Investors tend to look at portfolio risk in terms of geographic exposure or asset classes—but that’s not always an accurate gauge. Analytic Investors’ Harin de Silva explains the better approach to risk assessment, the value of long/short strategies and the investing trends that worry him now.
Q: Do you think investors are taking on too much risk today?
I don’t know that I would characterize it as taking on too much risk. I’d say that investors probably aren’t aware of the different types of risk they’re taking today. “Too much” of something implies one dimension; in reality, there are multiple dimensions.
Q: What should advisors tell investors about portfolio construction and risk?
People tend to look at their portfolios in terms of geographic exposure or asset classes. They’ll say, “Oh, I’ve got so much in emerging markets,” or “I’ve got so much in fixed income.” I think it’s better to look at a portfolio’s sensitivity to increases in risk, to jumps in the CBOE Volatility Index (VIX). Once you have that sorted out, you’ll have a much better sense of how the portfolio will do in the inevitable volatility shock.
Q: Does this make a case for long/short equity?
It does if you look at the different ways you can protect your portfolio. A short portfolio will naturally tend to do well in a down market. Shorting speculative stocks, particularly, can provide strong downside protection in unpredictable and volatile markets. By speculative, I mean higher-beta stocks.
Q: What should investors realistically expect from a long/short equity strategy?
Generally, a long/short strategy has a market exposure, or beta, somewhere in the 0.4-0.6 range. If the market is in the normal range, making 10 to 12 percent, the manager’s stock selection will dominate and the long/short portfolio should deliver market-like returns but with less variability. It’ll do even better if the manager’s a really good stock picker.
Q: Have you seen changes in investing behavior or attitudes over the last few years? Any trends? Any red flags?
In the last five years I’ve seen growing appreciation for risk-reducing strategies. I think people have become much more focused on the Sharpe Ratio and much less fixated on the Information Ratio. Ten years ago, I‘d go into a meeting and I’d talk about the Sharpe Ratio. People would say, “I don’t really care about your Sharpe Ratio; tell me about your Information Ratio.”
Q: In other words, they were asking how good you were as a stock picker?
Yes. Now people recognize that they have a certain risk budget in their portfolios and they’re asking us about the best places to spend it. That question wasn’t asked much until ’08 or ’09. Earlier, if people had strategic 60/40 [stocks/bonds] allocations, all they had to do was pick some really good stock managers and some really good bond managers to show value added. It’s a very different decision-making process now.
Q: Has this been across the board in terms of investor types? Are we talking about endowments making these kinds of decisions or are we talking about other kinds of investors?
My exposure is mostly institutions and sophisticated RIAs. The change in attitude has been pretty much across the board. Another thing to keep in mind is that there used to be a low-risk alternative that generated positive returns. If everything else failed, you could always go to T-bills and they’d produce two-, three-, four-, five- percent returns. Now you don’t have that, so it’s really become a more difficult investment environment. Years ago, an advisor could say, “Well, if my client wants lower risk, I’ll just put more money into cash.” You can’t think that way now, because you have negative real rates. The current environment has allowed people clever at portfolio construction to rise above the pack.
Q: You mentioned a trend toward risk reduction. That’s a positive. Are there any trends that are worrisome?
If I had to pick one red flag, it would be the current fascination with smart beta. I think it’s a great idea to know about different exposures—I’ve written a lot about this—but I think the idea that you can somehow buy a combination of ETFs and replicate fully what an active manager is doing is unrealistic. There are so many backtests and ETFs touted that it’s become hard to discern what’s really good and bad. I’m not sure what the outcome will be, but there will certainly be a lot of disappointment.
Q: Are people thinking that if they can get just the right mix of betas, the end result is going to be alpha?
They may think it’s going to be alpha, but in reality it may be something else altogether. People who buy a value ETF together with a momentum ETF may think, “Now I have value plus momentum,“ but what they don’t realize is these ETFs come with a bunch of other embedded exposures. Unless they’re sophisticated, they’ll end up having difficulty when they put the whole thing together. I always point people to the fact that there’s a large number of quantitative managers systematically trying to exploit these tendencies. Only 25 percent are successful, so it’s relatively hard to do. You shouldn’t think that you can do it on the back of an envelope with a bunch of ETFs.
Q: What’s the impact of emerging market volatility, particularly that of Chinese equities, on the long/short fund?
The volatility that China brings in isn’t really new. If you have a risk model that looks at correlations, the impact China has had in the last five years should already be reflected. The volatility impact shouldn’t be a complete surprise.
Q: What you’re saying, considering your universe of stocks, is that China is really an exogenous event.
Right. China’s stocks are not within our universe. But if you look at the global market, exposure to the China factor is something we monitor and it’s something we manage against. From a risk standpoint, I think the portfolio has done okay in this current shock.
361 Capital is an investment firm specializing in liquid alternative investments. Founded in 2001, the firm has long history of managing alternative portfolios for major institutions, financial intermediaries and wealthy individuals, leading to a deep understanding of the strategies that make up alternative investing, including managed futures, long/short equity, multi-strategy and market neutral.