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    Risk-Controlled Investment Strategies Risk-Controlled Investment Strategies Presentation Transcript

    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Risk-ControlledInvestment Strategies1Tuesday 5th March 2013
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Volatility Control2Dan MikulskisALM & Investment Strategy
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013We summarise our approach to putting clients in control of their funding goals in seven stepsRedingtonOur Approach33Volatility Control and Risk Parity are examples ofStep 3: Liquid Alpha and Beta strategies
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Introduction : How Does Volatility Control WorkDrive to the conditions4
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013How do we Volatility Control• Volatility Control is achieved through varying the exposure to equities dynamically in response to the volatility level• As equity volatility rises, we reduce exposure from equity toward cash, depending on the volatility target• Here we illustrate the dynamic exposure of a volatility control approach targeting 10% volatility5Source: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Why use Volatility ControlFor Defined Benefit pension funds:- Prudent way of controlling risk in equity portfolio;- Can get better risk adjusted returns than a fixed market exposure;- Can help to manage/improve the risk budget by targeting a set level of volatility;- More cost effective way of getting downside protection on an equity portfolio.For Insurance Companies:- May get capital reductions compared to a fixed allocation to equity markets;- For With Profit and Variable Annuity products, can get cheaper downside protection.For Defined Contribution pension funds:- Can get much cheaper downside protection than fixed market allocation;- e.g. 50bps per year to protect at 80% of highest NAV.6
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013What Volatility Control is (and isn’t)Volatility Control is ...• An alternative approach to allocating capital;• A technique for managing risk;• A passive investment style;• Implemented on a mandate level;• Also known as Risk Control or Volatility Target.7Volatility Control is not ...• A quantitative trading rule that tries to outperformequities;• A mechanism for trying to predict market crashes;• A process for selecting low volatility stocks;• A process for weighting individual stocks according to theirvolatility;• A guaranteed downside protection vehicle againstinstantaneous crashes.
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Why Volatility Control (1)• Equity Volatility varies very substantially through time.• Both above and below the long term average.8Source: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013What does Volatility Control achieve9• The Volatility Control approach keeps the trailing volatility close to the target level of 10%.Source: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Why Volatility Control (2)• Across time periods and markets, Volatility Control has historically produced better risk-adjusted outcomes than a fixedmarket exposure allocation100100200300400500600Volatility Controlled Portfolio FTSE 100 Total Return Portfolio
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Why Volatility Control (2)• Across time periods and markets, Volatility Control has historically produced better risk-adjusted outcomes than a fixedmarket exposure allocation11Source: Bloomberg; Calculations: RedingtonNotes:1. Measured in excess of relevant cash rate (3m LIBOR where data exists, proxy otherwise)2, Measured as standard deviation of daily returns (100 day measure)20 years ending31.12.2012MSCI World FTSE 100 S&P 500Index VolatilityControl 10%Index VolatilityControl 10%Index VolatilityControl 10%Excess Return1 (%p.a.) 2.6 3.6 2.9 3.2 4.6 4.1Volatility2 (%p.a.) 15.0 10.9 18.6 10.6 19.2 10.7
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Case Study 1 : January 2008 – June 200912• The FTSE 100 peaked in May 2008, then fell very sharply in September and October 2008 following the collapse ofLehman Brothers.• At this point volatility increased sharply.• The FTSE 100 reached its bottom in March 2009 before beginning its recovery.Source: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Case Study 1 : January 2008 – June 200913Source: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Case Study 1 : January 2008 – June 2009• The Volatility Control approach de-geared substantially well before the market lows• Hence the drawdown suffered was much shallower, around -25% compared to -55%14Source: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Case Study 2 : January 2004 – June 200615• Over this period the FTSE 100 index rallied consistently with a relatively low volatility, increasing by around 45% over the2.5 year periodSource: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013• As the volatility of the FTSE 100 fell below the target of 10%, the market exposure of the volatility controlled portfolioincreased to greater than 100%. A cap was in place at 150% exposure but this was never reached.• As volatility increased toward the middle of 2006 the volatility control approach de-geared to a 60% exposure level.Case Study 2 : January 2004 – June 200616-10%10%30%50%70%90%110%130%150%0%10%20%30%40%50%60%70%AnnualizedVolatility(%)ofFTSE100%AllocationofvolatilitycontrolledapproachFTSE Allocation FTSE Rolling VolatilitySource: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Case Study 2 : January 2004 – June 200617• In this case the value of the volatility controlled portfolio and the fixed market exposure portfolio increased roughly in line,with substantially the same realised volatility.Source: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Case Study 3 : January 2011 – December 2012• This period saw substantial market volatility across global markets during August and September of 2011, followed by asustained rally in 2012 and decreasing volatility.18Source: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Case Study 3 : January 2011 – December 201219• As the volatility of the FTSE 100 increased during August and September of 2011, the exposure of the volatility controlledstrategy decreased to around 40%.-10%10%30%50%70%90%110%130%150%0%10%20%30%40%50%60%70%AnnualizedVolatility(%)ofFTSE100%AllocationofvolatilitycontrolledapproachFTSE Allocation FTSE Rolling VolatilitySource: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Case Study 3 : January 2011 – December 2012• Despite the period of increased volatility, the FTSE 100 recovered to its pre-August 2011 level relatively quickly, andcontinued to rally from there.• As the volatility control approach had de-geared during the volatile phase, it did not participate fully in the recovery.• The volatility controlled approach behaved as it should have done, reducing volatility experienced during August andSeptember 2012.20Source: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Implementing Volatility Control• The most straightforward implementation is through a rebalancing program using futures.• Most efficient for this to be managed by the LDI manager to make the most effective use of collateral.• Most of the major UK LDI providers have indicated their ability and willingness to manage such mandates.• We believe appropriate fee levels are : Small mandate with no additional LDI ~ 20-25bps Large mandate alongside an LDI mandate ~10-15bps As Vol Control is a “passive plus” type of strategy, we believe these are appropriate• Separately it is possible to implement through a Total Return Swap (TRS) with an investment bank.• This potentially introduces an extra layer of complexity and liquidity, which will only be worth doing if the cost savings aresignificant enough.21
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013• One advantage of a Volatility Controlled approach to investing is that it is much cheaper to buy downside protectionagainst a large fall in the portfolio’s value.• The uncertainty of equity volatility (as shown before) means that downside protection options carry a large premium.Extensions of Volatility Control : A Pathway to Cost Effective Portfolio Downside Protection22Source: Bloomberg; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Extensions of Volatility Control : A Pathway to Cost Effective Portfolio Downside Protection23
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Extensions of Volatility Control : A Pathway to Cost Effective Portfolio Downside Protection241 Year Protection level Approximate cost to protect equityportfolio (%) over 1 yearApproximate Cost to protect 10% VolControl portfolio (%) over 1 year90% 3.9 1.385% 2.8 0.580% 1.9 0.2Source: Bloomberg, Barclays; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Volatility Control in the press and media25
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Volatility Control in the press and media26“Regarding target volatility indexes, we haveshown that their long-run Sharpe ratio is alwaysbetter than the Sharpe ratio of the underlyingequity index as long as the target volatility level ischosen within reasonable boundaries.”
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Volatility Control in the press and media27“To date, Volatility Target funds have not seenwidespread take-up. One of the major concernsseems to be whether the concept is too complexand difficult to communicate.”“However, it can be argued that such anapproach helps an advisor meet client suitabilityrequirements as it enables them to discussmaximum expected fund value falls.”
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Conclusions & Further Information Volatility Control is an approach to portfolio construction that aims for a more consistent risk through time, compared to afixed market allocation. It does this by varying the allocation to equities through time. Analysis over long time periods and across markets shows that this approach can deliver better risk-adjusted returnoutcomes than a fixed market exposure. Volatility Control is easy and cost-effective to implement, being a semi-passive approach.Further Reading -The Actuary Magazine December 2012http://www.theactuary.com/features/2012/12/volatility-control-taming-the-beast/RedViewshttp://redington.co.uk/getattachment/eea3dd74-37c8-446e-afa9-fd8d1973f295/Taming%20The%20Beast.aspxRedBlogshttp://blog.redington.co.uk/Articles/Dan-Mikulskis/September-2012/VOLATILITY-CONTROL.aspxhttp://blog.redington.co.uk/Articles/Dan-Mikulskis/December-2012/TAMING-THE-BEAST.aspxThe Journal of Indexes November / December 2012http://www.indexuniverse.com/publications/journalofindexes/joi-articles/12932-optimal-design-of-risk-control-strategy-indexes.html28
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Risk Parity: Balancing RiskAcross Asset Classes29Aniket DasManager Research Team
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013What is Risk Parity?30Risk Parity refers to a systematic approach to multi-assetinvesting which allocates to a variety of asset classes (or riskfactors) according to risk exposure rather than asset value.
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013The Problem with Traditional Asset Allocation – #131Average UK Pension Fund Asset AllocationEquitiesNominal Govt BondsInflation-Linked BondsPropertyAlternativesRisk AllocationEquitiesNominal Govt BondsInflation-Linked BondsPropertyAlternativesc.90% of risk from equitiesSource: UBS; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013The Problem with Traditional Asset Allocation – #232-10%-8%-6%-4%-2%0%2%4%6%8%Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12TrailingMonthlyReturnAverage PF Asset Allocation Equity ComponentCorrelation = 0.91Source: UBS; Calculations: Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Why do we have this situation?33
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Leverage in Risk Parity, Leverage in Equities34208%186%0%50%100%150%200%250%300%350%400%450%1995 1997 1999 2001 2003 2005 2007 2009 2011Totalleverage(DebttoEquity)MSCI World Debt to Equity Ratio Risk Parity 12% Vol Total Leverage EmployedMSCI World Average Risk Parity 12% Vol AverageSource: MSCI, S&P, Merrill Lynch; Calculations: Bloomberg, Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013What does a Risk Parity portfolio look like? – #135- Introducing a simple risk parity model we created, utilising 43 years of data:-- Equities: MSCI World Net TR Index (1970-2012)- Bonds: Bloomberg Generic 10 Year US Treasury (1970-73) / Merrill Lynch 7-10 Year US Treasury TR Index (1973-2012)- Commodities: S&P GSCI TR Index (1970-2012)- Equal risk weight to each asset class (i.e. 33.3% of portfolio risk in equities, 33.3% in bonds and 33.3% in commodities)- 24 month trailing volatility used to forecast future volatility- Rebalancing occurs monthly- No transaction costs (futures trading of major market instruments is relatively cheap)N.B: Manager implementations of risk parity will vary from this simple model as will be discussed laterEquitiesBondsCommodities
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013 360%10%20%30%40%0%5%10%15%20%25%30%1972 1977 1982 1987 1992 1997 2002 2007 2012EquitiesVolatility (LHS) Portfolio Allocation (RHS, Inverted Scale)0%10%20%30%40%50%60%70%80%0%5%10%15%20%1972 1977 1982 1987 1992 1997 2002 2007 2012BondsVolatility (LHS) Portfolio Allocation (RHS, Inverted Scale)0%10%20%30%40%50%0%10%20%30%40%1972 1977 1982 1987 1992 1997 2002 2007 2012CommoditiesVolatility (LHS) Portfolio Allocation (RHS, Inverted Scale)0%5%10%15%20%25%30%35%40%1972 1977 1982 1987 1992 1997 2002 2007 2012Trailing24-MonthVolatilityAsset Class VolatilityEquities Bonds CommoditiesWhat does a Risk Parity portfolio look like? – #2
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013What does a risk parity portfolio look like? – #3370%10%20%30%40%50%60%70%80%90%100%1972 1977 1982 1987 1992 1997 2002 2007 2012PortfolioWeightUnlevered, no volatility targetEquities Bonds Commodities0%50%100%150%200%250%300%1972 1977 1982 1987 1992 1997 2002 2007 2012PortfolioWeightLevered @ 10% volatilityEquities Bonds CommoditiesSource: MSCI, S&P, Merrill Lynch; Calculations: Bloomberg, Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Risk Parity Performance - #138Jan 1971 –Dec 2012UnleveredRisk ParityRisk Parity@ 10% Vol60% Equities40% Bonds50% Equities50% Bonds100% Bonds 100% Equities 100% CommoditiesTotal Return 9.46% 10.36% 8.73% 8.69% 8.10% 8.55% 8.98%Excess Return 2.91% 3.76% 2.21% 2.18% 1.63% 2.04% 2.46%Volatility 7.02% 10.00% 9.84% 8.77% 7.57% 15.18% 20.38%Sharpe Ratio 0.41 0.38 0.22 0.25 0.21 0.13 0.12-1000%0%1000%2000%3000%4000%5000%6000%1972 1977 1982 1987 1992 1997 2002 2007 2012CumulativeTotalReturnUnlevered Risk Parity Risk Parity @ 10% Vol60% Equities / 40% Bonds 50% Equities / 50% Bonds01101001972 1977 1982 1987 1992 1997 2002 2007 2012TotalReturnIndex(logscale)Unlevered Risk Parity Risk Parity @ 10% Vol60% Equities / 40% Bonds 50% Equities / 50% BondsSource: MSCI, S&P, Merrill Lynch; Calculations: Bloomberg, Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Risk Parity Performance - #239-30%-20%-10%0%10%20%30%40%50%60%70%1972 1977 1982 1987 1992 1997 2002 2007 2012CumulativeContributiontoPortfolioExcessReturnEquities Bonds CommoditiesSource: MSCI, S&P, Merrill Lynch; Calculations: Bloomberg, Redington
    • Teach-in Risk-Controlled Investment Strategies 5th March 20130%2%4%6%8%10%12%14%16%18%1970 1975 1980 1985 1990 1995 2000 2005 201010 Year US Treasury Yield Rising Interest Rate PeriodRisk Parity and Rising Interest Rates40# Time Changein Yield(bps)UnleveredRisk ParityRiskParity10% Vol60 / 40Portfolio1 Feb 1972 –Sep 1975+244 1.16% 0.00% -7.83%2 Dec 1976 –Feb 1980+571 -2.44% -4.13% -2.30%3 May 1980 –Sep 1981+508 -13.90% -9.83% -12.85%4 Feb 1983 –Jun 1984+304 -1.25% -2.89% -3.40%5 Aug 1986 –Sep 1987+231 10.44% 10.53% 14.32%6 Sep 1993 –Nov 1994+246 -7.48% -11.11% -4.37%7 Sep 1998 –Jan 2000+169 3.77% 4.78% 10.71%8 May 2003 –Jun 2006+130 7.58% 10.93% 8.68%Annualised Excess ReturnAnnualised Excess ReturnOver Months WhereInterest Rates RoseAnnualised VolatilityOver Months WhereInterest Rates RoseUnlevered Risk Parity -6.53% 6.75%Risk Parity 10% Vol -9.30% 10.04%60 / 40 Portfolio -6.72% 9.33%
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Alpha / Beta Separation41Return Cash Beta Alpha
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013The Risk Parity Manager Universe42Passive (β)• Relatively pure riskparity beta• Balances risk betweenasset classes or otherrisk factors• May include smarterbeta approaches withinasset classes (e.g. anenhanced commodityindex)Semi-Active (β + α)• Risk parity beta + mildamounts of alpha• Alpha may begenerated throughdiscretionary bets (e.g.taking macro views) orthrough systematic tilts(e.g. cutting thevolatility target inhigher riskenvironments)Active (β + α)• Risk parity beta + largeamounts of alpha(hopefully!)• May not resemble riskparity much if veryactive• Typically charge higherfees for the added“activeness” / alphaGlobal macro / quantitative equities/ hedge fund managersTraditional balanced fund managersnow offering risk parity solutions
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Risk Parity Managers – How do they vary?43•Pooled fund offerings will typically target a volatility of 8-10%, though there may bedifferences. For segregated mandates, the volatility target can usually be specified (up to 25%).Volatility Target•In our simple risk parity model, we used trailing 24-month volatility to forecast futurevolatility. Managers are likely to use different calculations from ours, including the use ofimplied volatilities in some cases.Volatility Window•Unlike our model in which we used 3 asset classes, risk parity managers may use more assetclasses (e.g. credit). However, the inclusion of more asset classes doesn’t necessarily make itbetter. Many managers balance risk across risk factors rather than asset classes.Asset Classes•We rebalanced monthly although most managers will trade more frequently than this, oftenwhen the benefits of rebalancing outweigh the costs (which are low due to the use of futurescontracts).Rebalancing•Within each asset class rests the choice of what futures instruments to use. For example, manymanagers are now choosing to use the 30 Year US Treasury rather than the 10 Year. Smarter,customised commodity indices are also a feature of many managers.Beta Instruments•These will vary depending on manager philosophy and investment process though cruciallythe purpose of alpha and beta separation is to isolate true skill from generic market riskpremia.Alpha Sources•Given the extensive use of futures contracts, the management of collateral is a key aspect interms of fund management for risk parity strategies. The level of free cash in place to satisfycollateral calls should be monitored.Collateral Management
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Drawdowns in the Risk Parity Manager Universe44Source: Managers, eVestment, Salient Partners, BloombergMax drawdown =-21.4%-54.0%-32.1%-60%-50%-40%-30%-20%-10%0%Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10DrawdownManager A Manager B Manager CManager D Manager E Manager FSalient Risk Parity Index MSCI World 60/40
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Risk Parity is a beta solution (and should be priced accordingly!)45Mgr A Mgr B Mgr C Mgr D Mgr E Mgr F Mgr G Mgr H Mgr I0102030405060708090100TotalExpenseRatio(BasisPoints)Source: Managers, eVestment
    • Teach-in Risk-Controlled Investment Strategies 5th March 2013Implementing Risk Parity in Your Portfolio46- Risk Parity is not a panacea. It is, however, a more efficient approach to portfolio construction than traditional methods. Itfirmly places a focus on risk as well as return.- There are other asset classes and risk factors with betas and alphas worth pursuing which risk parity cannot access easily.Risk parity requires exposures to be able to be taken synthetically. This precludes investment in asset classes which cannot betraded either through futures or swaps (e.g. illiquid credit, insurance-linked securities, etc.)- Therefore, risk parity can be seen as a solution to only part of the entire investment portfolio – that which focuses on majorpublicly-traded markets. This “bucket” in the investment portfolio is what we term “step 3 - liquid alpha and beta strategies”(see table below).- In addition to volatility-controlled equities and risk parity, within the liquid alpha and beta strategies bucket, we alsorecommend clients consider trend-following strategies (also known as CTA managers). These risk-controlled strategies offer aliquid risk premium as well as portfolio diversifying characteristics.Part of Redington’s SevenSteps to Full Funding™
    • Teach-in Risk-Controlled Investment Strategies 5th March 201313-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.ukContacts47DisclaimerFor professional investors only. Not suitable for privatecustomers.The information herein was obtained from various sources.We do not guarantee every aspect of its accuracy. Theinformation is for your private information and is fordiscussion purposes only. A variety of market factors andassumptions may affect this analysis, and this analysisdoes not reflect all possible loss scenarios. There is nocertainty that the parameters and assumptions used in thisanalysis can be duplicated with actual trades. Anyhistorical exchange rates, interest rates or other referencerates or prices which appear above are not necessarilyindicative of future exchange rates, interest rates, or otherreference rates or prices. Neither the information,recommendations or opinions expressed herein constitutesan offer to buy or sell any securities, futures, options, orinvestment products on your behalf. Unless otherwisestated, any pricing information in this message is indicativeonly, is subject to change and is not an offer to transact.Where relevant, the price quoted is exclusive of tax anddelivery costs. Any reference to the terms of executedtransactions should be treated as preliminary and subjectto further due diligence .Please note, the accurate calculation of the liability profileused as the basis for implementing any capital marketstransactions is the sole responsibility of the Trusteesactuarial advisors. Redington Ltd will estimate the liabilitiesif required but will not be held responsible for any loss ordamage howsoever sustained as a result of inaccuracies inthat estimation. Additionally, the client recognizes thatRedington Ltd does not owe any party a duty of care in thisrespect.Redington Ltd are investment consultants regulated by theFinancial Services Authority. We do not advise on allimplications of the transactions described herein. Thisinformation is for discussion purposes and prior toundertaking any trade, you should also discuss with yourprofessional tax, accounting and / or other relevantadvisers how such particular trade(s) affect you. Allanalysis (whether in respect of tax, accounting, law or ofany other nature), should be treated as illustrative only andnot relied upon as accurate.©Redington Limited 2013. All rights reserved. Noreproduction, copy, transmission or translation in whole orin part of this presentation may be made withoutpermission. Application for permission should be made toRedington Limited at the address below.Redington Limited (6660006) is registered in England andWales. Registered office: 13-15 Mallow Street LondonEC1Y 8RDDan MikulskisDirectorALM & Investment StrategyDirect Line: 020 3326 7129dan.mikulskis@redington.co.ukAniket DasAssociateManager Research TeamDirect Line: 020 3326 7153aniket.das@redington.co.uk