Equities these days are perceived as essentially a risk-free asset for any investor with a horizon longer than a year or two! This is a lesson the institutional investment community, and now even the retail community, has latched onto. It is a very dangerous lesson and breeds a disturbing complacency in the markets. The notion of equities as "the new risk-free asset" will have important repercussions in the next bear market (whenever that may be) as investors find their complacency first chipped and then shattered.
The recent market upheavals and the previous decade of extraordinary markets have taught us several things, some correct and some not. We know that markets can be discontinuous, that is, a stock can fall from 100 to 80 before we can decide that we were willing to sell it at 90. This is a very important and useful lesson to learn and remember.
A damaging lesson of the past decade is that, whenever the market goes down, it comes back remarkably quickly. A longer-term look at history suggests this is not always true, and that the experience of the past 15 years is really quite an extraordinary anomaly. The 1929 market crash required 25 years for the Dow to reach new highs, and more than 30 years for stocks to outperform bonds. For those with an eye toward ancient history, the investor in 1801 who invested in stocks performed less well over the next 70 years (!) than the investor who used government and railway bonds.
Historic context of last month
It is worth stepping back and asking whether what happened Oct. 27 and 28 is significant in a historical context.
For Hong Kong, of course, the answer would be a resounding yes. For the U.S., on the other hand, we had a market drop on the 27th that would be about the equivalent of a moderately bad month, followed by a market rebound that would be equivalent to a moderately good week.
In effect, we had a bad month and a good week compressed into two days. Except for those two days, volatility in 1997 has been higher than the prior six years, but below the long-term historical average (a fact that surprises many people). Would a 7% drop in the course of a month or a 4% rally in a week trigger a serious rethinking of investment policies, strategies or tactics? For any sensible long-term investor, the answer clearly would be no. So, why should the fact that the event happened in a day trigger a fundamental sweeping reaction? It shouldn't.
What risks do institutions manage?
Recent global market volatility, particularly in the Far East, reminds us that the job of risk management should take place before risks need managing. It is remarkable how often this simple truism is overlooked, as investors scramble to manage risks as they unfold or, worse yet, protect against losses after the losses have taken place.
A important lesson of market turbulence is the importance of a steady hand at the tiller. The temptation is to overreact. The investor who has sorted out issues of risk tolerance and risk management before market turbulence strikes will simply have no temptation to overreact.
For the institutional investor, the first question has to be, "What risks are we managing?" Is it the risk that a portfolio will lose money? That it will fail to meet the obligations or liabilities the portfolio's intended to serve? That it will underperform some objective benchmark? That it will underperform a peer group and wind up in the third or fourth quartile? The reality for most institutional portfolios is that the risk that matters is the one that bites us!
For most institutional investors, all of these risks matter. The result is a great deal of pressure to manage assets conventionally because unconventional investing carries asymmetric rewards. If one is successful, there's a "thank you," and a pat on the back. If unconventional and unsuccessful, the consequences can be dire.
In managing the risks of institutional portfolios, it is important to plan for turbulent markets before they arrive. An investor seeking to manage an institutional portfolio in the face of somewhat turbulent markets has several tools at his or her disposal.
Drifting with market whims
The most common "answer" is a mix that drifts with the whims of the markets, so that you are overweight at market highs and underweight at market lows, coupled with pockets of cash scattered throughout the portfolio that can hold down long-term returns, all subject to ad hoc investment policy decisions at the board level whenever market shocks occur. This is not a sensible framework for risk management!
Static policy asset mix
One answer is the "steady hand at the tiller," embodied in a simple static policy asset mix, with regular rebalancing and with equitization of cash reserves. The asset mix policy can be revisited in the context of changing liabilities or other obligations of the fund every three to five years and should be viewed dispassionately in the context of long-term expected future returns and risks.
This simple answer has an inherent buy-low, sell-high discipline. When a plunging market reduces your exposure below its intended policy, you buy. When a roaring bull market takes you above your target, you sell. There is a common sense aspect to this that can dissuade investment committees from ruinous ad hoc overreactions.
A second, more active, option is portfolio protection strategies. The best known of these would be portfolio insurance, although there are many variants (surplus insurance, one-time hedges, and so forth).
These strategies make sense for some investors, but not for most long-term investors.
For the long-term investor, protecting returns over a calendar year or fiscal year is artificial, costly and inappropriate. During a bull market, such strategies can hold down long-term returns by 500 basis points or even 1,000 basis points a year. Costly insurance, indeed.
Tactical asset allocation
A third option is tactical asset allocation, applied domestically or globally. The uninspired record for TAA in the United States in recent years has caused this option to fall out of favor to some extent.
However, a protective strategy that does not boost portfolio returns in a roaring bull market has done the investor no harm. Tactical asset allocation tends to perform at its best in weak and turbulent markets, which is precisely when an investor needs the protection.
Results of the last several years for TAA have, in my view, been sound for a strategy that, in many instances, has been adopted in order to protect against weak or turbulent markets.
When markets have been strong and relatively quiescent, a lack of incremental profits from such a strategy is not disappointing; indeed, it is expected. Most U.S. TAA strategies fared handsomely during the turbulence of the closing week of October. Global programs generally have been successful over the past nine years, since the first quantitative global TAA program was launched (by First Quadrant, I might humbly acknowledge).
Another choice is option-writing strategies. The selling of calls as a means of harvesting consistent profits has been largely discredited during the past seven years. Such strategies provide reliable income, but truncate the gains in a bull market. In a sustained bull market, the costs can be staggering. Selling puts and calls symmetrically (called "selling volatility") has proven more robust. It will add value whenever actual market volatility is less than expected.
History suggests investors usually expect more volatility than the markets actually deliver. This holds true in market after market around the world, and in each market holds true in far more years than not. This is a strategy that dovetails beautifully with policy allocation, rebalancing or with tactical asset allocation. Where tactical asset allocation and rebalancing strategies work best in weak and turbulent markets, option-writing strategies work in quiet markets. The two sets of strategies complement one another brilliantly.
Swaps and other esoteric strategies
Finally, there are more esoteric swap-based protective strategies, which merit exploration only if an investor:
1. Has the sophistication to understand what it is he or she is contracting for;
2. Has sorted out the interplay between these relatively short-term strategies and the long-term needs of the fund; and
3. Has the appropriate risk-monitoring and management systems, policies and procedures in place to assure the risks don't get out of hand.
My first observation on the closing week of October is that much of the investment community has been overreacting to a market event that is really not all that dramatic (except perhaps in Hong Kong). With that as a starting point, it behooves all investors to sort out their risk management options before they are needed, so they can weather choppy markets without a risk of overreaction, or, worse yet, forced reaction.
A key question is, "Is the policy for asset allocation one that we can live with in difficult times or are we biting off more risk than we can swallow when the going gets rough?" Secondly, once the basic policy is in place, are there opportunistic or protective strategies, such as option overlays, tactical asset allocation, or, for short-term-oriented investors, insurance strategies, that merit consideration? The thoughtful long-term investor will sort through the options before risk management is next needed, not after.