Risk & Risk Management

For decades, the standard deviation of investment returns and beta have been the dominant risk metrics and guideposts for building portfolios of risky assets, but these risk measures have provided little help in explaining the cross-asset and cross-market volatility experienced over the last two years. The most recent spate of selling-contagion arose largely as a result of fund flows across asset classes. These flows were related to the urgent and large need to reduce risk and leverage by those investors who found themselves on the brink of financial ruin as a result of losses incurred.

In the wake of 2008, investors are now painfully aware of tail risk – the risk of unexpectedly large losses. Today many institutional investors are insuring against tail risk directly, often by purchasing puts or structuring collars. Unfortunately, experience and financial theory suggest that the long-term cost of such insurance strategies will be larger than the payouts. No surprise, really. The expected return for perpetual insurance buyers is negative, and conversely positive for insurance sellers (see: the entire insurance industry).

Investors tend to think of expected returns as a function of asset class risk, but this thinking may have led them to take on too much equity risk. For behavioral reasons, diversifying across investment styles, such as blending momentum and value, may offer greater returns for less risk. Limited market timing may also increase returns.

The ideal fee structure aligns the incentives of the investor with those of the fund manager. Mutual funds typically only charge a management fee that is a proportion of the funds under management. Hedge funds, on the other hand, generally change an incentive fee that is a fraction of the fund’s return each year in excess of the high-water mark. The justification generally given for these incentive fees is that they provide the manager with the incentive to target absolute returns.