Risk management and high conviction investing

abnormalreturns
July 26th, 2007

Investing is hard. We have referenced this post any number of times. Not because it is particularly revolutionary, but because it rings true in any number of contexts. Undoubtedly recent volatility and market stresses have put any number of investors on edge. However, a recent piece by a prominent investor, Mohamed El-Erian of Harvard Management Company, may mean a more difficult time for investors in the future.

His entire comments are found at FT.com but this (extended) excerpt from a Helen Thomas recap at FT Alphaville gives you the gist of the argument.

Trouble is, suggests El-Erian, that the past few years, when virtually any risk asset has outperformed, has not been a good environment in which to test the appropriateness of portfolio construction, and whether by diversifying across risky asset classes, portfolios will continue to mitigate risk sufficiently.

we may well be in the middle of a regime shift: exiting a world in which the difference among individual investors’ performance was essentially a function of the degree of their exposure to the most illiquid and leveraged asset classes, and entering a world where more sophisticated risk management capabilities will increasingly be the main differentiator.

Recent market performance, including the unwinding of the subprime mortgage mess, is going to put into clearer focus those investors who have been taking on risk in a measured and prudent way, and those that have been doing so in a more cavalier fashion.

Risk management, as mentioned, is an often neglected topic. One respect in which it is underplayed is the way in which investors apply their findings of “market anomalies” to portfolio construction. A recent paper by Ryan McKeon at SSRN.com investigates the degree to which a portfolio could tilt towards known market anomalies within the constraints of institutional-type risk parameters.

Unfortunately the answer is not all that well. The author finds “…that long-only constraints and tracking error are significant real-world impediments to successfully implementing profitable strategies from the academic literature.” That would seem to argue for loosened constraints like those found in either a hedge fund or in the newly popular 130/30 fund structure.

Again the evidence is not crystal clear on this point. The fact of the matter is that the term ‘hedge fund’ has strayed markedly from its original use to describe a truly ‘hedged’ fund that includes both long and short positions. Today hedge funds, as an asset class, have become subject to “cloners” who seek to replicate their returns in a mechanical fashion omitting the possibility of generating alpha, while capturing so-called ‘hedge fund betas.’

130/30-type funds have become popular in that they are designed to allow institutional investors to have greater latitude to implement security selection while maintaining a (relatively) constrained risk profile. This is in contrast with many hedge funds where risk parameters are entirely less rigid. The always excellent All About Alpha blog has a post up on the question of whether 130/30 or 1X0/X0 funds are really and truly “high conviction” investment vehicles. As they write:

Therefore, if you’re looking for a concentrated fund, don’t assume that 130/30 fund necessarily fits the bill. In the end, a particular 1X0/X0 strategy might not actually be ”high conviction” at all. The irony is that 1X0/X0 strategies actually represent a way for managers to express more of their beliefs, not to necessarily express those same beliefs with a “higher conviction”.

What is the upshot of all of this? If we are entering an era in which the benefits of cheap leverage and now-mainstream alternative asset classes no longer provide easy alpha, then risk management and portfolio construction will become ever more important differentiators of performance.

Investors need to realize that while risk constraints may prevent portfolio accidents they will also prevent truly outstanding performance. The irony is that in order to generate truly unique returns investors will now have to take on meaningful idiosyncratic risk. Hey, wasn’t that the way it was supposed to work all along?