What is the best, and most effective, way to manage risk in investment portfolios? Milliman’s Head of Fund Services, Michael Armitage, sets the alpha rock stars against the actuarial nerds.
Generating returns may be the primary goal for investors, but protecting those gains is just as important.
It is an objective which places volatility – and risk management – firmly on the centre stage even if the spotlight is shared by two very different characters with unique approaches.
On one side are the ‘alpha rock stars’ of the investment industry, while on the other stand the ‘actuarial nerds’ of risk management. They differ in several major ways.
The alpha rock stars – or hedge fund managers – employ a range of complex strategies which can provide diversification during volatile market conditions. However, they don’t directly manage risk. They attempt to take advantage of mispricing opportunities and generate substantial returns by making many bets, banking that a small number will lead to big payoffs.
In stark contrast, actuarial nerds employ rules-based risk management techniques, which lead to more predictable performance during volatile market conditions. This hedging approach is applied to actual portfolio holdings and is not reliant on predicted asset class correlations or successful opportunistic bets.
Given the relative complexity of many hedge fund strategies it makes sense that the best can outperform less-skilled managers and generate alpha. But assessing these complex strategies is no mean feat and often acts as a deterrent for consultants and investors. How many investors can truly say they understand what is meant by “variance swaps” or “swaptions” – just some of the risk management techniques used by hedge fund managers?
Rules-based risk managers do not attempt to generate alpha. Instead, their transparent, replicable strategies have been used for many years by defined benefit super funds and insurance companies to explicitly manage their balance sheet risk.
The differences in approaches taken by the risk managers is reflected in differing cost structures.
Hedge fund managers often charge significant management fees for their purported skill while explicit risk management techniques are generally low-cost (effectively the price paid for insurance or reduced market exposure).
Which approach is the right one for investors?
Alpha rock stars can provide welcome diversification benefits through their absolute return goals and by taking bets on potential systemic events. But investors need to keep in mind that these types of discretionary strategies are impossible to model with certainty – they are best viewed as opportunistic plays which can manage potential risk factors.
However, the global financial crisis showed that the benefits of diversification may not always be present during broad-based market downturns.
Those investors seeking a more predictable outcome, which bolsters the benefits of traditional diversification, should consider an explicit risk management approach. It will become an increasingly important goal for those investors seeking more stable returns as they approach and enter retirement.
BetaShares combined its expertise with Milliman (a risk manager using a rules-based risk management technique) to launch the BetaShares Australian Dividend Harvester Fund (managed fund) last November. The fund invests in large-cap Australian shares with the objective of delivering franked income with the potential for at least double the yield of the Australian broad sharemarket while reducing volatility and managing downside risk.