risk-controlled investment strategies

Teach-in Risk-Controlled Investment Strategies 5th March 2013

Risk-Controlled

Investment Strategies

1

Tuesday 5th March 2013


Volatility Control

2

Dan Mikulskis

ALM & Investment Strategy


We summarise our approach to putting clients in control of their funding goals in seven steps

Redington

Our Approach

3 3

Volatility Control and Risk Parity are examples of

Step 3: Liquid Alpha and Beta strategies


Introduction : How Does Volatility Control Work

Drive to the conditions

4


How 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% volatility

5

Source: Bloomberg; Calculations: Redington


Why use Volatility Control

For 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.

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What 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.

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Volatility Control is not ...

• A quantitative trading rule that tries to outperform

equities;

• A mechanism for trying to predict market crashes;

• A process for selecting low volatility stocks;

• A process for weighting individual stocks according to their

volatility;

• A guaranteed downside protection vehicle against

instantaneous crashes.


Why Volatility Control (1)

• Equity Volatility varies very substantially through time.

• Both above and below the long term average.

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What does Volatility Control achieve

9

• The Volatility Control approach keeps the trailing volatility close to the target level of 10%.




• Across time periods and markets, Volatility Control has historically produced better risk-adjusted outcomes than a fixed

market exposure allocation

10

0

100

200

300

400

500

600

Volatility Controlled Portfolio FTSE 100 Total Return Portfolio



• Across time periods and markets, Volatility Control has historically produced better risk-adjusted outcomes than a fixed

market exposure allocation

11


Notes:

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 ending 31.12.2012

MSCI World FTSE 100 S&P 500

Index Volatility Control 10%



Excess Return1 (%p.a.) 2.6 3.6 2.9 3.2 4.6 4.1

Volatility2 (%p.a.) 15.0 10.9 18.6 10.6 19.2 10.7


Case Study 1 : January 2008 – June 2009

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• The FTSE 100 peaked in May 2008, then fell very sharply in September and October 2008 following the collapse of

Lehman Brothers.

• At this point volatility increased sharply.

• The FTSE 100 reached its bottom in March 2009 before beginning its recovery.




13




• The Volatility Control approach de-geared substantially well before the market lows

• Hence the drawdown suffered was much shallower, around -25% compared to -55%

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15

• Over this period the FTSE 100 index rallied consistently with a relatively low volatility, increasing by around 45% over the

2.5 year period



• As the volatility of the FTSE 100 fell below the target of 10%, the market exposure of the volatility controlled portfolio

increased 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.


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-10%

10%

30%

50%

70%

90%

110%

130%

150%

0%

10%

20%

30%

40%

50%

60%

70%

An

nu

aliz

ed

Vo

lati

lity

(%)

of

FTSE

10

0

% A

lloca

tio

n o

f vo

lati

lity

con

tro

lled

ap

pro

ach

FTSE Allocation FTSE Rolling Volatility




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• 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.



Case Study 3 : January 2011 – December 2012

• This period saw substantial market volatility across global markets during August and September of 2011, followed by a

sustained rally in 2012 and decreasing volatility.

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19

• As the volatility of the FTSE 100 increased during August and September of 2011, the exposure of the volatility controlled

strategy decreased to around 40%.

-10%

10%

30%

50%

70%

90%

110%

130%

150%

0%

10%

20%

30%

40%

50%

60%

70%

An

nu

aliz

ed

Vo

lati

lity

(%)

of

FTSE

10

0

% A

lloca

tio

n o

f vo

lati

lity

con

tro

lled

ap

pro

ach

FTSE Allocation FTSE Rolling VolatilitySource: Bloomberg; Calculations: Redington



• Despite the period of increased volatility, the FTSE 100 recovered to its pre-August 2011 level relatively quickly, and

continued 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 and

September 2012.

20



Implementing 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 are

significant enough.

21


• One advantage of a Volatility Controlled approach to investing is that it is much cheaper to buy downside protection

against 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 Protection

22




23



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1 Year Protection level Approximate cost to protect equity portfolio (%) over 1 year

Approximate Cost to protect 10% Vol Control portfolio (%) over 1 year

90% 3.9 1.3

85% 2.8 0.5

80% 1.9 0.2

Source: Bloomberg, Barclays; Calculations: Redington


Volatility Control in the press and media

25



26

“Regarding target volatility indexes, we have

shown that their long-run Sharpe ratio is always

better than the Sharpe ratio of the underlying

equity index as long as the target volatility level is

chosen within reasonable boundaries.”



27

“To date, Volatility Target funds have not seen

widespread take-up. One of the major concerns

seems to be whether the concept is too complex

and difficult to communicate.”

“However, it can be argued that such an

approach helps an advisor meet client suitability

requirements as it enables them to discuss

maximum expected fund value falls.”


Conclusions & Further Information

Volatility Control is an approach to portfolio construction that aims for a more consistent risk through time, compared to a

fixed 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 return

outcomes 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 2012

http://www.theactuary.com/features/2012/12/volatility-control-taming-the-beast/

RedViews

http://redington.co.uk/getattachment/eea3dd74-37c8-446e-afa9-fd8d1973f295/Taming%20The%20Beast.aspx

RedBlogs

http://blog.redington.co.uk/Articles/Dan-Mikulskis/September-2012/VOLATILITY-CONTROL.aspx

http://blog.redington.co.uk/Articles/Dan-Mikulskis/December-2012/TAMING-THE-BEAST.aspx

The Journal of Indexes November / December 2012

http://www.indexuniverse.com/publications/journalofindexes/joi-articles/12932-optimal-design-of-risk-control-strategy-indexes.html

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http://redington.co.uk/getattachment/eea3dd74-37c8-446e-afa9-fd8d1973f295/Taming The Beast.aspx












































Risk Parity: Balancing Risk

Across Asset Classes

29

Aniket Das

Manager Research Team


What is Risk Parity?

30

Risk Parity refers to a systematic approach to multi-asset

investing which allocates to a variety of asset classes (or risk

factors) according to risk exposure rather than asset value.


The Problem with Traditional Asset Allocation – #1

31

Average UK Pension Fund Asset Allocation

Equities

Nominal Govt Bonds

Inflation-Linked Bonds

Property

Alternatives

Risk Allocation

Equities

Nominal Govt Bonds

Inflation-Linked Bonds

Property

Alternatives

c.90% of risk from equities

Source: UBS; Calculations: Redington


The Problem with Traditional Asset Allocation – #2

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-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-12

Trai

ling

Mo

nth

ly R

etu

rn

Average PF Asset Allocation Equity Component

Correlation = 0.91

Source: UBS; Calculations: Redington


Why do we have this situation?

33


Leverage in Risk Parity, Leverage in Equities

34

208%

186%

0%

50%

100%

150%

200%

250%

300%

350%

400%

450%

1995 1997 1999 2001 2003 2005 2007 2009 2011

Tota

l lev

erag

e (D

ebt

to E

qu

ity)

MSCI World Debt to Equity Ratio Risk Parity 12% Vol Total Leverage Employed

MSCI World Average Risk Parity 12% Vol Average

Source: MSCI, S&P, Merrill Lynch; Calculations: Bloomberg, Redington


What does a Risk Parity portfolio look like? – #1

35

- 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 later

Equities

Bonds

Commodities


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0%

10%

20%

30%

40%0%

5%

10%

15%

20%

25%

30%

1972 1977 1982 1987 1992 1997 2002 2007 2012

Equities

Volatility (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 2012

Bonds


0%

10%

20%

30%

40%

50%0%

10%

20%

30%

40%

1972 1977 1982 1987 1992 1997 2002 2007 2012

Commodities


0%

5%

10%

15%

20%

25%

30%

35%

40%

1972 1977 1982 1987 1992 1997 2002 2007 2012

Trai

ling

24

-Mo

nth

Vo

lati

lity

Asset Class Volatility

Equities Bonds Commodities

What does a Risk Parity portfolio look like? – #2


What does a risk parity portfolio look like? – #3

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0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1972 1977 1982 1987 1992 1997 2002 2007 2012

Po

rtfo

lio W

eigh

t

Unlevered, no volatility target


0%

50%

100%

150%

200%

250%

300%

1972 1977 1982 1987 1992 1997 2002 2007 2012P

ort

folio

Wei

ght

Levered @ 10% volatility




Risk Parity Performance - #1

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Jan 1971 – Dec 2012

Unlevered Risk Parity

Risk Parity @ 10% Vol

60% Equities 40% Bonds

50% Equities 50% Bonds

100% Bonds 100% Equities 100% Commodities

Total 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 2012

Cu

mu

lati

ve T

ota

l Ret

urn

Unlevered Risk Parity Risk Parity @ 10% Vol

60% Equities / 40% Bonds 50% Equities / 50% Bonds

0

1

10

100

1972 1977 1982 1987 1992 1997 2002 2007 2012

Tota

l Ret

urn

Ind

ex (

log

scal

e)

Unlevered Risk Parity Risk Parity @ 10% Vol

60% Equities / 40% Bonds 50% Equities / 50% Bonds



Risk Parity Performance - #2

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-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

1972 1977 1982 1987 1992 1997 2002 2007 2012

Cu

mu

lati

ve C

on

trib

uti

on

to

Po

rtfo

lio E

xce

ss R

etu

rn




0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1970 1975 1980 1985 1990 1995 2000 2005 2010

10 Year US Treasury Yield Rising Interest Rate Period

Risk Parity and Rising Interest Rates

40

# Time Change in Yield

(bps)

Unlevered Risk Parity

Risk Parity 10% Vol

60 / 40 Portfolio

1 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 Return

Annualised Excess Return Over Months Where Interest Rates Rose

Annualised Volatility Over Months Where Interest Rates Rose

Unlevered Risk Parity -6.53% 6.75%

Risk Parity 10% Vol -9.30% 10.04%

60 / 40 Portfolio -6.72% 9.33%


Alpha / Beta Separation

41

Return Cash Beta Alpha


The Risk Parity Manager Universe

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Passive (β)

• Relatively pure risk parity beta

• Balances risk between asset classes or other risk factors

• May include smarter beta approaches within asset classes (e.g. an enhanced commodity index)

Semi-Active (β + α)

• Risk parity beta + mild amounts of alpha

• Alpha may be generated through discretionary bets (e.g. taking macro views) or through systematic tilts (e.g. cutting the volatility target in higher risk environments)

Active (β + α)

• Risk parity beta + large amounts of alpha (hopefully!)

• May not resemble risk parity much if very active

• Typically charge higher fees for the added “activeness” / alpha

Global macro / quantitative equities

/ hedge fund managers

Traditional balanced fund managers

now offering risk parity solutions


Risk Parity Managers – How do they vary?

43

•Pooled fund offerings will typically target a volatility of 8-10%, though there may be differences. 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 future volatility. Managers are likely to use different calculations from ours, including the use of implied volatilities in some cases.

Volatility Window

•Unlike our model in which we used 3 asset classes, risk parity managers may use more asset classes (e.g. credit). However, the inclusion of more asset classes doesn’t necessarily make it better. 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, often when the benefits of rebalancing outweigh the costs (which are low due to the use of futures contracts).

Rebalancing

•Within each asset class rests the choice of what futures instruments to use. For example, many managers 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 crucially the purpose of alpha and beta separation is to isolate true skill from generic market risk premia.

Alpha Sources

•Given the extensive use of futures contracts, the management of collateral is a key aspect in terms of fund management for risk parity strategies. The level of free cash in place to satisfy collateral calls should be monitored.

Collateral Management


Drawdowns in the Risk Parity Manager Universe

44

Source: Managers, eVestment, Salient Partners, Bloomberg

Max 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-10

Dra

wd

ow

n

Manager A Manager B Manager C

Manager D Manager E Manager F

Salient Risk Parity Index MSCI World 60/40


Risk Parity is a beta solution (and should be priced accordingly!)

45

Mgr A Mgr B Mgr C Mgr D Mgr E Mgr F Mgr G Mgr H Mgr I

0

10

20

30

40

50

60

70

80

90

100

Tota

l Exp

en

se R

atio

(B

asis

Po

ints

)

Source: Managers, eVestment


Implementing Risk Parity in Your Portfolio

46

- Risk Parity is not a panacea. It is, however, a more efficient approach to portfolio construction than traditional methods. It

firmly 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 be

traded 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 major

publicly-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 also

recommend clients consider trend-following strategies (also known as CTA managers). These risk-controlled strategies offer a

liquid risk premium as well as portfolio diversifying characteristics.

Part of Redington’s Seven

Steps to Full Funding™


13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk

Contacts

47

Disclaimer

For professional investors only. Not suitable for private

customers.

The information herein was obtained from various sources.

We do not guarantee every aspect of its accuracy. The

information is for your private information and is for

discussion purposes only. A variety of market factors and

assumptions may affect this analysis, and this analysis

does not reflect all possible loss scenarios. There is no

certainty that the parameters and assumptions used in this

analysis can be duplicated with actual trades. Any

historical exchange rates, interest rates or other reference

rates or prices which appear above are not necessarily

indicative of future exchange rates, interest rates, or other

reference rates or prices. Neither the information,

recommendations or opinions expressed herein constitutes

an offer to buy or sell any securities, futures, options, or

investment products on your behalf. Unless otherwise

stated, any pricing information in this message is indicative

only, is subject to change and is not an offer to transact.

Where relevant, the price quoted is exclusive of tax and

delivery costs. Any reference to the terms of executed

transactions should be treated as preliminary and subject

to further due diligence .

Please note, the accurate calculation of the liability profile

used as the basis for implementing any capital markets

transactions is the sole responsibility of the Trustees'

actuarial advisors. Redington Ltd will estimate the liabilities

if required but will not be held responsible for any loss or

damage howsoever sustained as a result of inaccuracies in

that estimation. Additionally, the client recognizes that

Redington Ltd does not owe any party a duty of care in this

respect.

Redington Ltd are investment consultants regulated by the

Financial Services Authority. We do not advise on all

implications of the transactions described herein. This

information is for discussion purposes and prior to

undertaking any trade, you should also discuss with your

professional tax, accounting and / or other relevant

advisers how such particular trade(s) affect you. All

analysis (whether in respect of tax, accounting, law or of

any other nature), should be treated as illustrative only and

not relied upon as accurate.

©Redington Limited 2013. All rights reserved. No

reproduction, copy, transmission or translation in whole or

in part of this presentation may be made without

permission. Application for permission should be made to

Redington Limited at the address below.

Redington Limited (6660006) is registered in England and

Wales. Registered office: 13-15 Mallow Street London

EC1Y 8RD

Dan Mikulskis

Director

ALM & Investment Strategy

Direct Line: 020 3326 7129 [email protected]

Aniket Das

Associate

Manager Research Team

Direct Line: 020 3326 7153 [email protected]

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