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As investigators continue to sieve through the wreckage of the 2007–2008 global financial crisis, one factor drawing attention is risk. The period before the crisis—known as the “Great Moderation” because it seemed that macroeconomic instability had been tamed—was a time of exuberance, wild hope and animal spirits when great profits were made.
The collapse of Lehman Brothers in September 2008, and the financial shock waves it caused, put an end to the notion of stability. It also called into question many beliefs about risk management—for example, the idea of diversification. Based on Portfolio Selection by Harry M. Markowitz, recipient of a Nobel Memorial Prize in Economic Sciences, many investors believed that reduced portfolio risk could be achieved simply by holding uncorrelated instruments.
As shown in Rethinking the herd, a 2008 Project M article by Dr. Christian Schmitt, as markets increasingly move in lockstep, it seems the attendant increase in correlations could unhinge this cornerstone of portfolio theory. As a result, many investors started taking a more active approach to managing downside risk. Strategies that address equity tail risk—“tail-risk hedging strategies”—in particular gained attention after 2008, although many sponsors find them ill-suited to long-term allocations. They can be expensive and may come with a high opportunity cost: Buying drawdown protection through put options can easily cost a few percentage points in implicit hedging costs year after year.
Some investors are turning to an approach known as tactical asset allocation (TAA), seeking to improve the risk-return profile of portfolios. Unlike diversification, TAA strategies have an objective to deliver alpha rather than meet a return target with minimal risk. But such strategies base rebalancing decisions on short-term return estimates that can be difficult to forecast. This means that regardless of returns, they may not be effective tools for risk mitigation.
Another approach is dynamic risk mitigation, a plan-level approach based on diversification and dynamic asset allocation. Similar to TAA in that it relies on rules to shift the portfolio’s asset allocation, a dynamic asset allocation (DAA) strategy integrates risk management with alpha generation. It synthesizes the benefits of diversification to potentially enhance the alpha potential of a portfolio. While dynamic risk mitigation does not provide the same downside protection that other strategies such as option-based tail-risk hedging may provide, it comes without the high price tag. Advocates argue that when successfully implemented, such a strategy can provide similar loss profiles with high confidence at a lower cost.
Typical institutional investors face the twin tasks of trying to avoid the dramatic loss of assets that occurred during recent financial crises, while delivering returns that meet or exceed the return of the strategic asset allocation in the long run. This is no easy task. To achieve both goals of a typical institutional investor—drawdown protection and upside participation—an efficient DAA strategy targets two dimensions: the return relative to the strategic asset allocation (SAA) benchmark, and the risk budget.
Ensuing risk budget
A dynamic risk-mitigation approach should be aligned with plan-level objectives and eliminate the need to place bets on asset-class return forecasts. The key is a pre-defined risk budget measured by capital loss (or funding-ratio loss), not tracking error or standard deviation. This can guide a rules-based allocation shift between return-seeking growth assets and defensive assets using simple inputs that can be measured: portfolio return versus the overall benchmark (static SAA) for the previous trading day; and portfolio value versus the remaining risk budget for the previous trading day. For dynamic risk-mitigation strategies to be effective, they should not interfere with a plan’s existing portfolio structure or managers. When implemented with an overlay, they can be cost-effective, as futures can be used to achieve the desired exposures.
Dynamic risk mitigation at its simplest should reduce risk-asset exposure when markets are declining and add it when risk assets are rising. This is pro-cyclical but does not fully exploit the cyclicality of asset-class returns. Most asset classes exhibit both “trending” and “mean-reverting” return patterns. That is, they cause medium-term cyclicality around longer-term risk premiums. Cyclicality is best captured by a version of risk mitigation that is created through a combination of pro- and anti-cyclical allocation responses to the return dynamics of asset classes.
Pro-cyclicality is captured in the notion that “the trend is your friend.” That is, it increases the risk exposure of a portfolio in good markets and decreases risk exposure in declining markets. Anti-cyclicality is about mean reversion. This decreases risk, although markets have performed well, and increases risk after or during market declines. The idea is that performance will ultimately catch up, and that rebalancing a portfolio back to its initial allocation is the best way to achieve the desired risk-return profile.
By combining pro-cyclicality with anti-cyclicality, the allocation seeks to balance “as many return-seeking assets as possible” with “as many safe assets as necessary” to meet the SAA return target within the risk constraint. At the core is a set of rules that drive the decisions when to take profits and when to re-enter markets. If the rules are effective, and a dynamic risk-mitigation strategy is successfully implemented, a portfolio could dynamically deploy risk-seeking and capital-preservation strategies.
How effective will dynamic risk mitigation be? Only time will tell, but it looks to enhance traditional notions of risk management while seeking to eliminate the weaknesses glaringly exposed during the financial crisis.
This article was originally published in Project M, an Allianz SE International Pensions publication featuring unique perspectives on investments and retirement.
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.
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