Investors are emotional beings, creatures of habit, and as a result, the makers of irrational and untimely decisions when it comes to their portfolios. These emotional responses are called biases and they play havoc with the an investors ability to stick with even the best portfolio during bad times. As we continue to get further away from the last bear market in 2008, these behavioral biases cause investors to seek maximum returns (Greed) instead of focusing on managing risk (Fear). The opposite is also true, during bear markets investors become scared watching their account balances spiral downwards causing them to sell to ‘stop the bleeding’. These behavioral flaws cause investors to make costly decisions at the wrong time.

It is critical to construct portfolios that investors can live with through both good and bad times. In order to do so, we believe the approach needs to be systematic to attempt to remove the behavioral biases that can hurt investor returns. We also believe the approach needs to be responsive to market changes where we can make adjustments that can help avoid prolonged bear market losses while attempting to capture bull market gains. Of course, this is can be a very difficult balance to meet – there are no silver bullets. Investors in risk managed strategies like we’ve described, will most likely see relative under-performance during bull markets due to the risk management strategies that are employed to protect their capital, and out-performance when the risk management pays off as markets decline.

It is very important to recognize what risks are manageable to some degree and which are not as not all types of risk can be managed effectively. The below table illustrates the various types of risks and whether it is likely they can be managed.

Different Approaches to Actively Manage Risk
Managing risk is best thought of as purchasing an insurance policy: there are many different forms of insurance and each costs a different amount and provides you with differing degrees of coverage if something goes wrong. Of course if nothing goes wrong you are effectively wasting money on your insurance premiums. But the purpose of insurance is that you don’t know if something is going to go wrong, and if something happens you are going to want to have coverage. A buy and hold approach through 2008 would have caused investors to have gut-wrenching drawdowns of 40-50% or more depending on their exposure. As a result, managing risk is generally prudent, but you want to keep the cost to long-term returns as low as possible.

If you’re going to manage risk in a portfolio you are limited to a few different options:

This is the traditional method for managing risk and has its roots in Modern Portfolio Theory. This involves holding multiple asset classes that are each uncorrelated in order to reduce risk. The challenge with this approach is that correlations often go to 1 in a crisis, and true negatively correlated assets such as bonds have lower expected returns than risk assets and produce a drag in return on the portfolio overall.

The most common option hedging method involves purchasing index put options to hedge your equity position. Alternative methods include purchasing long volatility instruments which profit from a spike in volatility. Both methods are more direct forms of insurance but they are the most costly and complicated to implement, and tend to have a negative expected return.

Risk Budgeting (Risk Parity)
This method involves a dynamic weighting between stocks and bonds depending on their relative volatility. The purpose of risk parity is to balance the risk allocation equally between asset classes to ensure equal risk contribution. This method is effective at reducing risk but relies on fixed income having reasonable returns to perform well.

Dynamic Hedging/Risk Managed Asset Allocation
This is like producing a synthetic put option by dynamically reducing risk by shifting to cash and fixed income when the underlying asset class is declining and volatility is rising. The most conventional approach is to use time-series momentum or moving average strategies on the underlying asset class. The advantage of this approach is that it is the least costly option – it produces some drag in bull markets (via whipsaw trades) which is generally recovered during bear markets as the portfolio reallocated to cash or fixed income. The net result of this approach is often out performance over a complete market cycle that includes both bear and bull markets.

Cost Comparison of Risk Management Methods
The different methods of managing risk each have their own associated costs – they reduce upside performance vs. buy and hold when they are included in a portfolio. The table below shows the cost of insurance as the gap between buy and hold and the associated strategy that manages risk. The maximum drawdown shows you the protection that you get in bear markets and this can be compared to buy and hold using the S&P500.

We can draw some observations and conclusions from the table:

  • Using Options and volatility hedging are the most costly forms of insurance, and may be inferior to using traditional diversification via a 60/40 mix or through holding multiple asset classes.
  • Using risk parity can effectively limit drawdowns and has a relatively low cost. However, it is more dependent on long-term bond returns.
  • Dynamic hedging strategies that attempt to replicate option payoffs are by far the cheapest form of insurance and provide good downside protection. In contrast, they are not sensitive to rising interest rates.

Our Dynamic Approach to Managing Risk
We use dynamic hedging which is the most inexpensive but arguably the most effective form of risk management. Generally this means that we employ a traditional time-series momentum approach with various enhancements to manage risk, reduce drawdowns and improve performance over a full market cycle including:

  • Multi-Time Frame Approach: By using a multi-time frame and lookback approach that can trade at various rebalancing windows (daily, weekly, bi-monthly and monthly), making the strategies much more robust.
  • Signal Processing: Use of advanced smoothing techniques and hysteresis to reduce ‘noise’ and excess turnover which enables more responsiveness.
  • Dynamic Lookbacks: Improved responsiveness by employing dynamic windows for lookback calibration which self-adapts to market conditions. In essence, it ‘listens’ to what the conditions suggest is optimal vs. setting and forgetting.
  • Inter-Market Signals: Use macro markets as a risk management signal source in addition to analyzing the underlying holdings of each individual asset class.
  • Multi-Asset Class Diversification: Holding a variety of asset class exposures within a particular asset category in order to diversify returns and reduce risk.
  • Momentum to Select Exposures: In addition to managing risk, we also allocate to better performing markets based on intra/inter asset class momentum to attempt to improve performance.

Goal of Risk Management – Participate and Protect
The goal is to participate in the upside of our target asset class performance while protecting capital by reducing volatility and avoiding large drawdowns that can occur during extended recessions and bear markets.

Dynamic Portfolio Allocation: (Offense vs. Defense)
As markets go down, we seek to de-risk by holding defensive (risk-off) assets such as fixed income or cash. As markets begin to recover we seek to re-risk by holding more offensive (risk-on) assets that have higher momentum within their respective universe.

As you can see in the on the next page, our dynamic approach can help mitigate these types of extended drawdowns like what investors may have experienced in 2008.


Definitions and Disclosures
There is risk of loss with any investment and past performance is not a guarantee of future results. Any graphs or charts contained herein cannot by themselves guide you in making any investment decision. We encourage all investors to use this report along with all other data sources and information to assess all relevant factors one needs to then draw conclusions, such as risk, volatility and diversification. “Risk” is generally discussed in terms of volatility. This presentation contains forward-looking statements. All strategies have risk such strategy fails to perform as expected. BSAM makes no assurance that any investment portfolio or products based on any strategy will accurately track expected performance, provide positive performance returns or perform consistently with forward-looking assumptions. Because no investor may invest directly in an index, data for all QuantX Index Strategies represented in this material does not reflect the deduction of any BSAM management fees, advisory fees or expenses, nor trading costs, all of which will decrease the return experienced by a client and this report should not be presented alone to advisory clients in order to market any related investable portfolio strategies. Value Added Index: The value-added index charts the total return gained by an investor from reinvestment of any dividends and additional interest gained through compounding.