The failure of risk management as we know it

The way portfolios are constructed traditionally reflects a mismatch between reality and academic hypothesis – especially the so-called efficient market hypothesis, notes Athanasios Ladopoulos, partner at Swiss Investment Managers and senior fund manager of the Directors Dealings Fund.

Efficient market hypothesis posits the existence of non-correlated markets. Reality suggests there is no such thing, partially due to globalisation of capital as well as due to what we came to call “crowded trades”. In times of crisis equity assets in particular converge to 1 – or absolute correlation.

The core idea in portfolio construction is that we can increase our expected returns by diversifying capital among what we came to call non-correlated assets. But in the absence of non-correlation, diversification isn’t the panacea it’s meant to be. Diversification might work in good times – say between 2001 to October 2007 – but has proved a failure in bad times, such as the period between October 2007 and as recently as January 2010.

Diversification Works!


 (click here to see full [asset_library_tag 3546,Diversification] chart)

…until it doesn’t


(click here to see full [asset_library_tag 3546,Diversification] chart)

In a bull market, the effect of diversification is to limit performance. Because a diversified fund will be exposed to some indices that do better and some that do worse, it will eke out an average return somewhere between the two, meaning that in good times it will underperform. In bad times it will do the same as everyone else because the correlation is 1.

In bad times, too, the ‘efficient frontier’ and ‘optimal portfolio’ constructions become inevitably a function of leverage. In other words, leverage begets the greater part of outperformance, not stock picking or the fund manager’s skills. This, of course, introduces a variety of new risks and problems, not least of which is how you hedge when leveraged. In the long run leveraging will only buy more under-performance.

Diversification, portfolio insurance, hedging with futures on a portfolio level, and pair trades are the four major ways to hedge across many investment strategies.

The problem, at a basic level, is that the notion of hedging is borrowed from another industry: the insurance industry. If you own a house, for instance, you buy insurance against fat tail risk – in this casesubsidence. For a monthly cash outflow, you are guaranteed that in the case of subsidence, your house will be repaired and made new by the insurance company.

This doesn’t quite work in the fund management industry. A fund that is 80% net long, for instance, is paying every month for a hedge position that isn’t guaranteed to cover it completely during an unexpected downturn – fat tail risk. But the effect of that monthly hedge payment is to ensure that the fund will underperform in good times. Obviously, if the fund is leveraged it is bleeding cash each and every month to pay for shorts. Leverage introduces further risk and reduces further the theoretical protection offered with diversification.

Just like long-biased funds, market neutral funds will underperform. In a crisis, what can happen is the fund turns out to be not market neutral at all. It is very, very complicated thing to be market neutral and it doesn’t create a profit.

As for pair trading, it operates within the efficient market theory. When a trader decides that a particular equity is overvalued, he is assuming, first, that he’s right and the market is wrong (which can happen) and, second, that from the point he takes his position the market will realise it was wrong and revert to the mean. That is less likely to happen, as markets can remain inefficient for longer than you can remain solvent, as John Maynard Keynes once pointed out.

Developed in the ‘70s, portfolio insurance relies on options to reduce volatility and give some form of protection. But there are drawbacks in setting them up. They’re expensive; the implied volatility of the security`s price reflected in the option could increase or decrease, and the time value of the option will decrease as it approaches the exercise day or period; and it introduces an element of uncertainty, the enemy of an efficient trade.

Options, fundamentally, introduce new elements of risk – specifically of strike price and time duration. The concept of reducing risk by introducing new forms of risk is an odd one, akin to the notion of fighting fire with fire. Sometimes it works. Often it doesn’t.

From 2007 to 2009, market correlation increased as international capital flows boomed. The search for a Holy Grail of truly diversified assets rapidly became equally legendary. Conventional diversification or portfolio insurance can not provide significant protection without significant time lag and cost.

At the same time, traditional pair trading – developed from the arbitrage generation – as well as shorting futures to protect directional portfolios does little to provide investors with sustainable, risk-adjusted, real returns. Hence a fresh approach to risk and money management is necessary, avoiding the herd mentality and relying on more counter-intuitive investment strategies.


Athanasios Ladopoulos is a partner at Zurich-based Swiss Investment Managers (SIM) and senior fund manager of the Directors Dealings Fund.


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