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May 10, 2004

Managing a Portfolio of Risks

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

The goal of investing is to construct a portfolio of acceptable risks that are reasonably expected to achieve desirable returns. The only way to achieve that objective is a) to be willing to take risk (which means recognizing that risk is, in fact, risk, and will occasionally demonstrate that fact), and b) to evaluate each risk in relation to the amount of return and diversification benefit that can be expected from it.

To some investors, all of that may seem obvious, but it is dramatically different from the following investment strategies, all of which are either impractical or demonstrably ineffective:

•  Trying to pick the next Microsoft, Cisco, etc;

•  Trying to buy the bottoms and sell the tops;

•  Buying into clear advances and selling into clear declines;

•  Disposing of risk because it has not recently been rewarded;

•  Taking on risk because the market has been heavily rewarding it;

•  Assuming that all risks are worth taking regardless of their price;

•  Investing based on the “obviously correct” consensus of other investors.

The risks that drive returns

If you think about the return on any security, it breaks down something like this:

Return = Independent factors + Market factors + Random factors

For us, that breakdown implies an entire investment approach. First, we focus on security selection – identifying stocks and other securities that appear to have favorable valuation, market action that conveys sponsorship from other investors and a willingness of investors to take risk in those securities, favorable industry characteristics, products, management, balance sheet factors, and so forth.

There is, of course, risk in these independent factors. The independent factors might change, disappoint, or otherwise prove unrewarding, regardless of what happens to the overall market. So our first objective is to select particular securities whose risks appear most likely to be associated with favorable returns. This is a lot of work, and for every good investor I know, is where most of the time gets allocated.

The next problem, independent of security selection, is to evaluate the market factors. Every security has some amount of sensitivity to overall market fluctuations. The question is whether to accept that impact, or to hedge it away. This is what our “Market Climate” approach is about. In general, our exposure to market risk is generally proportional to the return/risk profile of the market in each Climate we identify. The stronger that profile, the greater our willingness to accept the impact of market fluctuations in that Climate.

When overall market valuations and market action are sufficiently favorable, our returns are driven both by the particular characteristics of our holdings (the independent factors) and by the influence of the overall market. In contrast, if market conditions warrant a fully hedged position (as I believe is true in the stock market now), we try to shut down the impact of the market factors. As long as the securities we hold do not exactly replicate the indices we use to hedge, we continue to have residual “active risk” (independent factors) that will be responsible for our gains or losses, regardless of overall market movements. Virtually all of the performance of the Strategic Growth Fund from July 2000 through March 2003 was driven by active risk, since the Fund was generally fully hedged against market fluctuations during that period.

Finally, we have random factors. These represent what we view as “pure” volatility, unrelated either to the independent factors that we try to actively select, or to overall market fluctuations that we choose to accept. For any security, these random factors can be substantially positive or negative, but have an expected or “average” value of zero (which is unfortunately a useless fact over short periods of time, or for poorly diversified portfolios).

There are two ways we approach this randomness. The first is diversification. We try to construct portfolios sufficiently diversified that these “epsilons” are relatively uncorrelated, so that a negative shock to one security tends to be balanced out by flat or positive shocks in other portfolio holdings. There's no way to shut this risk down entirely unless we literally construct a portfolio that replicates some market index and then fully hedge the market risk using that same index (in this case, the expected return on the perfectly hedged portfolio, not surprisingly, would be the riskless Treasury bill yield).

The second way we approach randomness is to use it opportunistically. One of our daily disciplines is to try to buy higher ranked candidates on short-term weakness and to sell lower ranked holdings on short-term strength. Unlike the many stop-loss techniques we've tested (some of which reduce risk but none which usefully increase long-term returns), this opportunistic approach to portfolio management is an excellent way to provide liquidity to other investors, which tends both to reduce the market impact of our trading (since we tend to be buyers of securities other investors are presently selling and vice versa) and to improve return/risk performance.

In short, our job is to manage a portfolio of risks. For some investors, the objective of risk management is something separate from, even opposed to, the pursuit of returns. For us, those tasks are one in the same.

Market Climate

As of last week, the Market Climate for stocks continued to reflect unusually unfavorable valuations and unfavorable market action. The Strategic Growth Fund remains fully hedged against the impact of market fluctuations. One of the hallmarks of recent market action has been the somewhat ominous dispersion and internal turbulence of the market, which is not evident if you only watch the major indices.

For example, new highs and new lows have been simultaneously high in recent weeks (though recently new lows have flipped and are now dominant). This sort of broad internal divergence has historically been quite bad for the market, and there are a number of interesting technical indicators (including one pleasantly called the “Hindenburg”) that have been built on that fact.

Friday displayed a 12-to-1 lead of declines over advances, which was the worst single day for market breadth since October 1997, when the Dow dropped over 500 points. To have such a day on a much more modest decline in the major indices is again somewhat ominous.

That said, longer-term shareholders will recognize this Climate, and should also understand that oversold conditions have a tendency to be cleared unpredictably by fast, furious rallies that are prone to failure. Despite extensive historical research, I've found no useful way of capturing these advances or defining any “sub-climate” of conditions that does not require falling interest rates. In other words, it is dangerous to “buy the dips” in this Climate, particularly when interest rates are behaving badly.

Which brings us to the Market Climate for bonds, which remains characterized by modestly favorable valuations but unfavorable market action. In the Strategic Total Return Fund, we continue to hold a fairly short duration of 3.25 years in bonds, all representing Treasury Inflation Protected Securities (a 100 basis point move in interest rates would be expected to impact the Fund by about 3.25% in this position).

Given what I view as a fairly defensive position, the Strategic Total Return Fund has experienced what I view as an uncharacteristically deep pullback of about 7% since early April. Much of this pullback has been driven by our holdings in precious metals shares, and to a lesser extent, utility shares. While I require the Hussman Funds to be aligned with the Market Climates we observe, and the Market Climate for gold remains quite favorable, I do allow a limited amount of discretion in the specific percentage exposures and choice of securities I use to achieve those objectives. We're currently holding a smaller exposure to gold shares than is warranted by a purely quantitative view of present conditions. I have been somewhat conservative largely because the “theme trading” of investors has induced a spurious link between the U.S. dollar and U.S. bonds, which has made a portfolio including gold and bonds far more volatile than it would typically be.

As I noted last week, the result of that tight bond-dollar linkage was one of the deeper monthly pullbacks we've seen in historical tests of our fixed income approach in four decades of data. I realize that some investment managers might not consider a single-digit pullback worthy of discussion, but I believe that the better our shareholders understand our approach, risk management, and factors that influence our returns, the more likely they are to adhere to a disciplined saving and investing program, which is part of our mission.

In any event, I strongly believe that the thesis of the bond market is entirely wrong here. I'm not willing to stand in front of a train, of course, so our exposures are limited. But I still think the thesis is wrong. Evidently, investors believe that the economy is coming on strong, so the dollar has rallied, while bonds have declined substantially and gold (which moves inversely to the dollar) has plunged. Moreover, the bulk of the move in interest rates has represented a rise in real interest rates, suggesting that this is a “fast growth” thesis, not an “inflationary growth” one.

In my view, the fundamentals for the U.S. economy and prospects for the U.S. dollar are far weaker than investors recognize. The growth that we've seen is almost entirely the artifact of a one-time tax stimulus (third quarter of 2003) that hit the economy hand-in-hand with the peak of the refinancing boom. We fully anticipated that this would have a residual effect on GDP growth in the fourth quarter of 2003 through the first couple of quarters of 2004. At this point, however, the remaining impact is likely to be fairly small. We'll probably see some continued inventory rebuilding and capital expenditure, but at the expense of housing investment, with the end result that gross domestic investment will appear fairly stagnant from here. If China capitulates to rising pressures to revalue the yuan, the reduction in foreign capital inflows could be much more destabilizing to both the U.S. dollar and the U.S. economy than seems widely recognized. It seems clear that the short-end of the yield curve will do poorly in any event, though the effect on long-term nominal yields is unclear (economic weakness would provide downward pressure while inflation and capital flow effects would provide upward pressure). In contrast, foreign currencies, gold and securities providing default-free real yield (i.e. TIPS) would probably be among the primary beneficiaries. Warren Buffett isn't actively buying foreign currencies for nothing.

I recognize that many investors, particularly in precious metals shares, have a knee-jerk tendency to sell on declines. When faced with that impulse, I suggest the following acid test: if you didn't own the security, would you use that same weakness as an opportunity to buy it instead? If so, the urge to sell is based on the fact that you already have a position, not on the characteristics of the investment. At present, I am quite comfortable with our roughly 10% exposure to precious metals shares in the Total Return Fund here.

As a final note, it's no secret that apart from a small amount in money market funds, I have no investments outside of the Hussman Funds. It's probably worth mentioning that I deviated from my typical allocation and made a larger than usual investment in the Strategic Total Return Fund last week. That should in no way be construed as investment advice, is certainly not a forecast, and may not be appropriate for investors in different circumstances – but if other bond fund managers can tell their shareholders they've sold their personal holdings in the portfolios they manage, I feel fairly comfortable telling my shareholders that I've added to mine.


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