18 Jul 2019
Risk and uncertainty are challenging, even multi-dimensional, phenomena in investment. While investors crave simple risk ‘metrics’ or statistics with which to know the risks associated with an investment or a fund, James Clunie, Head of Strategy, Absolute Return, explains that risk management involves art, not just science.
My colleague Ivan Kralj and I often talk about how much the strategy could lose in a bad scenario: a situation in which most of the risks we take go wrong at roughly the same time. It is common for investors to want to know something about the risks associated with an investment and to seek useful, simple metrics or statistics that measure some aspect of risk. Yet, risk and uncertainty are challenging, even multi-dimensional, phenomena in investment. As such, our approach to measuring risk remains firmly rooted in the knowledge that markets are unpredictable, and that one can never know the ‘worst case scenario’. Gauging it relies on a combination of subjective judgement and the output from software packages that are designed to measure risk statistically.
An element of choice is also evident when measuring the ‘equity beta’ of the strategy. Beta is an important measure of the sensitivity of a fund to general moves in global equity markets. There are several ways to measure the beta statistically, leaving investors with the dilemma of which is the most appropriate for the circumstances. Should we choose one, or blend several?
Two useful metrics that require no subjective input are a portfolio’s ‘gross equity position’ and ‘net equity position’. Commonly used with long/short funds, these are simple, crude measures of risk, which are clearly defined and useful. A fund’s gross equity position is calculated by summing the long and short equity exposures together. For the net figure, shorts are subtracted from longs.
Ivan and I like these measures and we include them (and their historical paths) in our presentation material. Recall that our strategy usually just contains equity long positions, equity short positions and simple hedges (such as currency forwards, gold or options from any asset class). These hedges are designed to lower risks arising in the equity book, such as inadvertent currency risk or deflation risk. By excluding the hedges and distilling the gross and net equity positions, we’re losing some information, but we still end up with a useful measure.
Over time, these have both varied in the strategy and we can describe a ‘typical range’ over which they have varied or can be expected to vary – a gross equity range of 55%-125% and net of +/-40% is historically accurate. Of course, they might move out of these ranges in exceptional market circumstances. We aim to be easily understood, but never rigid in our approach.
How do we arrive at the actual gross and net positions? It’s a bottom-up, organic process. Then we check these exposures from the top-down, considering risks such as changing central bank policies, global liquidity conditions, elections and political turbulence – what we know about the world. We may seek to adjust the gross and net based on top-down ‘intel’: we could adjust the stock weights, eliminate stocks, deliberately seek out new long or short ideas or use equity futures or ETFs to modify the net equity position.
In practice, however, we usually leave the gross and net alone, but we think it can be quite powerful to combine insights from both bottom-up and top- down perspectives.
So, how much risk are we taking today? At the end of May our strategy had a gross equity position of 112% and a net equity position of -12%. We can find short ideas more easily than longs and we have reasonable conviction in them. Relative to our own history, our gross is higher than average and our net is lower (see chart 1).
Looking at this chart, a top-down interpreter might say that we have a negative view on future stock market returns and that we have some confidence in this view. However, as part of our checks and balances, we are careful not to let our bottom-up view be dominated by top-down notes. In our experience, our idiosyncratic stock-level approach – which incorporates analysis of the market ecology, quantitative signals and fundamental analysis – provides excellent information about the sorts of risks and anomalies in the stock market. Federal Reserve largesse since the financial crisis, for example, might have supported excessive borrowing by some high-growth stocks, especially in the US, but we haven’t taken short positions in these due to the actions of the Fed. Rather, we usually home in on a mix of issues: fragile balance sheets, a lack of profitability, management hubris, aggressive accounting choices.
Nevertheless, the more ideas we have and the higher the conviction we have in them, the higher the strategy’s gross equity position becomes. Everything else being equal, the potential losses in a ‘bad scenario’ become larger too. There is a fine balance between positioning for good opportunities and opening the strategy up to larger losses…this can make managing the strategy nerve-wracking.
If we lost more than we would expect in a bad scenario (and we just did in the period from Christmas to mid-May) it tells us that either we took too much risk relative to our appetite for losses, or that markets are in some way ‘weird’ or dislocated (or both). Only after events have played out can you tell with any confidence what just happened.
Are we taking too much risk? For investors, this question is more nuanced because they rarely hold our strategy in isolation. Instead it forms part of a suite of funds. Thus, what really matters is how the portfolio blends in with the other funds held by our clients. This judgement is best made by the clients themselves, as they can see all of their assets together. And for certain investors, it is feasible we are not taking enough risk. Nevertheless, we’re fairly confident that our portfolio is quite different from most other funds (see our recent note: ‘Why do more managers not do what we do?’ for more on this topic). As such, our strategy probably lowers risk and the potential for large losses, when included as part of a suite of funds. That’s probably the most important thing to say in any discussion of risk.
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