Strategic Risk Management

Introduction

Strategic Risk Management presents a visionary approach to redefining risk management in the aftermath of the covid - 19 pandemic. This innovative framework advocates for a cohesive strategy that harmonizes investment and risk processes, incorporating defensive measures, drawdown risk controls, volatility targeting, and strategic rebalancing.

For savvy investors seeking to safeguard their portfolios against unforeseen market downturns, this audiobook delves into a comprehensive exploration of scientifically supported strategies designed to mitigate losses during crises. We'll begin by delving into resilient investment tactics such as trend-following, followed by an in-depth discussion of sophisticated risk management techniques like volatility targeting and strategic rebalancing. These methods aim to fortify your portfolio against potential risks.

The audiobook concludes by showcasing how these integrated strategies not only safeguarded portfolios but also outperformed traditional investments during the tumultuous market crash induced by the pandemic."

Chapter 1: Unleashing Crisis Alpha

Let's delve into the concept of crisis alpha – a strategic approach focused on generating additional returns during market turbulence. At the heart of this strategy are dynamic trend-following tactics that adeptly adjust risk to safeguard those returns. These tactics involve selling during market downturns and buying during upswings, capturing momentum across various asset classes, spanning from stocks to bonds and commodities.

However, a pertinent question arises: Can these strategies remain effective even in the face of rising government bond yields? Research indicates that trend-following in bond futures has demonstrated a robust track record in mitigating tail risks. This efficacy stems from the tendency of bonds to move inversely to stocks. Eliminating exposure to bond market trends might compromise some of the downside protection offered by this strategy.

It's crucial to recognize that the utility of trend-following extends beyond equities; it can yield significant benefits for government bonds as well. Its strength lies in the diversification across diverse asset classes – restricting its application solely to non-equity markets may not provide optimal drawdown protection.

While skepticism may linger regarding the profitability of momentum strategies, the empirical truth remains: diversified trend-following has consistently delivered crisis alpha for over fifty years. Therefore, for portfolios seeking resilience in the face of crises, embracing adaptive systems designed to mitigate risk and sustain returns emerges as a promising avenue.

Chapter 2: Crafting a Resilient Portfolio

For investors, the ultimate quest is to fashion a portfolio impervious to crises, one that stands firm through the highs and lows of the market. Alas, unless armed with clairvoyance, vulnerability to unpredictability is inevitable. Nevertheless, an array of tools and strategies exists to fortify portfolios during significant stock market downturns.

While continuously holding short-dated put options proves a reliable albeit costly strategy, alternative approaches include maintaining positions in "safe haven" treasury bonds. Although these bonds can yield positive returns, their performance may falter in times of crisis. Long positions in gold and credit protection offer moderate reliability at a relatively lower cost.

Dynamic strategies emerge as a more adaptive choice. Options such as momentum and shorting currency carry can be tailored to evolving market conditions. Passive strategies, such as holding one-month S&P 500 put options and long credit protection, provide effectiveness during crises, albeit with associated costs.

The perennial question arises: Can a portfolio be made entirely crisis-proof? Given the inherent trade-off between security and cost, achieving absolute crisis-proof status may be financially prohibitive. However, crafting a crisis-resilient portfolio is within reach.

Passive option strategies may strain the budgets of many investors. Nevertheless, historical data underscores the relative success of futures time-series momentum and long-short equity strategies. The crux lies in attaining positive returns during market downturns without incurring undue costs in stable periods.

Investors must also factor in potential drawdowns in crisis-oriented strategies—those declines in investment value from peak to trough. While these strategies contribute to overall portfolio protection, weighing the trade-offs between reliability during crises and costs in normal market conditions is paramount.

Formulating a crisis-proof portfolio demands a synergy of passive hedges like long credit protection and dynamic strategies such as time-series momentum to sufficiently mitigate drawdowns, justifying associated expenses. While perfection remains elusive, preparedness with diversified crisis alpha potential for varied market conditions emerges as a sagacious approach.

Chapter 3: Crafting Resilience: Volatility Targeting

While investment strategies are integral to fortifying your portfolio against crises, this section explores an alternative approach—utilizing volatility targeting for enhanced crisis protection. The fundamental concept involves maintaining your portfolio's volatility at a predetermined target level, achieved by adjusting leverage in response to volatility fluctuations. Two key attributes of volatility contribute to the efficacy of this strategy: its tendency to persist and its negative correlation with stock returns.

Targeting volatility enables the mitigation of its inherent fluctuations, resulting in elevated risk-adjusted returns, reduced likelihood of extreme price swings, and diminished drawdowns. The persistence of volatility, coupled with its inverse relationship with stock returns, forms the foundation of this approach.

Volatility targeting operates by dynamically adjusting leverage in response to changes in volatility. When volatility rises, the strategy reduces leverage to control risk, and conversely, when volatility falls, leverage is increased to maintain the target. This method aligns with the historical observation that high volatility tends to persist, allowing the strategy to proactively respond to potential risks.

Given the inverse relationship between volatility and stock returns, these strategies increase exposure after price drops, coinciding with spikes in volatility. This aligns with the crisis protection provided by momentum strategies discussed earlier.

Beyond risk management, volatility targeting enhances risk-adjusted returns by counteracting volatility fluctuations. This adaptability not only reduces the likelihood of significant price swings and volatility spikes but also contributes to smaller maximum drawdowns, particularly in balanced and risk parity portfolios, as volatility smoothing leads to a smoother overall portfolio experience.

In essence, by dynamically managing volatility, the stability of your overall portfolio is significantly bolstered. The subsequent section will delve into a complementary risk management strategy—strategic rebalancing.

Chapter 4: Elevating Risk Management: Strategic Rebalancing

Diversifying risk in your portfolio can be achieved through strategic rebalancing—a method that involves periodically adjusting your asset allocation. While not a quick solution and potentially resulting in underperformance, this approach addresses the challenge of a purely passive buy-and-hold strategy, which allows the asset mix to drift over time, leading to a loss of diversification. Striking the right balance is crucial.

In the context of a stock-bond portfolio, monthly rebalancing may underperform a buy-and-hold strategy during prolonged downturns in one asset class. For instance, a 60-40 stock-bond portfolio rebalanced monthly might incur more significant losses than a buy-and-hold strategy during extended stock market slumps. This is attributed to mechanical rebalancing, which involves selling winners and buying losers, creating a concave yield curve.

However, strategic rebalancing can offset these drawbacks by incorporating nuanced considerations. These include utilizing monthly cash flows to gradually realign the asset mix to target allocations, integrating exposure to stock-bond trends, diversifying across a broader range of asset classes, including international ones, and allocating to comprehensive trend strategies that capitalize on macro asset trends during equity distress.

In essence, strategic rebalancing transcends routine portfolio adjustments. When executed thoughtfully, it actively manages risk rather than merely reacting to asset drift, transforming potential drawbacks into advantages for drawdown management. The synergy of rebalancing with momentum and diversification emerges as a potent strategy, turning the ebb and flow of assets into a strategic advantage.

Chapter 5: Navigating the Human Element: Drawdown Strategies

Maintaining a robust portfolio involves acknowledging the human element in investment management, recognizing that the skill set of managers is not a static trait. Unlike riding a bike, skills can be lost, and market dynamics or personal factors may necessitate decisions such as hiring, relocating, or terminating a manager for the benefit of your portfolio.

Central to these decisions is the concept of drawdowns, which quantifies the extent to which an account has declined from its peak to its trough. Drawdowns serve as a metric for assessing the potential downside risk of an investment, with larger drawdowns signaling the potential for more substantial losses. For instance, a 20 percent drawdown implies a decrease from an initial $10,000 investment to $8,000. Monitoring drawdowns becomes crucial in making informed decisions to mitigate these losses.

When a portfolio experiences a significant drawdown, the evaluation of whether to retain or change investment managers becomes paramount. This assessment involves weighing the risks associated with keeping an underperforming manager against the potential loss of parting ways with a successful one.

Given the unpredictable nature of drawdowns, it is imperative to establish reasonable limits based on return distribution parameters. Preset drawdown rules act as a check against excessive risk-taking. Clearly communicating these drawdown limits serves to incentivize managers to prudently manage risk. Additionally, implementing automatic deallocation at predefined levels acts as a fail-safe against last-minute, high-risk decisions.

Recognizing that two primary errors exist—the failure to retain talented managers and the failure to dismiss underperforming ones—calculating the costs of these errors guides decisions regarding hiring and firing. Total-return rules prove effective in assessing managers' consistent ability to generate positive returns, while drawdown rules specifically address scenarios of abrupt skill deterioration.

Consideration should be given to adopting a time-varying drawdown rule. Over time, hitting a certain drawdown level becomes more likely, even if a manager's skill remains constant. This adaptive approach adds a layer of prudence in navigating the complexities of drawdown management.

Chapter 6: Navigating Fund Management: Systematic vs. Discretionary Approaches

As we've explored, effective portfolio risk management involves strategic investing, employing risk mitigation strategies, and ensuring the proficiency of your investment manager. In this section, we delve into the dichotomy between systematic and discretionary approaches in hedge funds, unveiling the associated risks with each style.

Systematic funds operate on algorithmic, rules-based strategies, leveraging large datasets, risk management techniques like portfolio diversification, emotionless decision-making, backtesting algorithms, and high-frequency trading. On the flip side, discretionary funds rely on human expertise and real-time insights, excelling in fundamental analysis, market sentiment, short-term volatility, qualitative risk assessments, tailored objectives, and private equity deals.

Historically, both systematic and discretionary equity and macro strategies have demonstrated similar risk-adjusted returns on average. However, skepticism toward systematic strategies persists, primarily because different market inefficiencies align with each approach.

Equity long-short funds, for instance, are susceptible to company news or media events, while long-biased funds can be highly sensitive to the performance of key holdings. Given that each hedge fund is a unique amalgamation of strategies, it becomes susceptible to a distinctive combination of risks.

Rather than deeming one approach inferior to the other, it is prudent to cultivate a balanced perspective that recognizes their complementary strengths. Systematic strategies excel in data-driven, technical analysis, while discretionary strategies thrive in fundamental, qualitative assessments. Your choice between the two should align with your objectives, time horizon, and risk tolerance.

Understanding that each approach has its strengths and vulnerabilities, integrating a diverse range of strategies into your portfolio can create a robust risk management framework, providing resilience across various market conditions.

Chapter 7: Real-world Validation of the Strategic Risk Management Framework

The quantitative strategic risk management framework elucidated in this audiobook underwent a rigorous trial during the tumultuous covid - 19 pandemic. This unprecedented period served as an out-of-sample stress test, subjecting equities to a severe drawdown and affirming the effectiveness of these quantitative approaches in navigating real-world extremes.

The initial assessment scrutinized the performance of diverse investment strategies. Allocations to trend-following and specific long-short equity strategies emphasizing quality and profitability emerged as effective during the drawdown, fulfilling their promise of providing crisis alpha. These positive convexity approaches demonstrated resilience in the face of market turmoil.

Subsequently, the efficacy of volatility targeting strategies was evaluated. Functioning both as a risk management technique and an investment strategy, volatility targeting exhibited prowess during the pandemic, particularly in managing equity and credit exposures. Portfolios employing this approach significantly curtailed drawdowns compared to traditional investments.

The final examination focused on various rebalancing methodologies. A conditional rebalancing approach, strategically delaying rebalancing during market downtrends, outperformed mechanical calendar rebalancing. This empirical evidence provided further validation for the effectiveness of strategic rebalancing techniques in mitigating risks during challenging market conditions.

The pandemic experience underscored the suboptimal nature of separating investment and risk management and revealed the inadequacies of many traditional risk metrics. The solution, as emphasized throughout this audiobook, lies in adopting an integrative risk management philosophy. The amalgamation of investments and risk management through advanced methods such as trend-following, volatility targeting, and strategic rebalancing has demonstrated the capability to substantially mitigate drawdowns, even in the face of an unprecedented crisis.

Summary

Optimal long-term investment management necessitates a thoughtful blend of diverse investment methods and risk management strategies. Incorporating approaches like trend-following, which excels even in market downturns, is key. Complementing this with tools such as strategic portfolio balancing, vigilant monitoring of market fluctuations, and proactive measures to control significant losses serves as a robust preventive mechanism against setbacks.

The effectiveness of this comprehensive strategy was notably demonstrated during the covid - 19 downturn. By integrating methods that thrive in adversity with vigilant risk management, investors were able to weather the storm and navigate through challenging market conditions. This adaptive approach not only proved resilient in the face of unprecedented uncertainties but also positions investors to confront and endure future market challenges with confidence.

About the author

Sandy Rattray is CIO of Man, a London-based investment group. He was previously a managing director at Goldman Sachs.

Otto van Hemert is a former finance faculty member of NYU Stern and the current Director of Core Strategies at Man AHL.

Campbell R. Harvey is a professor of finance at Duke University, a research associate at the National Bureau of Economic Research, and an investment strategy advisor at Man.