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Downside of Managing Downside Risk

Morningstar Commentary: The Downside of Managing Downside Risk (Daniel Needham, CIO), April 22, 2017

“Products that promise to reduce risk are tempting, but it’s better to focus on valuations and long-term fundamentals than short-term price movements.”

  • Despite the postelection rally that delivered robust returns for US equities, 2016 was a volatile year for markets and with heightened market volatility came increased discussions about risk management
  • This is a common response and when volatility returns, popularity of risk-focused approaches and products will spike too
  • Take issue with most risk-management approaches and risk-based products that stem from modern portfolio theory (“MPT”) for long-term investors
    • Disagreement starts with the MPT definition of risk as short-term return variation, runs through the practice of portfolio diversification, and how risk-based strategies are managed and marketed

Risk Management, MPT-Style

  • Risk management in the MPT world is largely represented by the management of the movement and comovement of asset returns over short intervals using historical return data
  • Past relationships are extrapolated into the future, directly or indirectly
  • Cornerstone of MPT is measuring risk via the relative movement of market returns to produce metrics such as beta and alpha – terms related to the defunct capital asset pricing model
  • These frameworks rely on econometric analysis of monthly return data and use various forms of short-term return variation to measure and attribute risk
  • Because MPT focuses on short-term variations, generating smooth returns has become the holy grail in our profession
    • For many investors, this is not only irrelevant but also can be expensive
    • Desire for smoothness reduces returns over time while not necessarily reducing the risks the investor should be worried about
  • Myopic loss aversion seems to have been codified into many investing frameworks and processes – this came not from inexperienced investors but from the professional investment management industry itself
    • Practically, this led to a revealed preference for investment strategies with embedded managed volatility, downside protection, or variable-annuity riders, despite their costs to long-term investors

Protection Costs

  • Short-term, volatility-based downside protection doesn’t generally work for long-term investors because of 3 main kinds of costs
  • First is opportunity cost: every dollar invested in a protection strategy that accepts lower upside in return for downside protection is one not capturing the long-term “miracle of compounding” of reasonably priced equity markets or other assets that can be volatile in shorter periods
    • Short-term smoothness of returns often comes at the cost of lower long-term portfolio value
    • For investors with a long horizon it can be better to take a lumpy 12% return over a smooth 9%
  • Second cost is a matter of value: few downside-focused investors consider the value they get for the fees paid or how they might accomplish the same goal differently (especially true for downside strategies whose costs vary over time such as annuities)
    • When the price you’re paying is high relative to the thing you’re trying to avoid, the implied probability of the bad thing happening rises
    • Often, investors collectively dislike these bad things at the same time, and the cost can become excessive
    • For long-term investors, volatility can create opportunities, as prices tend to move around more than fundamentals – paying a fee to remove an opportunity seems illogical
  • Third cost relates to how investor demand shifts with recent performance
    • After steep losses in late 2008, many investors rushed into downside protection strategies in 2009
    • Investors who entered these strategies likely ended up with much lower returns than the returns of the strategies they left behind; this underperformance comes from timing – they sold something with a low valuation and bought something that was overvalued

Diversification

  • Also possible to pay too much for diversification and to overdiversify – MPT considers diversification through the lens of backward-looking data
  • Asset A may zig when Asset B zags, but if A is overpriced, why would I hold it? Few assets are diversified by just one other asset. It seems more sensible to hold assets that not only add diversification but also are underpriced. What doesn’t seem sensible is overloading a portfolio with assets in the vague hope that they will add diversification
    • If fundamentals are the primary driver of returns, they must also play a major role in diversification
    • Stocks of two companies that are fundamentally similar should not be relied upon to provide diversification, irrespective of the historical correlation of short-term returns
  • Fundamentals also drive diversification at the asset-class level. Corporate profits supply the returns from stocks, as interest rates do for bonds. Stocks provide cash to investors via dividends and buybacks, bonds via coupons and repayments of interest and principal. When the economy falters, profits tend to slip, leading to falls in stock prices. Bonds tend to see policy rates fall along with inflation expectations, leading yields to fall and prices to rise
    • This fundamental linkage that drives the diversification benefits of stocks and bonds
    • This extends to commercial property, with cash flows linked to contractual rental income often tied more closely to inflation
    • Diversification at the asset-class level links back to cash flows that are generated by the underlying assets
  • Fundamentals matter in the long-run and the short-term comovement and beta are less important; most important inputs should be valuation and fundamental risks, at the asset and portfolio level
  • Diversification helps manage uncertainty, reduces the risk of being wrong, provides offsetting gains and losses during extreme environments, and helps set the level of risk consistent with an investor’s tolerance

Absurdities in Practice

  • Many strategies that seek to manage risk by using monthly, weekly, or daily price movements for investors often lead to expensive smooth return lines but not necessarily to lower risk of the permanent loss of capital
  • Think of managed volatility, options, or long-volatility strategies
    • At the risk of oversimplification, these strategies are designed to sell when markets fall and buy when prices rise
    • Through attempting to limit downside risk or match a volatility target, the strategies exhibit strong procyclicality: the more markets fall, the more they sell, and vice versa

Pocket the Insurance Premium

  • Risk, to paraphrase Warren Buffett, is a loss of future buying power
  • An unleveraged investor who doesn’t need to sell his assets for many years typically has little need for a smooth line. Even retirees in the “danger zone” usually do not need as smooth a line as is sometimes suggested
    • That is not to say bad things can’t happen in the market – they can and do
    • However, the price one pays for something matters and many investors are overpaying for downside protection
    • Volatiltiy market or any investment product that pays for lower volatility through upside reduction is prone to overpricing and this tends to find its way into various forms of hedging

“I urge investors to remain focused on the long term and the fundamentals. We need to remember that the underlying fundamentals drive most long-term investment returns, that price matters, and that investors’ goals and time horizons should inform strategy”

Image Source: Markit
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