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- We compare and contrast different approaches to risk managing equity exposure; including fixed income, risk parity, managed futures, tactical equity, and options-based strategies; over the last 20 years.
- We find that all eight strategies studied successfully reduce risk, while six of the eight strategies improve risk-adjusted returns. The lone exceptions are two options-based strategies that involve being long volatility and therefore are on the wrong side of the volatility risk premium.
- Over time, performance of the risk management strategies varies significantly both relative to the S&P 500 and compared to the other strategies. Generally, risk-managed strategies tend to behave like insurance, underperforming on the upside and outperforming on the downside.
- Diversifying your diversifiers by blending a number of complementary risk-managed strategies together can be a powerful method of improving long-term outcomes. The diversified approach to risk management shows promise in terms of reducing sequence risk for those investors nearing or in retirement.
I was perusing Twitter the other day and came across this tweet from Jim O’Shaughnessy, legendary investor and author of What Works on Wall Street.
As always. Jim’s wisdom is invaluable. But what does this idea mean for Newfound as a firm? Our first focus is on managing risk. As a result, one of the questions that we MUST know the answer to is how to get more investors comfortable with sticking to a risk management plan through a full market cycle.
Unfortunately, performance chasing seems to us to be just as prevalent in risk management as it is in investing as a whole. The benefits of giving up some upside participation in exchange for downside protection seemed like a no brainer in March of 2009. After 8+ years of strong equity market returns (although it hasn’t always been as smooth of a ride as the market commentators may make you think), the juice may not quite seem worth the squeeze.
While we certainly don’t profess to know the answer to our burning question from above, we do think the first step towards finding one is a thorough understanding on the risk management landscape. In that vein, this week we will update our State of Risk Management presentation from early 2016.
We examine eight strategies that roughly fit into four categories:
- Diversification Strategies: strategic 60/40 stock/bond mix1 and risk parity2
- Options Strategies: equity collar3, protective put4, and put-write5
- Equity Strategies: long-only defensive equity that blends a minimum volatility strategy6, a quality strategy7, and a dividend growth strategy8 in equal weights
- Trend-Following Strategies: managed futures9 and tactical equity10
The Historical Record
We find that over the period studied (December 1997 to July 2018) six of the eight strategies outperform the S&P 500 on a risk-adjusted basis both when we define risk as volatility and when we define risk as maximum drawdown. The two exceptions are the equity collar strategy and the protective put strategy. Both of these strategies are net long options and therefore are forced to pay the volatility risk premium. This return drag more than offsets the reduction of losses on the downside.
Not Always a Smooth Ride
While it would be nice if this outperformance accrued steadily over time, reality is quite a bit messier. All eight strategies exhibit significant variation in their rolling one-year returns vs. the S&P 500. Interestingly, the two strategies with the widest ranges of historical one-year performance vs. the S&P 500 are also the two strategies that have delivered the most downside protection (as measured by maximum drawdown). Yet another reminder that there is no free lunch in investing. The more aggressively you wish to reduce downside capture, the more short-term tracking error you must endure.
Relative 1-Year Performance vs. S&P 500 (December 1997 to July 2018)
Thinking of Risk Management as (Uncertain) Portfolio Insurance
When we examine this performance dispersion across different market environments, we find a totally intuitive result: risk management strategies generally underperform the S&P 500 when stocks advance and outperform the S&P 500 when stocks decline. The hit rate for the risk management strategies relative to the S&P 500 is 81.2% in the four years that the S&P 500 was down (2000, 2001, 2002, and 2008) and 19.8% in the seventeen years that the S&P was up.
In this way, risk management strategies are akin to insurance. A premium, in the form of upside capture ratios less than 100%, is paid in exchange for a (hopeful) reduction in downside capture.
With this perspective, it’s totally unsurprising that these strategies have underperformed since the market bottomed during the global market crisis. Seven of the eight strategies (with the long-only defensive equity strategy being the lone exception) underperformed the S&P 500 on an absolute return basis and six of the eight strategies (with defensive equity and the 60/40 stock/bond blend) underperformed on a risk-adjusted basis.
Annual Out/Underperformance Relative to S&P 500 (December 1997 to July 2018)
Diversifying Your Diversifiers
The good news is that there is significant year-to-year variation in the performance across strategies, as evidenced by the periodic table of returns above, suggesting there are diversification benefits to be harvested by allocating to multiple risk management strategies. The average annual performance differential between the best performing strategy and the worst performing strategy is 20.0%. This spread was less than 10% in only 3 of the 21 years studied.
We see the power of diversifying your diversifiers when we test simple equal-weight blends of the risk management strategies. Both blends have higher Sharpe Ratios than 7 of the 8 individual strategies and higher excess return to drawdown ratios than 6 of the eight individual strategies.
This is a very powerful result, indicating that naïve diversification is nearly as good as being able to pick the best individual strategies with perfect foresight.
Why Bother with Risk Management in the First Place?
As we’ve written about previously, we believe that for most investors investing “failure” means not meeting one’s financial objectives. In the portfolio management context, failure comes in two flavors. “Slow” failure results from taking too little risk, while “fast” failure results from taking too much risk.
In this book, Red Blooded Risk, Aaron Brown summed up this idea nicely: “Taking less risk than is optimal is not safer; it just locks in a worse outcome. Taking more risk than is optimal also results in a worst outcome, and often leads to complete disaster.”
Risk management is not synonymous with risk reduction. It is about taking the right amount of risk, not too much or too little.
Having a pre-defined risk management plan in place before a crisis can help investors avoid panicked decisions that can turn a bad, but survivable event into catastrophe (e.g. the retiree that sells all of his equity exposure in early 2009 and then stays out of the market for the next five years).
It’s also important to remember that individuals are not institutions. They have a finite investment horizon. Those that are at or near retirement are exposed to sequence risk, the risk of experiencing a bad investment outcome at the wrong time.
We can explore sequence risk using Monte Carlo simulation. We start by assessing the S&P 500 with no risk management overlay and assume a 30-year retirement horizon. The simulation process works as follows:
- Randomly choose a sequence of 30 annual returns from the set of actual annual returns over the period we studied (December 1998 to July 2018).
- Adjust returns for inflation.
- For the sequence of returns chosen, calculate the perfect withdrawal rate (PWR). Clare et al, 2016 defines the PWR as “the withdrawal rate that effectively exhausts wealth at death (or at the end of a fixed period, known period) if one had perfect foresight of all returns over the period.11
- Return to #1, repeating 1000 times in total.
We plot the distribution of PWRs for the S&P 500 below. While the average PWR is a respectable 5.7%, the range of outcomes is very wide (0.6% to 14.7%). The 95 percent confidence interval around the mean is 2.0% to 10.3%. This is sequence risk. Unfortunately, investors do not have the luxury of experiencing the average, they only see one draw. Get lucky and you may get to fund a better lifestyle than you could have imagined with little to no financial stress. Get unlucky and you may have trouble paying the bills and will be sweating every market move.
Next, we repeat the simulation, replacing the pure S&P 500 exposure with the equal-weight blend of risk management strategies excluding the equity collar and the protective put. We see quite a different result. The average PWR is similar (6.2% to 5.7%), but the range of outcomes is much smaller (95% confidence interval from 4.4% to 8.1%). At its very core, this is what implementing a risk management plan is all about. Reducing the role of investment luck in financial planning. We give up some of the best outcomes (in the right tail of the S&P 500 distribution) in exchange for reducing the probability of the very worst outcomes (in the left tail).
There is no holy grail when it comes to risk management. While a number of approaches have historically delivered strong results, each comes with its own pros and cons.
In an uncertain world where we cannot predict exactly what the next crisis will look like, diversifying your diversifiers by combining a number of complementary risk-managed strategies may be a prudent course of action. We believe that this type of balanced approach has the potential to deliver compelling results over a full market cycle while managing the idiosyncratic risk of any one manager or strategy.
Diversification can also help to increase the odds of an investor sticking with their risk management plan as the short-term performance lows won’t be quite as low as they would be with a single strategy (conversely, the highs won’t be as high either).
That being said, having the discipline to stick with a risk management plan also requires being realistic. While it would be great to build a strategy with 100% upside and 0% downside, such an outcome is unrealistic. Risk-managed strategies tend to behave a lot like uncertain insurance for the portfolio. A premium, in the form of upside capture ratios less than 100%, is paid in exchange for a (hopeful) reduction in downside capture. This upside underperformance is a feature, not a bug. Trying too hard to correct it may lead to overfit strategies fail to deliver adequate protection on the downside.
- 60%/40% split between S&P 500 Index and Bloomberg Barclays Aggregate Bond Index
- Salient Risk Parity Index
- CBOE S&P 500 95-110 Collar Index
- CBOE S&P 500 5% Put Protection Index
- CBOE S&P 500 PutWrite Index. It may be surprising at first glance that we consider writing to be a risk management strategy. However, research (e.g. Embracing Downside Risk from Roni Israelov, Lars N. Nielson, and Daniel Vallalon at AQR) suggests that put-writing can output long-only exposure on a risk-adjusted basis with lower volatility and lower drawdowns.
- MSCI USA Minimum Volatility Index
- MSCI USA Sector Neutral Quality Index
- S&P 500 Dividend Aristocrats Index
- Credit Suisse Liquid Managed Futures Index
- Backtested custom index that allocates between the S&P 500 Index and the Bloomberg Barclays Aggregate Bond Index based on a range of time-series momentum indicators.
- Sequencing, Perfect Withdrawal Rates and Trend Following Investing Strategies: Making the Known Unknown Less Unknown