Is risk hedging a risk in itself?

Thu May 3, 2012

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A bit like a metallic umbrella in a lighting storm, crowding in these types of investments is actually likely to lead to the manifestation of an investor’s worst nightmares

By Susan Barreto

The buzz words du jour with institutional investors this month have one thing in common – risk. Risk parity and tail risk hedging pop up in many discussions with investors in hedge funds these days. This is despite the uncertainty about whether they will really do what they promise to do.

Investors have been here before. In the 1980s it was portfolio insurance, a few years ago it was portable alpha – to the savvier investor this was double leverage but few listened – and now the latest risk management fad being sold to investors is also claiming to fill a tall order.

Let’s start with risk parity, which this month we see catching on at the $73 billion Ohio Public Employees’ Retirement System, which issued a request for information seeking up to five managers to handle a portfolio totalling up to $450 million (see page 5). The premise is simple and has been gaining in popularity with public pension plans over the last couple years. The Pennsylvania Public School Employees Retirement System plans to implement a new asset allocation that includes a $2 billion-plus allocation to risk parity strategies (see page 4).

The thought is that investors can simply decrease their exposure to assets that take up a larger share of the risk budget and increase (via leverage in some cases) to asset classes that are understood to be less risky. The $8.2 billion San Diego County Employees’ was one of the pioneers in this area. The pension fund reports that it returned more than 21% for the fiscal year (the 12-month period ending 30 June 2011) and exceeded 6% for the calendar year when markets were challenging. In 2011, losses in the global, private and emerging market equity markets were counterbalanced by gains in the pension fund’s allocations to global macro, CTAs, emerging market debt, relative value and US treasuries within a 'stable value’ component of the portfolio.

Risk parity may see hedge funds becoming an integral part of various asset classes rather than a standalone component, which traditionally has been done without the risk parity label at university endowments and more forward-thinking US pension plans. Firms winning such mandates are accustomed to navigating equity risk with the likes of AQR and Bridgewater leading the way.

A long-lost cousin to risk parity – tail risk hedging – seems to be coming late to the party as investors worry over the impact the growing Eurozone crisis will have on global markets. Investors are hiring firms such as Capula and Pine River to add a tail risk segment to their absolute return programmes.

Tail-risk hedging aims to curtail huge losses should extreme market events create portfolio shocks. These strategies performed well in 2011, but the expectation is that 2012 will see their performance slip. A bit like a metallic umbrella in a lighting storm, crowding in these types of investments is actually likely to lead to the manifestation of an investor’s worst nightmares.

After the Black Monday stock market crash in 1987, one hedge fund manager attributed the crash to portfolio insurance derivatives. That manager, Paul Tudor Jones, is said to have profited from the crash as he believed it was something that could be foreseen. So in this current era of uncertainty, could these new sets of risk management fads being creating another crash? If so, who is looking to profit from this market downturn?

Those buying derivatives today – whether it is for a risk overlay programme or internally managed risk parity programme – need to ask themselves who is selling this insurance and why. Analysis and market research gathered independently or in conjunction with underlying managers may provide the best snapshot for CIOs and trustees to chart a course for investment success rather than headline-making losses.

ISSN: 2151-1845 / CDC10004H

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