Dynamic Risk Management

Unrest in the middle-east and a horrible series of disasters in Japan, among other things, have investors on edge. However, despite these events, there has been very little panic selling outside of the individual markets/regions that were directly affected. In fact, the VIX Index, which measures the equity market's expectation of near-term volatility (or risk), is trading near its 52-week lows (see chart at right). 

The VIX is a little like the flying in an airplane. Any spike higher in the VIX is similar to the fasten seat belt sign going on—99.99% of the time everything is fine. Even so, that little sign and the accompanying bumps raise your heart rate; fear levels go up. A spike above 30 or so is like the oxygen masks dropping down—the plane is not necessarily crashing but something frightening is happening; everything is not ok. Finally, any reading consistently above 35 or higher for more than several weeks is a sign that there is something systemically wrong—it is time to put the parachute on and exit the plane.

The reason I point this out is because many investors I have recently spoken with have expressed concern over the market. And, given recent events, some concern is warranted; however, the fasten seat belt came on only briefly over the last several months. Surprisingly the markets have shrugged off a series of horrible news and appear to want to go higher. (As explained in last month’s commentary, we believe this is in large part due to easy monetary policies in most developed countries.)

Regardless, given how unpredictable and uncertain the first three months of this year have been, the rest of this month’s commentary is dedicated to explaining our risk management process (i.e. when we strap on our parachutes).

There are two core components to our risk management strategy—strategic asset allocations and dynamic risk management. The combination of the two results in a portfolio with positively skewed monthly returns and significantly fewer negative months (see chart below).



Strategic Asset Allocation forms the “broad strokes” of our models and is based on our 3-5 Year Investment Outlook, as well as mean-variance optimization. Mean-variance optimization attempts to maximize portfolio return for a given amount of portfolio risk. The product of the two is a policy portfolio that balances investment opportunities across geographies and asset classes, and that serves as the reference portfolio off which we structure all of our models.

In theory, a well thought-out mixture of uncorrelated assets (equities, fixed income, commodities, currencies) should reduce overall risk and protect your portfolio against wild swings—when one asset zigs, the other zags—however, in practice, in times of severe disruption, all markets tend to move in the same direction at the same time.

Therefore, we have an added layer of risk management, Dynamic Risk Management, that acts as the “fine tuning” for our models and your portfolios. We follow a purely mechanical logic based on the current price level for any given security relative to its N-period simple moving average (SMA)—where N varies depending on certain preset parameters. Although, our process is slightly more complicated, at the most basic level when the monthly closing price for a security is above its SMA, we are invested; when it is below its SMA, we are in cash.

While not fail-safe, this mechanical system allows us to rapidly adjust our models to the prevailing trading environment and avoid making unwise investment decisions based solely on emotion. This in turn dramatically reduces the risk inherent in our clients’ portfolios (which is one of the key reasons many of our clients rely on us).

To receive a PDF presentation on our Portfolio Construction Process and Dynamic Risk Management please contact us.

Bottom Line: Despite the horrible toll on life, the recent events only temporarily raised the level of fear in the financial markets.