Investment returns have always found a natural place in the spotlight. But volatility, and the impact it can have on a portfolio, is only now getting the attention it deserves.
I recently attended a seminar where volatility as an asset class was discussed, along with the opportunities available through volatility hedge fund managers and risk management firms. The seminar not only illustrated the powerful risk management and diversification attributes of volatility but also uncovered two key differences in risk management philosophy.
On one side stands the “alpha rock stars” of the industry—hedge fund managers who apply their skill by taking advantage of mispricing opportunities across derivative markets or taking bets on the likelihood of a negative outcome. Their strategies (such as pure play long volatility, convexity, and divergent global macro managers) can provide diversification and potentially buffer market risk exposure through an ability to make money in market dislocations or periods of high volatility. On the other side are managers that use explicit risk management techniques. These techniques are fully transparent and rules based, leading to generally predictable performance during extreme market conditions.
While alpha managers can certainly provide diversification for a portfolio, they do not necessarily seek to directly manage the risk exposures within a portfolio. It is when markets are particularly stressed that they can generate substantial returns through their long optionality bets. While many of these don’t pay off, the downside is limited compared to the potential upside.
Given the relative complexity of many of these alpha strategies (e.g., variance swaps, swaptions and other OTC derivatives) it makes sense that the many skilled fund managers can potentially outperform less skilled managers and generate alpha.
Complexity is a deterrent
However, assessing such complex strategies also acts as a deterrent for financial advisors and their investors. Operational issues, leverage, and custody risks compound an already difficult story.
Meanwhile, alpha managers’ trading strategies may not always be transparent. For example, alpha-seeking managers may use discretionary option trading strategies in an effort to provide a beneficial exposure to volatility or manage downside protection. The high price of options means these managers will typically rely upon opportunistic bets, timing the market or volatility levels. Further, many option strategies may use spreads and/or covered calls that do not provide long optionality or convexity, thereby limiting the level of downside protection.
For many investors, uncertainty around performance and a lack of predictability continues to limit the popularity of these investment options.
In contrast, explicit risk management strategies are growing in popularity among retail investors. These strategies have been used for many years by defined benefit plans and insurance companies to manage risk on their balance sheets, and are now making their way to advisory practices. In these scenarios, the mantra is that “boring is better,” with transparency and direct risk management as the key to their appeal.
The combination of a well-diversified portfolio and explicit risk management aimed at stabilizing volatility and avoiding large losses (rather than outperformance of a benchmark for a performance fee) underscores this distinction in philosophies.
For many of these explicit approaches, any hedging of risk is applied to the actual portfolio holdings of the investment and as a result, is not reliant on predicted asset class correlations. Explicit risk management also has a negative expected return (and negative correlation to the risk being managed), which is analogous to the price paid for insurance or reduced market exposure.
Opportunistic plays
Alpha rock stars don’t take this approach. Often, their discretionary strategies are impossible to model with certainty and should only be viewed as opportunistic plays at managing potential risk factors. While they may offer compelling general usage in a well-diversified portfolio, explicit protection isn’t granted and is not able to be measured.
Investors face numerous risks. Some of these risks can be managed through diversification. However, as the global financial crisis underscored, expected diversification benefits may not be present when needed most.
Alpha rock stars may provide diversification benefits through their absolute return goals and bets on various potential systemic events. But a more sedate explicit risk management approach should be used when a more predictable outcome is demanded and an investor is concerned that portfolio diversification alone is not a prudent risk management policy. Given the need for greater stability in returns by those approaching and entering retirement, it may be a case that actuaries will indeed inherit the risk management earth.
The materials in this document represent the opinion of the authors at the time of authorship; they may change, and are not representative of the views of Milliman FRM or its parents, subsidiaries, or affiliates. Milliman FRM does not certify the information, nor does it guarantee the accuracy and completeness of such information. Use of such information is voluntary and should not be relied upon unless an independent review of its accuracy and completeness has been performed. Materials may not be reproduced without the express consent of Milliman FRM. Milliman Financial Risk Management LLC is an SEC-registered investment advisor and subsidiary of Milliman, Inc.
The information, products, or services described or referenced herein are intended to be for informational purposes only. This material is not intended to be a recommendation, offer, solicitation or advertisement to buy or sell any securities, securities related product or service, or investment strategy, nor is it intended to be to be relied upon as a forecast, research or investment advice. The recipient should not construe any of the material contained herein as investment, hedging, trading, legal, regulatory, tax, accounting or other advice. The recipient should not act on any information in this document without consulting its investment, hedging, trading, legal, regulatory, tax, accounting and other advisors. Information herein has been obtained from sources we believe to be reliable, but neither Milliman Financial Risk Management LLC (“Milliman FRM”), nor its parents, subsidiaries or affiliates warrant its ¬¬completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties.
The products or services described or referenced herein may not be suitable or appropriate for the recipient. Many of the products and services described or referenced herein involve significant risks, and the recipient should not make any decision or enter into any transaction unless the recipient has fully understood all such risks and has independently determined that such decisions or transactions are appropriate for the recipient. Investment involves risks. Any discussion of risks contained herein with respect to any product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved. Investing in foreign securities is subject to greater risks including: currency fluctuation, economic conditions, and different governmental and accounting standards.
© Milliman Financial Risk Management
