The two sides of risk management: Alpha rock stars versus actuarial nerds

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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 showed two key differences in 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 which use explicit risk management techniques – they are fully transparent and rules based, leading to 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 huge potential upside).

Given the relative complexity of many of these alpha strategies – using variance swaps, swaptions and other OTC derivatives – it makes sense that the most skilled fund managers can outperform less skilled managers and generate alpha.

Complexity is a deterrent

However, assessing such complex strategies also acts as a deterrent for consultants 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 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 and limit the level of downside protection.

For most investors, this uncertainty around performance and a lack of predictability will continue to limit the popularity of these funds. In contrast, explicit risk management strategies are growing in popularity with retail investors after being used for many years by defined benefit super funds and insurance companies managing their balance sheets. In these scenarios, the mantra is that “boring is better” with transparency and direct risk management is key to their appeal.

The combination of a well-diversified portfolio and explicit risk management aimed at 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. Their discretionary strategies are impossible to model with certainty and should only be viewed as opportunistic plays at managing potential risk factors. While they offer compelling general usage in a well-diversified portfolio, explicit protection isn’t granted and isn’t able to be measured.

Investors face numerous risks and some of these can be managed through diversification. However, as the GFC underscored, expected diversification benefits may not be present when needed.

Alpha rock stars can 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 nerds will indeed inherit the risk management earth.

This article was first published in Professional Planner.