Adding Value By Managing Risk Information Gap
By: Denis R. Taillefer
Managing the risk definition gap is as important as managing risk. Denis Taillefer, of the Montreal Exchange, looks at how value is added by managing risk.
In a 1952 edition of the Journal of Finance, Harry Markowitz, with his paper entitled ‘Portfolio Selection,’ laid the foundation for Modern Portfolio Theory (MPT). He addressed the issue by stating that portfolios are either constructed in such a way as to produce the highest expected return at a given level of risk or the lowest risk for a given expected return. The efficient frontier became synonymous with maximizing returns while minimizing risk.
MPT is about diversifying away all possible unsystematic (diversifiable) risk with a portfolio of un-correlated or negatively correlated financial instruments until only market risk remains. The underlying premise of his theorem was that:
- Risk is equally as important as returns
- Risk can be minimized through a quantifiable diversification process
Risk is a wide topic and caries a different definition depending on whose opinion you’re soliciting. An institutional investor might define risk symmetrically as the dispersion or standard deviation of returns around the mean regression line whereas individuals usually define risk asymmetrically as an adverse dollar change in the value of their holdings.
As a case in point, someone recently told me that they thought Japanese equities were now risky. “Now risky, how’s that?” I asked.
“Well, they’ve been going down recently and have under-performed throughout the ’90s!” was the response. Now as true as that might be, it does not necessarily mean that they’re any more risky now than they were 10 years ago.
Consequently, managing the risk definition gap will be as important as managing risk itself, going forward. For example, these days, when clients tell us they want to minimize risk, what they’re really saying is that they want to avoid absolute losses.
Most investment management strategies and processes focus on maintaining portfolio risk and returns in an equilibrium based on maximizing each client’s utility curve.
For example, institutional portfolio management generally revolves around adding value in excess to a portfolio benchmark such as the S&P/TSX 60 or the S&P500. Consequently, managing benchmark risk is essential for most institutional investment management firms.
Notwithstanding, rewards have traditionally been viewed first with risks at an acceptable level and thereafter because, from a marketing standpoint, it’s more appealing to converse about the process that seeks to uncover the most undervalued opportunities or identify the next growth stocks or sectors than it is to explain the value and process of risk control, let alone the process of containing risk in absolute terms. Moreover, with the exception of dedicated cash flow and dynamic immunization mandates that seek to maximize a minimum guaranteed portfolio, very few investment policy and goal statements stipulate risk in terms of measurable objectives … at least not on a stand-alone basis.
However, following two years of negative returns, with major equity markets continuously challenging technical support levels, it’s not surprising to hear that risk control is the primary topic of discussion.
There are four elements to investing:
Even though risks are uncertain, they’re manageable. The same holds true for time (by choosing your entry and exit points) and fees (supply and demand). However, in the context of an equity portfolio, returns are both uncertain and unmanageable. Therefore, the plurality of the investment management process should begin by quantifying the elements that are manageable: namely risks.
Risk includes many subsets including Market, Interest, Political, Sovereign, Currency, Credit, Liquidity, Model, Counterparty, Basis, Operational, and Legal. Each one of these may adversely and materially impact the value of a portfolio and should, therefore, be assessed and dealt with accordingly.
The most important is market risk which, incidentally, is the most challenging. Current practices that attempt to reduce market risk include:
- tactical asset allocation
- raising cash
- market neutral hedging models
Even then, these might only offer partial solutions. You’re either reallocating equities to other regions or sectors that may equally be affected by a systemic pull back or taking money off the table through market timing or hedging the market and, consequently, limiting your upside in the process.
Moreover, switching asset class to straight bonds in a rising interest rate environment is analogous to jumping ship into a deflating life raft.
Finally, implementing a full market hedge ‘a la Alfred Jones’ is not the solution and problematic at best.
The point is that we don’t want to reduce or neutralize market risk. We do, however, want to minimize its downside and not only during periods of financial stress.
Once the decision to manage market risk is accepted in principle by all concerned, it then falls on the plan actuary to advise the plan sponsor as to maximum loss the plan is able to withstand over one or several horizon periods. This process should identify the minimal acceptable rate of return to satisfy the plan’s objective. It’s then up to the investment counsels to strategize and implement policy control guidelines that are both agreeable to, and fully understood by, the plan sponsor.
While standard deviation is the generally accepted measure that identifies the risk of not achieving the mean, it’s not appropriate for downside protection since it operates in a quasi-symmetrical, two-tailed environment of positive and negative returns.
Approaches to modeling and managing asymmetrical ‘tail risk’ based on Value at Risk (VaR) are more appropriate. Value at Risk, for example, is used to identify the minimum acceptable return by identifying the maximum loss for a specific time horizon, at a given level of confidence. However, like many other models, VaR is an ex-post method that only takes into consideration historical events. Consequently, several techniques should be utilized since each model has its share of limitations.
Once the minimum acceptable return, or maximum loss, has been identified, implementing a stop-loss strategy comes next. Since there’s always a cost to insure the portfolio from sustaining a loss, we would want to identify the funding methodology that’s both appropriate and acceptable for the client.
Another decision is whether to implement the portfolio insurance strategy as an overlay or at the fund level. For example, should your plan have the appropriate characteristics to utilize the services of a hedge fund, you may be able to port the alpha generated by the market neutral strategy as a funding instrument to subsidize the overlay.
In this context, you may believe that it’s best to use the services of a specialist firm. However, since the incumbent managers are always best positioned to fine-tune the risk control measures specifically to their portfolios, you might feel it makes more sense to implement the stop-loss strategy for the plan, starting at the fund level.
One of the simplest and most efficient structures that can be used to implement a stop-loss mechanism at the fund level is a synthetic short collar. It’s constructed through the combination of a short call option and a long put option with the same expiry date but with different exercise prices. This strategy is also known as a zero-cost (or cashless) collar. (I don’t particularly like this label because it implies getting something for nothing, which is rarely the case. Every strategy has a tradeoff because if it didn’t, it would be called an arbitrage.)
Unlike an ‘At the Money’ synthetic short position illustrated through put-call parity, a collar provides a flexible width or range made available through different strike prices that’s completely adaptable to any core portfolio (Charts 1 & 2).
The stop-loss protection (which incidentally offers the benefit of no-slippage) is provided by purchasing put options with strike prices set at or near the VaR limit. Meanwhile, the funding is made available by writing call options on the core holdings with strike prices set at, or slightly higher than, the stipulated sell targets.
Trading-off the upside may appear as counter-intuitive but it’s literally an extension to your managers structured sell disciplines. Essentially, this process monetizes the uncertain future capital gain opportunity beyond the sell target (which they didn’t believe was going to materialize anyways) to subsidize the purchase of the put options that provides the absolute stoploss protection for the period. Moreover, it offers a simple solution to a very real, often misunderstood yet manageable, problem.
Since the downside risk is being truncated at the fund level by avoiding potential losses, volatility is minimized in the process. Consequently, standard deviation is reduced, returns to risk ratios are enhanced, and portfolio risk/return profiles on a scatter gram are tilted closer to the top left quadrant (High Returns/Lower Risk).
Furthermore, the investment management industry is extremely dynamic and new metrics are constantly being introduced to quantify the value-added benefit through risk avoidance. One of these, for example, is the upside potential to downside risk ratio (UPR), which provides the average return in excess of the portfolio’s minimum acceptable return.
Markowitz demonstrated that only market risk remains once individual risk is eliminated through diversification. Jones hedged away market risk through pairs trading. Our choices are no longer limited to living with or without market risk. There are two sides to market risk and, without choosing either extreme, steps can be taken to benefit from the upside while managing and restraining the alternative. Going forward, the firms that will differentiate themselves are those whose skill sets are able to add value regardless of market direction, both in relative and absolute terms.
Denis R. Taillefer is regional manager for the Montreal Exchange.
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