Introducing risk mitigation as a strategy

As the saying goes, “risk and return, you cannot have one without the other.” The positive correlation between risk and returns in a way explains how equities hold a place in the hearts of those seeking to maximise returns. 

However, this greater risk also widens the spectrum of potential outcomes, introducing uncertainty that tests the mettle of an investor portfolio. 

On this risk paradox, here are some borrowed words from Howard Marks, the co-founder of Oaktree, from his letter Risk in 2006: “But riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple: if riskier investments reliably produced higher returns, they wouldn’t be riskier!”

The fundamental truth remains that down the path of increasing risk does not guarantee a favourable outcome, and the inherently risky nature of assets challenges the notion of being reliable or predictable. But, what would be the outcome when we focus on the other side of the same coin – the path of mitigating risk yet without compromising returns?

Risk reducers – from both the tactical and strategic lens

When considering reducing risk, investors often contemplate tactical shifts towards strategies deemed as “safe havens” during periods of market turmoil. 

US Treasury bills, gold, or even the use of complex option and derivative strategies to “hedge” risk are common strategies for investors to seek refuge and shield portfolios from risks. A recent example dates back to earlier this year when investors dashed for gold for a sense of comfort as dramatic clashes between Israeli and Hamas forces escalated.

In strategic asset allocation, risk-reducing strategies exist and are widely adopted by retail investors. One such example is the inclusion of fixed income as a reliable portfolio ballast, as simple as implementing the classic 60/40 allocation. In this, bonds play a role in smoothing out market fluctuations, thereby enhancing overall risk-adjusted returns.

As a broad group, alternatives could play a role as a portfolio diversifier and risk reducer. They help retain the potential upside from equities while effectively reducing the volatility of outcomes, including minimising downside risk.

In search of daily liquid strategies for risk mitigation

In thinking about risk, a thorough analysis is conducted to find out the most prevalent options available to investors to mitigate risk while maintaining daily liquidity. 

This review would form a foundational understanding of a portfolio we constructed to capitalise on the most effective protective characteristics, while crucially, removing the arduous task of making tactical calls. 

Buy US Treasury

Allocating to safe fixed income assets, such as government bonds, has proven beneficial for portfolios during equity drawdowns post-2000. However, it showed limited efficacy in earlier market downturns. 

With the post-Global Financial Crisis quantitative easing winding down, it’s possible that US Treasuries are not as beneficial as they have been going forward given a potential shift back in the equity-bond correlation. 

Buy gold

Traditionally, gold has shown superior performance only during periods of crisis compared to more stable times. 

Yet, gold earns little long-term yield, rendering any strategic asset allocation to it potentially erosive to overall returns. 

Additionally, it contains considerable idiosyncratic risks unrelated to the financial markets. Potential negative influences could come from an unfavourable monetary policy cycle, sentiment toward the US dollar in which gold is priced, as well as political instability that impacts gold mining or miner strikes. 

In sum, gold stands as an inconsistent and unreliable instrument for risk mitigation.

Buy equity put options

The inherent mechanics of equity put options are similar to short-selling, which buoys their performance during market downturns, especially when a crisis hits. 

The downside is that equity put options come with a high cost in more stable periods and under bull markets. Akin to buying insurance, unless something bad happens, you will be paying away the premium. 

Times series momentum and trend-following

Institutional investors have long acknowledged the significance of trend-following strategies as a means to diversify and safeguard their portfolios. 

Trend following employs a systematic approach designed to capitalise on both rising and falling price movements within the strictly regulated and highly liquid global futures markets. 

Historically, such strategies have excelled during times of crisis, including the notable instance in 2022, showcasing the kind of positive convexity that risk mitigation strategies ought to strive for. 

The Socgen CTA Index serves as the benchmark for these strategies. These are one the most reliable sources of risk mitigation and will be used as a building block.

Long-short low- vs high-risk equity

A quality stock can broadly be described as a company with strong financial health, consistent earnings growth, and stability, often making it a resilient investment choice. 

As the bull market approaches its peak, quality stocks frequently appear undervalued and unloved by investors relative to some market darlings, according to research conducted by Asness, Frazzini, and Pedersen in 2019.

The inherent defensive characteristics lead to the outperformance of quality stocks during market downturns. This phenomenon is referred to as the flight-to-quality effect. This too offers a robust source of risk mitigation that we will use.

Liquidity: A pivotal element in risk mitigation

Liquidity provides investors with the essential flexibility to adjust or reallocate their capital as necessary during times of crisis. A daily liquid diversifier, unrestricted by gates, stands out for its value and adaptability over semi-liquid options, even though the latter usually offer the benefit of illiquidity premiums.

Through the use of shorting and leverage, liquid alts aim to shield against macroeconomic uncertainties and deliver truly diverse returns. 

These “cash-plus” strategies – aiming for performance above cash returns – further benefit from rising cash rates, as they hold free cash in tandem with their active investments.

The emphasis should be on remaining invested over attempting to time the market, which is notoriously difficult and labour-intensive. Pursuing a more strategically diversified asset allocation presents a more meaningful investment objective.

We summarise the previous results in the following table:

The three-year rolling annualised returns of the Morningstar Developed Markets Index, any period below the grey line means the return over that 3-year period is less than 5%. The expected return from the Morningstar Developed Market Index over the long term is around 7 - 8%.

Enhancing a core allocation with liquid alternatives 

The enhanced core portfolio approach is globally diversified and strategically incorporates liquid alternatives to effectively mitigate risk while maintaining daily liquidity. Liquid alternatives, as the name suggests, provide investors with the flexibility to invest beyond traditional asset classes while ensuring liquidity. 

By focusing on risk management, the portfolio aims to outperform the traditional 60/40 portfolio over a market cycle, delivering higher returns per unit of risk.

As such, this approach takes into account the impact of the addition of alternatives to the investors’ conventional public portfolio and views it holistically. 

Endowus gets its name from “Endowment investing for all of Us”. At its core, the investment philosophy is about goal-based investing and, by extension, structuring investment portfolios such that they meet the short-term and long-term goals on an inflation-adjusted (or real) basis. 

Being globally diversified over the long term, without taking unnecessary concentration risk while keeping the cost of investing low, is what gives investors the highest probability of success. 

* Subject to redemption restrictions set out in Terms & Conditions.

Scenarios where the approach’s strengths prevail more and less

In the approach, the portfolio incorporates strategies that have consistently demonstrated positive convexity while still delivering a positive long-term track record of returns. 

Convexity, in the context of investments, can be simplified as the ability to shield an investor's capital from the complete impact of certain market fluctuations.

The advantage of incorporating these strategies lies in a lesser decline in value amid market downturns, thereby serving as a protective buffer against potential losses. Based on this, here are scenarios where the enhanced core allocation could show strength. 

1. Empowering investors, who prioritise risk-adjusted returns, with access to a long-term, diversified portfolio for core allocation. This portfolio encompasses major traditional asset classes and provides enhanced protection against market downturns.

2. Navigating the latter stages of a prolonged bull market, and effectively mitigating the potential impact of an imminent equity market downturn.

3. Offering flexibility to investors seeking to capitalise on long-term equity gains, while harbouring concerns about the liquidity risk, without incurring a considerable reduction in overall returns

On the flipside, there are scenarios where this portfolio approach will face risks.

1. Quick regime change: The market experienced a rapid shift in sentiment, with a new trend yet to fully materialise.
2. Beta compression: One notable risk to this approach is the convergence of betas for all stocks towards 1. This means the relationship between a specific stock and the broader market is exhibiting a homogenous sensitivity with other stocks versus the market. 
3. Junk rally: The risk taking environment where investors favour companies with lower quality fundamentals, weaker financials or lower creditworthiness. 

Start your enhanced core investing journey with Endowus Private Wealth

The core portfolio approach is considered a daily liquid element investing in public markets in Endowus’ alternative building block framework. Our mission is to bring the Yale model of “endowment-style institutional investing” to all.

Combining liquid alternatives with the Endowus Flagship Portfolio, the newly launched Endowus Core Enhanced Portfolios aims to reduce equity correlation, volatility, and risk without compromising the returns.

Log in to your Endowus Private Wealth account to explore liquid alternative strategies exclusive to Professional Investors. For more information on Endowus Private Wealth and alternative investing, please contact us for a consultation.