The recent revelations of a $50 billion Ponzi scheme at Bernard Madoff Securities will have repercussions far and wide across Wall Street, Main Street and obviously within the offices of regulators who were clearly asleep at the switch.
The Madoff scandal also points up some of the benefits of working through a large, well-known company like Vanguard.
But the greater lessons to be taken away from this situation are some of the classics that I have always preached and continue to live by.
First, always understand the investment process and philosophy of the investment manager you work with. Very few of Madoff’s clients actually understood what he was doing. If they had, they’d have known it could not possibly succeed.
Within Vanguard there is pretty good transparency as mandated by the regulations concerning mutual fund companies. But it isn’t perfect.
I believe some of my research and unbiased questioning of things that many investors take for granted, though, leads to even greater transparency when it comes to your Vanguard investments — particularly my willingness to call a dog a dog when one of Vanguard’s funds truly stinks — such as Diversified Equity (VDEQX), for instance, or Growth Equity (VGEQX), or when former Chairman Bogle would write to his “fellow” shareholders though he wasn’t actually a shareholder in the fund, or when former CEO Brennan would wax on about stocks a particular fund held when it actually didn’t, or at least not for the period he discussed, or — well, you get my point.
Second, there is no free lunch. The notion that someone could guarantee small, consistent returns month after month for years on end may have raised some eyebrows, but it apparently wasn’t worrisome enough to keep investors from giving Madoff billions. If it seems too good to be true, it almost certainly is. Period.
Finally, the idea that hedge funds and funds-of-funds and high-net-worth investors are somehow more sophisticated or smarter about how they invest, or can generate higher returns for their clients…
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…is simply false. Again, there is no free lunch, and investors in the funds that invested with Madoff are now paying a very high price for their ignorance.
How to Know Your Risk
One of the ways I assess risk, besides the Greek alphabet soup of betas and standard deviations and relative volatility measures, is something I believe is much more practical, and which speaks plainly to you and me when we talk about portfolio risk: Maximum Cumulative Loss, or MCL.
Maximum cumulative loss is akin to a “drawdown,” something commodity traders have used to measure risk for decades. It looks at how much you actually lost, rather than assigning some Greek letter or mathematical factor to your holdings. It’s one thing to say a fund has a beta of 1.35, which means it can move 35% more than the market in either direction. But it’s quite another to say, for instance, that the worst loss suffered by a shareholder in that fund was 35%. You tell me which one makes more sense to you. (Learn more here.)
In any case, I measure MCL on a monthly basis, using month-end performance and pricing. For example, take Windsor II (VWNFX). The fund’s shareholders took a 28.2% hit during the 2000 to 2002 bear market, but in the current market it has dropped 43.8% from its high, through November.
Knowing one particular fund’s MCL is helpful, but being able to put them all together — with the underlying data — to measure portfolio risk is even more useful. I have built a proprietary risk calculator that we use at Adviser Investments, my portfolio management company, that I use for assessing portfolio risk when combining various Vanguard funds into one portfolio.
The calculator measures maximum losses as well as worst-case one-year, three-year and five-year returns on a rolling basis. As is often said in the investment business, historical performance is no guarantee of future performance. But when it comes to measuring risk, I can’t think of a better way to do so than to use historical periods to get a sense of how a fund or portfolio of funds might perform when the storm winds are blowing.
Members who read Dan Wiener’s Independent Adviser for Vanguard Investors know how much he despises risk. He goes to extraordinary measures to make sure your Vanguard risk is prudent and as small as possible. And, of course, he provides updated year-end MCLs and graphs for every Vanguard fund in the 2009 Independent Guide to the Vanguard Funds. If you haven’t yet reserved your copy, sign up for Independent Adviser today and receive your copy absolutely FREE. Click here now to learn more about this special offer.
