There is a movement today among pension funds toward systemic risk mitigation — or "safe haven" — strategies. This makes great sense as a potential solution to the widespread underfunding problem. Many pension funds still haven't fully recovered from the crash of 2008, and can't afford another. Moreover, truly effective risk mitigation must lead to an incrementally higher long run compound annual growth rate; and a higher CAGR is the way to raise a pension plan's funding level over time.
Just how does risk mitigation raise the CAGR? Well, it usually doesn't, on its own. Modern portfolio theory tells us to mitigate risk through diversification, but this tends to lower CAGRs (in the name of higher Sharpe ratios); one is then forced to apply leverage to raise the CAGR back up, which just adds back a different risk by magnifying the portfolio's sensitivity to errors in one's spurious correlation estimates. Diversification, unfortunately, is not "the only free lunch in finance" that it has been made out to be. So much risk mitigation is simply about moving from concentration (or typically beta) risk to levered model risk.
True risk mitigation shouldn't require financial engineering and leverage in order to both lower risk and raise CAGRs. After all, lower risk and higher CAGRs should go hand in hand! It is well known that steep portfolio losses crush long-run CAGRs. It just takes too long to recover from a much lower starting point: lose 50% and you need to make 100% to get back to even. I call this cost that transforms, in this case, a portfolio's +25% average arithmetic return into a zero CAGR (and hence leaves the portfolio with zero profit) the "volatility tax:" it is a hidden, deceptive fee levied on investors by the negative compounding of the markets' swings. (The destructiveness of the volatility tax to a portfolio explains in a nutshell Warren Buffett's cardinal rule — "don't lose money.").
Achieving higher sustained CAGRs through volatility tax savings is the name of the game in risk mitigation. All such strategies aim to do it, but not all are created equal. They all ultimately require a trade-off between the degree of loss protection provided vs. the degree of opportunity cost paid by the allocation of capital to that protection rather than to the rest of the portfolio. These are the two sides of the safe-haven coin, and we can only measure each side vis-à-vis the other. Evaluating the trade-off is tricky, and is fraught with mathematical mistakes, as the effect on the volatility tax is often indirect or invisible. The best risk mitigation solution can be a counterintuitive one.
We will thus focus only on a straightforward criterion: higher portfolio-level compound annual growth rates from lower risk (or specifically from paying less volatility tax). We will use this criterion to evaluate cartoon versions of the three canonical prototypes of safe-haven strategies out there, where each exhibits a very distinct protection-cost trade-off. They are depicted in Figure 1.