Portfolio Risk

Keeping a watchful eye on investors' appetite for risk

Originally published in the July 2007 issue

The creation of wealth requires the pursuit of high returns which has always included an element of risk-taking. Underestimating this risk may lead to the unexpected erosion of capital. Entrepreneurs are used to taking risks in their businesses to create wealth. Once they sell their business, passing on the proceeds to a trustee or investment manager, their appetite for risk changes as their objectives change from the creation to the preservation of wealth. Mindful of this objective and given the current macro environment, we at Stenham are concerned about the build up of risk in investors’ portfolios. In our view this is a time investors should actively be de-risking their portfolios.

Nursing heavy losses from the bursting of the tech equity bubble followed by a long period of unprecedentedly low interest rates (and tax breaks in the US) has encouraged the notoriously optimistic investor to seek out higher returns by taking on ever-greater degrees of risk; investing in ways that under more normal circumstances they would not even consider. They are probably unaware of the real risks involved – such as using high levels of leverage secured on over-inflated asset prices, or investing in higher-yielding emerging market assets.

What the future holds

Global macro imbalances are continuing to grow and past experience would lead us to expect that these imbalances are unlikely to unravel smoothly, having unpredictable effects on global markets. It is extremely difficult to anticipate these shocks and to get it wrong could significantly erode investors’ capital.

The growth of the global economy over the last 5 years has been driven by massive liquidity driving asset prices to bubble levels, especially in the property and bond markets, with equities beginning to feel the same effect. This liquidity has been stimulated by extremely lowinterest rates, Government spending, tax breaks, global growth and even high oil prices. These trends are now in reverse, which is beginning to suck liquidity out of the system, so far without any material impact on asset values. Investors seem unconcerned as they think that their portfolios are liquid and diversified – a valid view whilst the world has been awash with liquidity and partly because any unexpected shocks have been easily absorbed.

Reasons to be nervous

As liquidity tightens and investors become increasingly edgy a relatively small shock – political instability in the Middle East or the fear, real or perceived, of a spike in inflation – could send investors running for the door and their portfolios turn illiquid and apparently unrelated assets, particularly the risky ones, become correlated. This would send prices plummeting and set off further panic across the broader markets, including those markets where the fundamentals may still be sound. Many of these investments have been financed with debt and so not only could the investors suffer but so too could the creditors, most likely the banks. We are particularly concerned about the banking system that has provided massive leverage secured against inflated asset prices. As this debt begins to unravel, bank excesses may, yet again, become apparent.

The main driver of tightening liquidity is continuing upward pressure on interest rates. Loose money and strong global growth may translate into rising prices, as we experienced in the 1960s and 1970s. We believe the real rate of inflation is higher than the indices are indicating and higher than the market is pricing.

Will history repeat itself?

Economic theory tells us that excess liquidity combined with high levels of state spending will feed through into inflation. During the Johnson era, in the US, unprecedented inflation followed a period of liquidity and state spending on the Vietnam War and the Great Society. At least Johnson partly financed this with taxes, unlike Bush who has financed his war with debt, further fuelling liquidity, whilst reducing taxes. Today, growth in low cost economies, such as China and India, has so far kept inflation under control. China has been artificially keeping its currency low and wages down but we do not feel comfortable continuing to rely on these relatively untested economies where trends are changing. A similar scenario existed in the 1960s and 1970s when emerging market productivity delayed the passing on of inflation from raw materials to end prices.

Wages, a key indicator of inflation, are beginning to grow in key parts of the world economy; for example in India strong demand and a mobile labour force are putting pressure on wages and in the UK, trade unions are now demanding 10% wage increases. Company margins have continuously been squeezed by higher energy and raw material costs but there is increasing evidence that companies are taking advantage of strong demand and are beginning to pass on these higher costs. Even the cost of bread has begun to rise. Consumers often regard food prices as an indicator of real inflation potentially impacting current wage negotiations further. There are increasing signs that the US dollar could devalue further if the Asian countries stop supporting it as they begin diversifying into the Euro or possibly gold. Even if the dollar does not devalue, the Renminbi will probably have to revalue so either way inflation will be imported into the US. This is fuelling further uncertainty in the US where there is a lame duck President, a faltering housing market and a highly indebted consumer who is beginning to look less resilient. There are also a range of other global geopolitical and environmental concerns all leading to a general feeling of nervousness.

Looking to produce positive returns

We are not saying that these potential shocks are going to occur but that there is an increasing probability that they will. Accurately predicting the timing of these events is almost impossible, so we believe investors should be reducing the risk in their portfolios right now. We believe that part of this solution should include an allocation to diversified fund of hedge fund portfolios targeting returns uncorrelated to equities and bonds.

At Stenham, for the last 20 years, we have specialised in constructing portfolios that deliver positive returns irrespective of global macro volatility. Over this time our investment process has evolved to be as much about managing risk as delivering returns. We do this by constructing diversified portfolios of non-correlated investments. This means that in varying market conditions some investments gain value while others may lose, but overall the portfolios deliver positive returns in most months. Using a fund of funds approach brings highly effective diversification of strategies, territories and managers. The firm’s broad allocation in our multi-strategy portfolios is 50-60% long/short equity, 15-25% trading strategies and 15-25% arbitrage. Within these sectors we reposition the portfolio tactically between the varying hedge strategies depending on our macro outlook. At a point in time we may have no exposure to certain strategies and be overweight others.

Figures 1 and 2 show the current broad strategy and geographical allocations, as at May 2007, for Stenham Universal, one of our multi-strategy portfolios, launched in 1992. In our experience, it is at times like this that it is most important to adhere to one’s principles and not to be taken in by consensus market sentiment. Increasingly we see funds and even strategies becoming highly correlated, particularly at times of stress and we have actively been searching for ways to mitigate this. Over the last 12 months we have been repositioning the portfolios more defensively by increasing our allocations to strategies that will deliver performance uncorrelated to equities and bonds. Within these strategies we have been favouring defensive or contrarian style managers who will smooth performance positively irrespective of market volatility and avoiding those that use excessive leverage.

Move towards long volatility and short-bias credit

As an example we have recently been increasing our allocation to long volatility and short-bias credit. Concerns about an increase in equity volatility motivated a decision to allocate to strategies uncorrelated to equities and which act as insurance in the portfolio at times of stress. The exact weightings to these strategies are based on an analysis of the amount of net long equity exposure we have in the portfolio. We investigated a number of possibilities for insurance and concluded that these strategies were the most efficient options.

Figure 3 shows the performance of a European long/short manager, a long volatility manager and the VIX index. The European long/short manager was one of our top performers last year but we have recently redeemed our investment with this manager because their performance was driven by market momentum. It is apparent that at each point of increased volatility, the fund suffered drawdowns compared to the recently-added long volatility manager who delivered value at these times of stress. In summary our current investment themes for our multi strategy portfolio are:

  • No direct investments with fixed income and convertible arbitrage strategies or any highly leveraged strategies. These strategies have had to increasingly rely on leverage to deliver returns and we are uncomfortable about being exposed to leveraged managers at a time when there is interest rate pressure globally.
  • Reduced allocations to distressed debt in favour of multi-strategy event-driven and merger arbitrage. Whilst there is strong M&A activity we will retain our weightings with merger arbitrage but we are waiting to re-enter the distressed space again.
  • Reduced allocations to net long equity momentum managers in favour of market neutral stock pickers who deliver returns less correlated to the equity indices. The net long exposure in the equity hedged part of the portfolio has been reduced to 15%.
  • Increased allocation to long equity volatility and short-biased credit strategies to act as a hedge against any equity exposure.
  • Maintaining high allocations to discretionary global macro managers who deliver good value at times of stress.
  • No weightings to pure CTAs or systematic managers because of their inherent volatility.
  • Overweight Europe and Asia (including Japan) relative to US long/short equity.

To demonstrate how effective this approach has been, Figure 4 compares the risk/return characteristics of Stenham Universal against a number of indices over ten years. Despite, or probably because of, our risk-averse culture we have consistently delivered returns materially above bonds with much less volatility, with a ten year compound average return of Libor +6% and a standard deviation of below 4%.Investing clearly requires a degree of risk taking. At certain times in the cycle, often when the consensus is for the continuance of an already long bull run, it is sensible to start restructuring portfolios more defensively. It is better to begin this process early rather than waiting until it is too late, eroding capital that can take many years to recover.

Harry Wulfsohn is a Director at Stenham Advisors