Managing risks dynamically with an overlay

Managing risks dynamically with an overlay

Managing risks dynamically
with an overlay
Risk
Management
Dr Wolfgang Mader
Managing Director,
Head of Investment &
Risk Strategy, risklab,
AllianzGI Global
Solutions
Dr Thomas Stephan
Managing Director,
CIO Overlay,
Allianz Global Investors
Financial markets started into 2016 with a jolt: Assets from commodities
and high yield bonds to equities in developed and emerging markets
were severely down while volatility spiked up. These widespread losses
without significant diversification benefits have reminded investors
that efficient and intelligent risk management should be their top
priority. The two main reasons: ensuring a smoother ride toward their
investment goals while experiencing less drawdown risk in order to
gain by not losing.
Current challenges for risk and return
management
The world hasn’t become a safer place. Nor, by
any means, have the capital markets. After a weak
December 2015 that already disappointed investors
who expected the customary “Santa Claus effect”,
the extent of the downturn on capital markets in the
first 6 weeks of the new year surprised even many
sceptics, with Eurozone equities down 15 % and
Japanese and Chinese equities tumbling more than
20 %, which made the S&P500 with –10 % look like an
outperformer. Alternative assets like private equity
and hedge funds provided investors with no respite,
either, as can be seen in Chart 1.
This lack of diversification benefits is typical for a
severe down market and even reminded investors
of the Great Financial Crisis of 2007 / 2008, although
the fundamental and economic driving forces look
rather more balanced in 2016.
Worries over a potential hard landing instead of a
managed slowdown of China’s economy (the world’s
second-largest economic power), the renewed
collapse in oil prices (which markets interpreted
as a symptom of weak demand rather than just
excess supply), and jitters about the liquidity of bond
market spread segments conspired to turn market
sentiment distinctively sour. Geopolitical hotspots,
especially the situation in the Middle East and also
in Europe, which is struggling to find an answer to a
potential Brexit and to the migration and debt crisis,
may flare up into major conflagrations at any time.
While the fundamental macroeconomic backdrop
in US and Europe still seems to be more in line
with trend growth than with a recession, the most
important tailwind for the valuations of risky assets
over the last years has been massively supportive
monetary policy in the form of quantitative
easing (QE), with the European Central Bank (ECB)
Focus: Managing risks dynamically with an overlay
Chart 1: History doesn´t repeat itself, does it?
30/11/2015 – 12/02/2016
Return
Equities
Commoditites
Fixed Income
Hedge
Funds
5%
0%
–5 %
–10 %
–15 %
Global
Equities
EM
Commodities
Equities
REITs
Convertibles
HY
Bonds
EM
Bonds
IL
Bonds
EMU Gov
Bonds
Hedge
Funds
Source: Allianz Global Investors based on Bloomberg data for index performance. Data as of 12 February 2016.
Past performance is not a reliable indicator of future results.
increasingly following in the footsteps of the US
Federal Reserve and Bank of Japan (BoJ). However,
a widely discussed question among investors is
currently whether the central banks have run out
of amunition. As QE has so far not produced the
promised goods in terms of bringing inflation rates
back to target levels, i. e. of higher nominal growth
rates, not least owing to lower oil prices, it seems to
be down to a beggar-thy-neighbor policy targeting
lower exchange rates, which is a zero-sum game for
the world economy at best.
It is probably fair to say that fundamental and
economic factors alone do not account for all of the
market gyrations we are currently witnessing. As
George Soros puts it, there is a good part of “selfreflexivity” of the financial markets with feedback
loops also back into the real economy via sentiment
effects (especially in the US). The flip-side of this
insight is that fundamental or economic analysis
alone cannot be expected to provide investors with
risk management that can be relied upon.
“The current market environment
presents institutional investors with
major challenges and, more than ever,
requires the very conscious and active
management of risks.”
The simplest risk management strategy – avoiding
risks – is an unsustainable solution given that, in
many cases, money market and government bond
rates are in negative territory – even deeper than
ever before. 10 year Japanese government bond
yields dropped to record lows (in February even
to negative rates) after the BoJ adopted a negative
interest rate policy at the end of January 2016. The
ECB’s massive bond purchase programme, launched
in March and extended in December 2015, will pour
over 1.4 trillion euros of central bank money into the
bond markets overall, where returns on German,
French, Dutch, Belgian, Austrian and Finnish
government bonds with maturities of up to six years
and beyond are hovering in negative territory. More
than 40 percent of total Eurozone government
bonds had negative yields at the beginning of
February 2016, as the AllianzGI QE Monitor shows.
The fact is, the greatest risk is avoiding risk
entirely. European institutional investors, who had
traditionally used low-risk bonds as their anchor
investment, will not be able to sustainably meet
their medium-term yield targets with this portfolio
structure. The strategic challenge in the coming
years is therefore to take advantage of the risk
premiums on equities and other risky asset classes
for investments, while simultaneously protecting
the usually modest risk budgets.
Strategic return and risk management
Given the market environment described above,
return and risk management should be of particular
importance to investors. A 4-point plan (Chart 2)
takes a holistic view of the sources of income on
the one hand (pillars 1 and 2) and the risk-reducing
components in a portfolio context on the other
(pillars 3 and 4). In order to harmonise earnings
targets, risk budgets and other constraints, such as
liquidity requirements, a strategic asset allocation
(SAA) and the allocation of alpha sources must be
2
Focus: Managing risks dynamically with an overlay
Chart 2: The 4-point plan
1
3
Return Enhancement
Diversification
2
4
Alpha
Dynamic Risk Management
The allocation should be broadly and globally
diversified to reduce risk. To protect against future
inflation, real assets should be included.
Increase the average allocation to risky assets to
have the return potential to achieve the desired
target returns.
Dynamically manage risk to reduce losses while
keeping the upside potential.
Add uncorrelated sources of sustainable alpha to
increase the return potential for low risk budget
consumption.
Source: Allianz Global Investors, as of February 2016.
given a tactical orientation and make use of sensible
risk management which sustainably supports, rather
than hampers, the generation of long-term returns.
Broad diversification of a strategic asset allocation
reduces portfolio risk and thus makes the first
significant contribution in the context of risk
management. However, in order to ensure a high
level of confidence in compliance with a defined
risk budget, beta risks should also be controlled
dynamically over time, especially if there needs to be
a higher allocation of risky investments in a portfolio
to achieve the required rates of return. This dynamic
element of the investment concept (dynamic asset
allocation, DAA), which is usually implemented in
the form of a derivative overlay, is already standard
at many institutional investors and uses the defined
SAA to reallocate assets to provide the desired
asymmetry of the results (see Chart 3).
This means that downside risks are significantly
reduced due to the dynamic allocation, while
the return potential in positive market phases is
retained. This sort of asymmetry cannot be achieved
via purely forecast-based tactical approaches
to asset allocation (TAA); a systematic dynamic
strategy is also required to reduce unfavourable
investment results or downside risks independently
of short-term return forecasts.
Dynamic asset allocation
In order to effectively generate the desired
asymmetric return profile, a state-of-the-art
dynamic asset allocation solution has to address,
among other things, the weaknesses of wellknown portfolio insurance strategies (such as
constant proportion portfolio insurance, CPPI).
CPPI offers protection in bear markets, but often
Chart 3: Dynamic Asset Management Combines Long-term Return Targets and Short-term Risk Targets
Building Blocks of Expected Total Portfolio Return
Expected Total Portfolio Return
Market Return
Strategic Asset Allocation
Seek to harvest longterm risk
premiums while benefiting from
diversification
Allocation Performance &
Risk Mitigation
Selection Performance
Active Asset Allocation
Seek to reduce downside risks and
enhance returns over a market cycle
Active Strategy & Security Selection
Excess return based on underlying
active management
Overlay Implementation
Underlying Implementation
The information and charts above are provided for illustrative purposes only, illustrating what returns would make up the total return of a
portfolio. The information above is not indicative of future results.
3
Focus: Managing risks dynamically with an overlay
Chart 4: Markets are trending / Markets overreact
Past 12 months‘
performance
Excessive
negative trend
Normal negative
trend
Normal positive
trend
Excessive positive
trend
Subsequent
6 months‘
performance
negative trend
reverses
negative trend
continues
positive trend
continues
positive trend
reverses
4 different
market regimes
Subsequent
6 months‘
performance
–2
–1
0
1
2
Std.*
*) Std = Standard Deviation. Schematic illustration. Performance patterns for conditional 6 month performance derived from S&P 500
returns 1928 – 2010 based on calculations by Allianz Global Investors. Past performance is not a reliable indicator of future results.
does not permit attractive participation in a market
recovery. CPPI strategies act purely pro-cyclically,
which creates value in clear trends, but lacks
correction mechanisms in market exaggerations.
The pro-cyclicality of such simple risk management
approaches results from fully linking the allocation
decision to the available risk budget. However, as
capital markets have scientifically proven trends, and
a tendency to revert to the mean after positive and
negative exaggerations (mean reversion), a dynamic
allocation strategy should take these properties into
account.
from the mean return), on average the subsequent
6-month returns are higher than the unconditional
mean return of the S&P 500. Likewise, an excessively
strong positive trend over 12 months on average is
followed by sub-par returns over the next months.
Chart 4 shows some stylized empirical facts about
the trending and mean-reverting behaviour of many
asset classes:
• Dynamic risk mitigation, in its simple version, is
purely pro-cyclical and does not fully exploit the
cyclicality of asset class returns. Pro-cyclicality is
the notion that “the trend is your friend.” While
this contributes to positive return expectations,
this component is also central to risk mitigation.
The pro-cyclical component gives the portfolio
an opportunity-oriented focus when more risk
budget is available and reduces the risks when
(explicit or implicit) risk budget is low. Procyclicality involves an increase in the weighting
of risky asset classes in the event of a positive
performance and a reduction in their weighting
in the event of a negative performance.
To begin with, when looking at the average return of
US equities (measured by S&P500 index data), four
different market regimes can be identified, ranging
from an excessive negative trend to an excessive
positive trend. In the lower part, the average return
of US equities over 6-month periods is shown,
conditional on the direction and significance of the
trend in the 12 months preceding these 6-month
periods. As can be seen, a trend that is “normal”
(but not excessive) is on average continued over the
next months, with better returns over preceding 12
month periods followed by above-average returns
in the next 6 months. On the other hand, excessive
trends tend to be corrected to the same extent as
some mean-reversion. For example, when the trend
is excessively negative for the preceding 12 months
(deviating by more than 2 standard deviations
In order to capture these stylized facts (which our
research has confirmed for a wide range of liquid
asset classes), a state-of-the-art dynamic strategy
for risk mitigation should use a smart combination
of pro- and anti-cyclical allocation components (see
Chart 5):
• Anti-cyclicality is about mean reversion. An
anticyclical approach decreases risky asset
weights, although markets have performed well,
and increases risk after or during market declines.
The countercyclical component takes effect in
more extreme market movements.
4
Focus: Managing risks dynamically with an overlay
Chart 5: Pro- and anti-cyclicality on portfolio level and asset class level
Performance
Pro- and anti-cyclical
dynamic asset allocation
an
c li c
ti- c y
pr o - c y
cli
a
r of
lp
xcess
c al  e
clical 
Take
profits
ck-in
r et ur n
target re
pro-cyclical  enha
anti-c y
it l o
Exposure to
risky assets
ncing stability
market
re-entr
Enhance
returns
Pro-cyclical
• Trend following behaviour
• Capture short- to mid-term
performance trends across asset
classes
Mitigate
downside
risk
and
turn*
Time
y
• Intelligent allocation framework
based on analysis of the market cycle
• Incorporates smart combination of
two core market phenomenon:
Anti-cyclical
• Mean reversion behaviour
• Manage overall portfolio risks
Re-enter
market
*) The target return is the long term expected return of the asset class or, at the portfolio level, the long term expected return of a SAA.
Schematic illustration for illustrative purposes only. The information and charts above are provided for illustrative purposes only, illustrating
how a pro-cyclical and anti-cyclical process can be implemented. The charts do not reflect actual data or show actual performance and is
not indicative of future performance.
• These pro- and anti-cyclical elements can and
should be applied to the overall portfolio risk as
well as on the level of the individual asset class
weights, also reflecting idiosyncratic trends for
individual markets. Prominent examples for the
latter have been emerging markets, commodities,
as well as government bonds of the Eurozone
periphery.
In order to efficiently implement such a strategy
for risk mitigation with minimal transaction costs,
a focus on highly liquid linear derivatives (futures,
swaps, FX forwards) is appropriate. This dynamic
risk management concept is highly flexible and can
be customized to any SAA that is focused on liquid
assets and any risk budget, as long as the latter is
compatible with the downside risk implicit in the
SAA.
Summary
The current market environment presents
institutional investors with major challenges and
more than ever requires a smart, robust and active
management of risks. In our opinion, the importance
of dynamic risk and allocation management has
noticeably increased. Fundamentally, many markets
are in an unstable balance between moderate
growth at best, high valuations and unconventional
supportive monetary policy which may have run
out of ammunition. Still, for long-term investors it
remains paramount to take “strategic” risks in order
to reap the associated premiums. In this low interest
rate environment, the hunt for yield has already
reduced some of these risk premiums and increased
their volatility. Therefore, a smart way to actively
manage exposures over time can be a highly
instrumental element of the overall investment
plan. A dynamic allocation approach that takes
into account stylized empirical facts of asset class
returns can help to mitigate downside risks and,
at the same time, provide investors with attractive
return potential in strong markets.
We believe that a desired long-term asymmetric
return profile can, in fact, be achieved1. We are also
convinced that, in the current market environment,
the added value provided by systematic dynamism
in the portfolio is an indispensable component of
institutional investors’ future-proof investment
concepts.
1
There is no guarantee that a dynamic allocation approach will be
successful.
Imprint
Allianz Global Investors GmbH
Bockenheimer Landstr. 42 – 44
60323 Frankfurt am Main
Global Capital Markets & Thematic Research
Hans-Jörg Naumer (hjn), Ann-Katrin Petersen (akp),
Stefan Scheurer (st)
Allianz Global Investors
www.twitter.com/AllianzGI_VIEW
Data origin – if not otherwise noted:
Thomson Financial Datastream.
Calendar date of data – if not otherwise noted:
February 2016
5
Further Publications of Global Capital Markets & Thematic Research
Active Management
→ “It‘s the economy, stupid!”
Alternatives
→ The Case for Alternatives
→ The Changing Nature of Equity Markets
and the Need for More Active Management
→ Volatility as an Asset Class
→ Harvesting risk premium in equity investing
→ Active Management
→ Market-neutral equity strategies –
Generating returns throughout the market cycle
→ Active Share: The Parts Are Worth More Than The Whole
→ Benefiting from Merger Arbitrage
Financial Repression
→ Shrinking mountains of debt
Capital Accumulation – Riskmanagement – Multi Asset
→ Smart risk with multi-asset solutions
→ QE Monitor
→ Sustainably accumulating wealth and capital income
→ Between a flood of liquidity and a drought
on the government bond markets
→ Strategic Asset Allocation in Times
of Financial Repression
→ Liquidity – The Underestimated Risk
→ Macroprudential policy – necessary, but not a panacea
→ Monetary policy divergence – a new transitory regime
for global central banks
Strategy and Investment
→ Equities – the “new safe option“ for portfolios?
→ The Long and Short of Volatility Investing
Behavioral Finance
→ Behavioral Risk – Outsmart yourself!
→ Reining in Lack of Investor Discipline:
The Ulysses Strategy
→ Behavioral Finance – Two Minds at work
→ Behavioral Finance and the Post-Retirement Crisis
→ Capital Markets Monthly
→ Dividends instead of low interest rates
→ Is easy monetary policy fuelling new economic
imbalances and credit bubbles?
All our publications, analysis and studies
can be found on the following webpage:
http://www.allianzglobalinvestors.com
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