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“We’re putting our toes in the water,” Jerry Clack, Board of Trustees member for the Oklahoma State University (OSU) Foundation, says via southern drawl and telephone in early February. He’s referring to an index options overlay of the equity portion of their $450 million portfolio— which is managed without a chief investment officer but with close cooperation between a consultant and an investment committee— and how his fund is dealing with risk via this dynamic process.
Tulsa is a long way from New York City or London, but this doesn’t mean that Clack and his fellow committee members aren’t dealing with the very same investment risks as every other medium-size asset owner worldwide. While the fund avoided much of the carnage of 2008, it still was hit by falling valuations across its portfolio, leading to a search for a system that could hedge against such risk in the future. “With your equity portfolio, if you can get 70% of the upside and limit your downside to 50%, the math works in your favor—especially in a fund that has to pay out regularly, like ours,” Clack says. How to do this, then, is the most central question that Clack and his peers have had to confront as 2008 recedes further into the rear-view mirror.
The analogy is appropriate. When thinking of investment risk, it is helpful to think in tactical and strategic terms and, to do this, the transportation imagery works well. Let’s say you need to get from point A to point B. There are various travel options, some faster and riskier, some slower and less risky. Your choice of transportation mode—you can walk, ride a bike, drive a car, take a train, fly a plane—is your strategic choice. A car might be safer, but it takes longer; a plane might be more dangerous, but you get there faster. These are strategic choices, with you understanding (to a degree) the risks involved and making your decision accordingly. If the driver in this analogy is a chief investment officer or investment committee, then this choice is the asset allocation decision. The question of transportation method used to get to point B is the same as what mix of assets you want in your portfolio to get the maximum return for the least amount of risk. Tactical risk management, on the other hand, is the airbag in the car, the helmet on the cyclist, or the ejection seat in the plane. The decision of how to travel has already been made; at this point, the passengers are relying on safety mechanisms to prevent death.
That investors like Clack face strategic and tactical risks is unquestionable. Figuring out how best to protect capital from both, however, is questionable. On a strategic level, the OSU Foundation looks toward a diversified, endowment-style asset allocation to avoid the pitfalls of overreliance on any one asset class. “Before the crisis, we had implemented an allocation that resembled the endowment model—private equity, hedge funds, all that,” he says. “Luckily, we also had a focus on liquidity before that was such a big issue, which helped us avoid the worst of the crisis.” While he’s cognizant of David Swensen’s warning that smaller funds won’t have access to top-decile managers, and, thus, will miss out on the best returns, he does note that recent results show a strong private equity portfolio and a hedge fund return-set that he is “satisfied” with. There are other portfolio products that claim to provide risk management on a strategic level, of course—few will have failed to notice the recent success of risk parity vendors, who rely on risk-weighted portfolios to bring (relatively) stable and robust returns—but, for foundations and endowments, the notorious Yale Model seems to be the reigning view. (Strategic asset allocation is not a zero-sum argument, of course: Many endowments and foundations include a risk parity solution within their portfolios).
Yet, it is at a more granular risk management level that Clack and his fellow board members are pushing the edges of their envelope. The fund wants to maintain its significant exposure to equity markets, but it also aims to reduce volatility. After an extensive search to find a suitable vendor, the solution they decided upon was this: the previously mentioned index options overlay, managed actively by the Englewood, New Jersey-based Gargoyle Group. With a static approach to overlays, the hedge is set once a month; with this dynamic approach, the portfolio is watched each day, with Gargoyle looking to ensure that preset long/ short parameters aren’t violated.
This form of tactical risk management doesn’t use any excessively fancy derivatives—it’s just selling index call options, after all—but, historically, it can and does generate alpha: Over the past 10 years, Gargoyle’s dynamic hedging strategy has produced an annual compound rate of return of 3.5%, compared with a passive options overlay rate of return of 1.6% (represented as the options component of the BXM, a Chicago Board of Exchange stock-and-option strategy index).
Yet, besides the additional return— which, like any investment, may see weaker performance over another time frame—why the focus on dynamism? “The dynamic approach can be adjusted as time goes by, through different market environments,” says Clack approvingly. “Of course, all we’ve seen is [Gargoyle’s performance] in an up market, so we’ll see what happens in a down market. In a sideways market, it is fine, you can keep rolling the options over but, in a down market, we will need to see if what is promised turns out to be true.” Gargoyle’s answer to the dynamic question is this: “It’s simple,” says Gargoyle Managing Partner of Investment Strategies Joshua Parker, “because our clients’ portfolios are exposed to market risk every day.” Such a strategy can be a drag on performance in a quickly growing equity market, of course, but passive option hedging strategies can as well.
Some argue that investors like OSU should go even further, of course. Arun Muralidhar, former World Bank pension head of research and Chairman and Co-CIO at AlphaEngine Global Investment Solutions, believes that active risk management should be applied across all asset classes in a portfolio. “Unless it’s across the entire portfolio, it’s suboptimal,” he says. “Risk management should be managed for the entire portfolio and not just each asset class at a time.” A static approach to investing with dynamic markets is likely to fail, Muralidhar claims, and, thus, executing risk management through a rules-based rebalancing of the portfolio provides the best answer to the problem of risk, “defined not just as volatility of returns but of asset or solvency drawdown.” The rules that define when and how a portfolio will be rebalanced, he says, can be based on peer-reviewed journal articles—to bring an economic basis to the tilting—and the rebalancing itself should be zero sum. At its core, Muralidhar’s theory is that economic factors should form the basis for being over- or underweight certain assets, all within a strict and predetermined set of rules. Alternatively, it is possible to manage the beta risk of the portfolio through an absolute-return-oriented strategy that is negatively correlated to the portfolio and managers, he adds. Clack and the OSU Foundation are on the right track, Muralidhar might say, but they need to go further to truly be managing risk.
“This is really the beginning of a conversation in risk that we’re having,” Clack says. The point, however, is that he’s having that discussion at all. The global financial crisis emphasized to many asset owners the need to think about protecting their portfolio against extreme events. Vendors, as always, have stepped in to fill this need—both smaller firms like Gargoyle as well as larger firms like Deutsche Bank (with its ELVIS and other hedging product) and PIMCO— but this is about more than buying a product. It is, Clack says, about “understanding, on a greater level than before, what risks the portfolio is exposed to, whether those risks can be dealt with on an asset allocation level or if they have to be dealt with more tactically,” and then finding out how to turn abstract thought into concrete solution. While reasonable people can argue over whether the OSU Foundation is executing both strategic and tactical risk management in an optimal way, or over whether a dynamic or static approach to tail hedging is the best route to take (to potentially overuse the transportation analogy), they can’t argue over the necessity of addressing these issues in the first place for, while capital pools have largely recovered from their 2008 nadir, the next crisis may be just around the corner— and only intelligent risk management will suffice to prevent another accident.