Indexing Volatility, Sharpening Performance

Dec 11 2012 | 12:27am ET

Stephen Hammers says the key to successful portfolio construction is to “equalize the risk” among asset classes so that no “one particular asset class or individual holding can hurt you.”

To do this, Hammers, chief investment officer of Compass Efficient Model Portfolios, told FINalternatives during a recent phone interview, the Nashville, Tenn.-based money manager applies a technique it calls “volatility weighting” to the 15 asset classes—subdivided into “growth” and “income” classes—in which it invests.

“What we do is we take all the growth asset classes and we weight them based on their risk, and then we equally-weight the income asset classes also based upon their risk," Hammers said. What that gives you, he says, is “significantly lower volatility than a typical stock portfolio, or stock and bond portfolio.”

When it launched in 2003, Compass, which now manages $1 billion, decided that to gain access to all the asset classes in which it intended to invest it would be “more efficient” to create its own volatility-weighted indexes, Hammers, who began his career with Merrill Lynch and who was the founder and CIO of Trinity Planning and Consulting, said.

These (patent pending) indexes, now published by Dow Jones, form the basis for the firm's 16 mutual funds, 13 individual asset class funds and three multi-asset class funds. One of the indices, the CEMP U.S. Large Cap 500 Volatility Weighted Index, has beaten the Standard & Poor's 500 Index 10 out of 11 years.

“The S&P 500 is not a broad-market index because all the weighting and all the performance comes from the top few stocks,” said Hammers. “A big chunk of the S&P return this year is Apple. If Apple had not done well this year, the S&P would be a lot worse than what it is."

“It's amazing, if you look at every single bull market and bear market going back to 2000, our long/cash index beats the S&P because the S&P's return all comes from about 50 stocks.”

Risk Weighting

To explain how the Compass EMP volatility-weighted indexes work, Hammers uses the example of commodities. “Most commodity portfolios are production-weighted, which means they have a lot of energy in them. A lot of commodity indexes are production-weighted. The Goldman Sachs Commodity Index has over 70% energy. Well, it's an energy fund, it's an oil fund. The Dow Jones UBS commodity index is over 50% energy,” Hammers said.

“Because we evenly weight the 20 most liquid commodities based on their risk, every commodity has the same contribution to our commodity portfolio or our commodity index, the CEMP Commodity Volatility Index. It has, so far, superior risk-adjusted returns to any other commodity index or portfolios going back many years."

“We take that and use it as a commodity long/only, but we also take that and do a commodity long/short off of it because every single calendar year there's always at least four or more of our 20 most liquid commodities that are down. It's not like stocks; there's always a commodity asset that's down. One year it could be oil, the next year it could be silver and the following year it could be cattle. It's just the way they are.”

Alternatives

Within the mutual fund wrapper, Compass offers investors some hedge fund-like strategies. The Compass EMP Alternative Strategies Fund, for instance, is “only alternative assets,” according to Hammers.

“We take all those growth alternatives and we put them together and we weight them all on their risk. U.S. long/short, international long/short, we have a long cash, managed futures, real estate, commodity long-only, commodity long/short and a global bond hedge. When you put it all together, you get something different.”

The alternatives fund aims to return 9% to 11% over time but “it gets there in a different way than stocks do because of its ability to be long/short or long/cash and that sort of thing,” said Hammers. “If you look at its volatility versus the S&P, it's about 70% less.”

Hammers sees indices like Compass' long/cash index for stocks as appealing to retail investors, “simply because a lot of investors don't really understand long/short, they don't understand managed futures, they don't understand a lot of high-tech stuff, but what they do understand is when you're in the market and when you're not.”

The overarching goal, according to Hammers, is to build portfolios containing many different asset classes having low-to-negative correlation.

“The problem with many portfolios is that people will overweight and underweight based on what they think is going to happen, or they may overweight a portfolio they think is going to have a better return, and when they go through a market cycle they wind up being very surprised, because one particular asset hurt them more than they expected or one particular asset they had too much of it and it didn't really help that much. We actually explain and help people understand that, if you have a portfolio and you don't have assets that can force or give you low correlation when you need it, it doesn't do any good.”


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