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Industry Voices

Commentary: Uncovering the hidden trade-offs in risk-mitigation strategies

U.S. pension funds are seeking protective strategies to offset the portfolio equity and credit losses expected in an economic downturn. Given funds are unlikely to allocate more than a fraction of their capital to such strategies, getting as much bang for the buck is a priority. They need confidence the strategy will move the needle when it really matters.

Pension fund executives might benefit from a new framework that offers them levers to help inform their decision process.

So-called crisis risk offset or risk mitigation strategies typically include both bonds and systematic trend following. The bond allocation is a bet that bonds will rally when equities fall. The trend allocation is supported by the observation that in past equity crises, trend strategies delivered positive returns, providing what some call crisis alpha. History shows crisis alpha has come from both short positions in equity index futures and the capture of large, though crisis-specific, moves in other assets. For example, during the accounting scandals in 2002, the U.S. dollar depreciated, but it appreciated during the 2008 Lehman crisis.

Mandates tend to be for core trend following: diversified across asset classes, but excluding less liquid markets, and strategies like risk premiums or long-short equity. This suits asset managers that have turned more multistrategy recently and are prepared to offer capacity in a core product at a discount. Cynics might add that competition and investor pressure leave these managers little choice.

Reasons to like core trend strategies

Pension funds might prefer these trend products over dedicated tail-protection schemes for multiple reasons. Established brand-name managers are willing to supply them in standardized formats like 1940 Act mutual funds, easing due diligence. They appear cheaper and more liquid than traditional 2-and-20 hedge funds. Flat fees are approaching the levels of passive index trackers, and subscriptions and redemptions can often be made daily. There is also a perception that options-based protection is expensive, difficult to implement and not as reliable as the presentation of textbook hockey-stick payoffs suggest.

There is another reason. Tail protection, like any insurance, can be a hard sell. Reframing trend as an alternative asset class with positive returns and low correlation to equities may enable investors to sidestep this hurdle and justify allocation on portfolio diversification grounds.

But while framing trend as an asset class might have benefits, it underplays both the needs of pension funds and the non-linear risk characteristics of trend-following strategies. Pension fund executives' preferences over gains and losses are asymmetric. Plans needs to avoid big hits to capital because they do not have the luxury of time to restore it. Related to this is a convexity problem. After a 10% hit a fund needs an 11% return to replenish capital. After a 20% hit it needs a 25% return. The bigger the hit, the harder the recovery. Liabilities cannot be postponed. Pension funds lack downside protection more than upside participation. Some plans are in funding danger zones already.

Given this asymmetry, some like ourselves question why a fund — specifically looking to protect against an equity crisis — would add a strategy that can contain long equity positions. Implementing directionally agnostic trend for non-equity assets seems sensible. But why not exclude equities completely, or simply stop the trend follower from taking long positions, for example via a cap on exposures?

One reason is an unconstrained trend strategy has higher historical (real or simulated) returns than had equity upside participation been limited. We can assume this because historically equity indexes have generally risen, especially recently. The higher the headline return expectation, the greater is the sense that the risk-mitigation strategy pays for itself. For those thinking in insurance terms, this surely helps. But the more a risk-mitigating strategy appears to pay for itself, the more it is worth asking why.

Creating simulations

What would be handy is a method by which investors can explore the value of adding trend to their pension plan.

The exercise will be probabilistic and forward-looking because an assessment of the current health of a plan is a function of future uncertain liabilities and market outcomes. Fortunately pension fund executives are well-equipped. A forward-looking mindset is intrinsic to liability-driven investment.

Even better still would be the availability of risk-management levers that influence the balance of upside and downside participation.

One possible solution is to deconstruct trend into a dynamic hedging problem. It sounds complicated but is not. In trying to delta-hedge an option exposure, a trader's reaction to price movements is formulaically governed by the shape and horizon of the payoff they are hedging. Although perfect dynamic hedging is unachievable (because of transaction costs, slippage, gaps, stochastic volatility and non-continuous trading), these exact same problems befall trend followers. Little if anything is lost by reframing trend following this way, and valuable and interpretable risk management levers are gained.

Simulating the evolution of the risk-mitigation strategy and the pension plan together produces rich information about the risks and trade-offs around strategy design. New techniques are needed. Monte Carlo simulation likely will underplay extreme risks. Investors need methods like agent-based modeling that can reflect the rough and contagious volatility that real markets exhibit. Cloud computing is making these more granular simulation engines economically viable. Millions of possible outcomes can be explored and the creative use of scenarios, especially ones not seen in the past, can further enrich investment committee discussions.

Not the most popular narrative

This idea will not be universally popular. Trend managers may claim their secret sauce makes them unique despite the high correlations that suggest otherwise. Also, if trend can be reframed as a form of dynamic hedging, then the equity sector of an equity-capped trend follower starts to sound a lot like the portfolio insurance schemes implicated in the 1987 crash. This is perhaps another reason equity-capped trend following has not yet been widely promoted. But while it might not look like a duck, it certainly walks and quacks like one. Combining a design-driven approach with simulation gives pension fund managers the levers to explore these questions themselves.

Robert Hillman is chief investment officer of Neuron Advisers LLP based in London.This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.