Risk is bad, right? Volatility is the enemy of the efficient portfolio? All else being equal, the intelligent investor would prefer less ups and downs in their investments… right? Our friends over at Covenant Capital are out with a deceivingly short piece originally written for Futures Magazine, bringing these long-held beliefs into question. We say deceivingly short, because this one pager touches on all sorts of interesting ideas and questions in the asset management space, while at the same time keeping those questions just below the surface. Read on:
“The impact of a high volatility investment on a portfolio can be mitigated by the allocation size given to that product. By normalizing for volatility, theoretically, high and low volatility investments can have equal impact on a portfolio’s total return. This leads us to a different way to view risk. Risk is the difference between the anticipated worst loss and the realized worst loss. When viewed through this lens, lower volatility equals higher risk (see “Low vol is not so smart,” right).
“While its low volatility seems safe, CZY Fund has almost all the risk in this portfolio. First, its allocation is quite large because of its low volatility. Second, its potential for a downside surprise (realized loss > anticipated loss) is also quite large. The bulk of the money has been given to the investment with the greatest potential of portfolio devastation. Look at SMT Fund. Even if SMT went bankrupt, that loss would only be 1.33 times the worst anticipated loss. The portfolio would feel the same pain if CZY fund lost 6.67%. If CZY fund lost 15%, that pain exceeds the worst possible performance of SMT. The banking system did not go bust in 2008 because mortgages lost 80% of their value. The banking system went bust because mortgages lost 80% of their value, AND the banks thought mortgages could only lose 5% of their value. If SMT above loses 80% of its value, the portfolio does not like it, but it is far from catastrophic. Here’s the other kicker. The portfolio pays CZY fund 15 times the fees of SMT for the same exposure and 100 times the catastrophic risk. Quite the bargain.”
Why it works This allocation has done several things for the portfolio. Most importantly, the exposure to the asset classes and potential upside of these investments has been maintained or amplified depending on the allocation of profits. This allocation only uses 15.75% of the capital. Downsize surprises have virtually been eliminated. The maximum loss has been capped at 15.75%. Fees have been cut by 84.25%. All the things you look for in a diversified portfolio are accounted for:
- Increased liquidity, check.
- Increased upside; check.
- Maintain exposures; check.
- Limit downside; check.
- Eliminate catastrophic losses; check.
All of this for an 84% discounted price. Seeking rather than avoiding volatility can lead to a lower cost, more liquid portfolio with a reduced level of risk and an increased potential of returns.
The main thrust is to not be afraid of high volatility, as the perceived safety of the low volatility portion of the portfolio will be offset by the increased allocation amount you’ll have to set the low volatility portion at. It’s a sort of ‘avoid the single point of failure’ argument, and kind of a twist on the old ‘all your eggs in one basket’ metaphor, with Mr. Billington in effect saying that the largest and perceived safest basket for your eggs can become that much more unsafe because you will logically put more of your eggs into it. Better to have many weaker baskets, the breaking of any which one will not have a material effect on all your eggs.
But the interesting parts to us were twofold: First, the idea that low volatility investments have a larger gap between the amount of loss or drawdown an investor anticipates and the actual realized amount of that loss. This is completely logical and quite a simple concept, but you would be amazed how many people miss this. Your average investor can understand that a baseball player on a hitting streak of 10 games likely won’t keep that streak alive for the next 3 years. But then look at an investment with low volatility and project that low volatility out into the infinite future. It’s sort of a case of the low volatility investments not yet having seen their bad period, versus the high volatility investments wearing their sins on their sleeve. And of course, the flip side of this is that the high volatility (high drawdown) investment doesn’t have a long way to fall, making it easier for investors to stomach because the difference between the anticipated and realized losses is smaller. In short, investors can handle losing more if it was expected, than losing less (but more than expected). Put forward as one of those behavioral economics tests, the question would look something like – would you prefer to lose $75 out of $100, when promised to only lose $60; or to lose $50 out of $100, when promised to only lose $25.
Second, is the idea that investors tend to overpay for low volatility. We hear the arguments that fees are coming down in the hedge fund space all the time, but that is usually just a sort of general commentary that people don’t like paying 2 and 20. The more sophisticated conversation which Mr. Billington touches on is what are you paying for… and the realization that if you have to do much more of an investment for it to hit your risk budget target, you’ll be paying a lot more for that access.
Even without the fact that you may be paying more total dollars for a low volatility program because you have to do more of it… there’s the issue that the fees as a percentage of the risk taken and reward given on a low volatility program are much higher than the same fees (say 2%) on a higher volatility program. Consider the following four theoretical investments. Fund 1 is heads and shoulders above the rest in terms of Sharpe ratio, delivering more return per unit of volatility. But what if we assume a 2% annual management fee for each of these investments and look at how big that fee is in relation to the return and exposure the investment is delivering for me. You’ll see the numbers inverted, with the most bang for your buck coming from the highest volatility investment. This is in stark contrast to how the rest of the world works, where you pay more if you want a bigger room at the hotel, pay more for a car that can go faster, and so forth – essentially paying more when you get more exposure.
But here in the alternatives world, the search for low volatility can result in your paying more for less exposure. Maybe this is why we have hedge fund managers who make billions each year – they’ve figured out that they can charge more for less. The more precise approach would be for investors to pay a cost calculated off the amount of exposure delivered. Some risk based cost. But until then…