve our advisors well.