Aurora Borealis
13 July 2018 Financial Analysts Journal Book Review

Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility (a review)

  1. Nick Ronalds, CFA
Reducing the Risk of Black Swans is a compact handbook by practitioners for practitioners on how portfolio managers and investors can use the empirical findings of financial research to optimize portfolio construction. It explains the work of such pioneers as William Sharpe and Harry Markowitz in the 1950s and 1960s, Eugene Fama and Kenneth French on the three risk factors in the 1990s, and more recent work that has uncovered additional risk factors. The focus throughout is on actionable tools and instruments that enable practitioners to translate theory into practice.

Financial industry practitioners know that theoretical and empirical research over the past half-century or so has created the tools to construct portfolios according to far more scientific principles than the seat-of-the pants methods from prior eras. In this compact handbook, Larry Swedroe and Kevin Grogan, CFA, explain the scientific state of our investment knowledge in an accessible fashion to provide investment advisers and sophisticated investors with all the tools our current state of knowledge—and investment technology—allow.

The first pioneer in this scientific revolution was Harry Markowitz, who, in the authors’ words, showed that “it’s not a security’s own risk and expected return that is important to an investor, but rather the contribution the security makes to the risk and expected return of the investor’s entire portfolio.” He was followed by William Sharpe and John Lintner, who developed the capital asset pricing model (CAPM), the first precise definition of risk and how it drives returns. In the next three decades, researchers identified anomalies with CAPM that demonstrate the shortcomings of both the model and investment science to that point. A large chunk of stock returns—about a third—was unexplained by beta alone. These lines of inquiry culminated in the work of Fama and French, who in 1993 proposed a three-factor model showing that sources of return “unexplained” by the market factor are largely driven by company size and the value-versus-growth factor. This advance shrank the unexplained portion of equity returns to less than 10%.

Larry Swedroe is an experienced financial professional, author of a number of investment books, and currently principal of Buckingham Asset Management. Kevin Grogan is director of investment strategy at the same firm. They also co-authored the 2014 edition of Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility.

This new edition revamps the previous one by elucidating two key developments: (1) “the ‘retailization’ of investment strategies that were once solely the domain of hedge funds and institutional investors such as the Yale Endowment Fund” and (2) the fintech revolution, which has disintermediated traditional lenders and, in the process, created new channels of access for a broader swath of investors. These developments, according to the authors, have made possible investment vehicles that embody uncorrelated return factors beyond the Fama–French set. As a result, financial advisers and sophisticated retail investors can avail themselves of the full menu of style and risk factors previously accessible only to endowments and other large institutional investors via private equity, hedge funds, and more-esoteric vehicles.

Guiding the reader through these developments up to the present, the authors show how each step along the way has enabled investors to approach the ideal of maximizing return per unit of risk. They describe five “alternative” factors and explain how each one can be used to create more efficient portfolios, where to find these factors, and how to incorporate them into portfolios. These alternative sources of return—such as momentum, reinsurance, and the variance risk premium—are equity like but with low or no correlation to the Fama–French factors.

The story gets a bit muddled at one point, when the authors discuss the AQR Style Premia Alternative Fund, which invests long and short across six asset groups: stocks of major developed markets, country indexes, bond futures, interest rate futures, currencies, and commodities. Are the authors claiming that these premia are new and different from others already discussed, or that they are the old premia in new packaging? Their point is not clear. A reader might also wonder whether the performance records and diversity of products available for some the new investment vehicles sustain enough competition among funds to ensure the quality and governance that prudent investors require. But these gripes are minor for a book with many strengths.

One particular strength of this volume is that the authors show exactly what happens to both return and risk as each style factor is added to a portfolio. In the process, they clear up several misconceptions that are widely held, even among professionals, about such basic concepts as correlation and the measurement of style factors. Another strength is clarity. For example, Swedroe and Grogan identify specific investment vehicles available in the markets for obtaining exposures to style factors and state which ones they recommend to their clients.

No mathematics is needed to understand Reducing the Risk of Black Swans other than a basic knowledge of statistics. In assembling portfolios via funds with style tilts, the authors use round-number increments such as 5% or 10%. This intuitive approach helps make the book accessible and easy to read despite its information richness.

The appendices contain additional valuable material on style factors, REITs, how to evaluate passive funds, and more, including the mostly overlooked importance of knowing “when you have enough”—the answer to which should profoundly affect one’s investment strategy.

In summary, this short but information-dense book is a valuable resource for any financial services professionals seeking to sharpen their understanding of how to build better portfolios.

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