Beyond Bonds

Choosing the right risk-management strategy

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822465_focusIn the aftermath of the financial crisis, a broad range of risk-managed portfolio solutions have gained in popularity with institutional investors. These strategies, which include tail hedge funds, risk parity, volatility management and absolute-return hedge funds, are generally designed to reduce the equity risk associated with the traditional 60% stock/40% bond portfolio. Using additional techniques to mitigate risk is particularly important in today’s low-interest-rate environment when bonds won’t deliver returns or provide the same degree of downside protection they have in the past.

While the past performance has been impressive for risk-managed solutions, a framework is necessary for analyzing the behavior of these strategies and incorporating them into a broad investment portfolio. Such a framework can help identify optimal risk-management solutions by first pinpointing the risk that keeps investors up at night. For example, if a plan is most concerned with the impact of a short-term market crash, strategies that insure against big market downturns by strategically owning protection against those events are in order. These include tail hedge funds and put-option overlays.

In deciding which risk-management solution is the most appropriate, it’s important for plan sponsors to analyze the equity beta of the portfolio, the alternative sources of return that they provide, the tail character (or how the strategy performs in extreme markets) and the consistency with which it behaves as an effective hedge for equity-market risk.

Which strategies work best?

Insurance strategies have negative betas to the market and sacrifice significant return in exchange for attractive tail behaviour delivered consistently across down markets. Active management of the option positions is necessary to help reduce the return drag. Tactical-allocation strategies should result in far less return sacrifice, since they are effectively timing when to reduce exposure as opposed to constantly paying an insurance premium for protection. The trade-off is sacrificing some return consistency and market upside. Finally, diversifying strategies, which tend to use leverage to access attractive, weakly correlated sources of return, have high alternative returns but may incur some negative tail performance when cross-asset correlations rise. That’s why they are best suited for investors with longer investment horizons who can weather some short-term tail-event risk.

When these return and risk characteristics are well understood, investors can evaluate the potential impact of each strategy on meeting overall investment objectives. Since many of the strategies cross a broad array of assets, use complex derivatives and may employ leverage, they don’t neatly fit into traditional investment categories. Hence, they may not be intuitive to some investment boards, which makes manager-education initiatives important.

Daniel J. Loewy is chief investment officer, Multi-Asset Solutions AllianceBernstein L.P.

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