Managed Risk goes mainstream | BetaShares

Managed Risk goes mainstream

BY Roger Cohen | 24 May 2016
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BetaShares currently runs three Managed Risk Equity Funds. These funds employ a systematic, rules based risk management strategy, which seek to control volatility and defend against market losses. Since the launch of our first managed risk fund about 18 months ago, total assets in our Managed Risk suite recently surpassed $200m.

The BetaShares Managed Risk series of funds currently consists of:

The risk management strategy used in these funds is run by global actuarial consulting firm, and specialist in risk management, Milliman (www.milliman.com). Acting as a sub-advisor, Milliman’s Managed Risk Strategy (MMRS) is incorporated into these funds. Essentially the same MMRS is used to provide risk management to over USD150bn in assets globally, ranking Milliman amongst the largest risk managers[1]. With its managed risk suite of funds, BetaShares has made the MMRS available to Australian investors for the first time in an exchange traded form, accessible to all classes of investors (including individuals).

This piece is not intended as a discussion of the features of the above products, of Milliman, or the MMRS. Discussion on the latter can be found here . Rather, this is an outline of the process underlying the decision that led BetaShares to use the MMRS in our products.

I’m going to predict the future.

My view is that over the next 20 years, we will see at least one market crash (a decline of 20% or more). We will see more than one year with negative market returns, and 20 years in the future, the markets will be higher than they are today.

It’s not really much of a prediction. Rather, just an extension of what the markets have been doing ever since there were markets. From the great depression of 1928, through to the tech wreck, and the GFC, we have seen crashes, years with negative returns and an overall rising market over the long term.

Unfortunately, what I can’t predict is in which year we will see the crash, or, in which years will we see these negative returns. If I could, all that follows would be moot. Further, I know – especially in the current low interest rate environment – that over the medium to long term, the equity markets are one of the few places where an investor can achieve both growth and yield. Despite the risk of shorter term negative performance, some exposure to equity markets over the medium and longer term should be considered as part of any diversified investment portfolio (dependent on your circumstances and tolerance for risk, of course).

To Manage Risk or Not to Manage Risk. That is the question.

When investing, there are good reasons both for and against employing any form of risk management. The main reason against, is that it always comes at a cost. This may be explicit or implicit, but nothing comes for free. On the other hand, there are many reasons for using risk management, including mitigating falls, controlling volatility and smoothing returns. The rest of this post is not a case for or against the use of risk management. Rather, it focuses on the case where risk management is going to be used.

(A little digression – A Socratic dialogue)

Risk Manager: “Is your house going to burn down tomorrow?”

Investor: “No it’s not.”

RM: “Is your house going to burn down the day after?”

I: “No its not.”

RM: “The day after that….?”

I: “No….”

RM: “Then why do you pay for insurance which protects your house from burning down.”

Absurd, perhaps, but if we use insurance to protect our property, then it must be in place continuously. We most definitely should not try to time it, or we will figuratively (and possibly literally!) get burned.

Exactly the same logic applies to investments. Either use a risk management strategy or don’t. Any strategy which relies on timing is (in the author’s opinion) not risk management. It is more an active management decision, and should be treated as such. That doesn’t necessarily mean it is a bad decision, but it definitely should not be considered risk management in the context illustrated above.

In reference to markets, the equivalent of insurance contracts are put options. These are contracts which underwrite the value of a security or portfolio. A good description of put options can be found here. Because the likelihood of a down year in the markets is much greater than the likelihood of my house burning down (refer to my prediction above again!), the price of put options is relatively much higher than the cost of household insurance. Thus, put options as a form of continuous protection are not viable. Their cost will severely impact returns over the medium and long term.

24/7 Risk Management of Investments

When considering the best way to manage risk for our Managed Risk Series, we sought a viable risk management strategy, which can be in effect at all times, and which comes at a lower cost than purchasing put options.

Choosing a Risk Management Strategy

The discussion above underlies the basis by which the risk management strategy in the BetaShares managed risk suite of funds was chosen. The key elements required for the risk management strategy we selected were:

  • Non options based – our view is that premiums are too expensive for continuous cover
  • No market timing – whether to protect must not rely on an active decision
  • Continuous (24/7) – the risk management must be in place at all times
  • Rules based – risk management is not a discretionary process
  • Transparent – the methodology and implementation must be explainable and observable

In our view, the MMRS satisfies all these conditions. It is a dynamic (or active) strategy, which uses the current portfolio valuation, volatility and the path or trajectory of the portfolio, to determine the level of hedging required at any time. Exchange traded futures are the hedge instrument. They are liquid, readily tradeable at low cost, and are centrally cleared. The outcome of the MMRS is that volatility is able to be controlled, and the downside cushioned. The investor receives dividends and franking credits (where applicable) from the underlying share portfolio, and there is still a level of upside participation. Since inception, the funds have successfully performed in accordance with these objectives.

Note: BetaShares’ Managed Risk Equity Funds do not aim to track the performance of a published benchmark.

[1] http://au.milliman.com/FRM/

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