Rethinking Diversification: Alternative Downside Risk Management

okay hello everyone my name is Mark rascoff I'm a portfolio manager here at Russell Investments and in a research capacity I cover tactical trading strategies um I've been uh researching alternatives for three decades now and I've been at Russell for 14 years and we have a fascinating topic today rethinking diversification and just to frame things it's clear that institutions today are committed to large core equity allocations and frankly I don't blame them because from my seat it's convin it really convincingly looks like we're on the cusp of a transformative productivity and efficiency cycle driven by the enterprise-wide adoption of AI but that's really a topic for another day today we wanted to show you a powerful diversifier that not only protects equities but can increase total returns over time we'll get to the detail uh but the punchline is if you can opportunistically short risk assets capitalize on spikes in volatility and regularly rebalance your hedging gains into equities you not only improve your draw down but you improve your total return as well um before we dive in I wanted to quickly tell you about the three folks with me on the call First is am need Singh a senior Quant specialist in Russell's assocation strategy Group which is really one of the main engine rooms here Russell am NE was one of the architects of our alternative diversifier solution and he has both a strong he has great intuition and a strong skill set across modern quantitative processes which really seems to be where the ball is rolling in Asset Management today um and meet's been with Russell for about seven years and has been in the industry about 15 years um also on the call of Cedric fan Cedric is one of the most senior members of Russell's portfolio management team uh he has a background in both liquid alternative and private markets today Cedric heads up the hedge fund effort of Russell and he also manages traditional portfolios for many of our largest clients um Cedric's been investing for about three decades and has been here at Russell for 21 years finally we're lucky to have Patrick casley with us today he's a recovering aqr associate and for the past few years he's been running the custom Solutions business for one River Asset Management in Stanford Connecticut which is a multi-billion dollar alternative shop focused on Tren following and volatility strategies it's really great to have Patrick with us today because we use one River as a Cornerstone in our Alternatives diversifier solution okay so over the next 30 minutes or so the four main points will cover our first even though institutions rely heavily on Equity beta we'll briefly show you a reminder about valuations then we'll talk about the longv and Trend strategies the core of our alternative diversifier solution next we'll talk about what to expect from manager selection and finally we'll talk about implementation and I think the highlight of this webinar is the last visual which is an animation and I think you really enjoy how simply it shows the power of conditional negative correlation rebalancing okay let's get going um so I'm gonna first turn to Patrick Patrick please feel free to share your uh exhibits on your end um so where are we with equities today and what are the implications thank you great thank you Mark and thanks so much for having me on um you know first we' like to begin with just kind of a bird's eye view of what the equity markets have delivered recently and we defined recently maybe a bit differently or maybe perhaps in line with many of of the clients on this call but just to Define it we look at rolling 20 15 and 10e periods and what we've generally observed over that and why why that period's important is that more or less defines the success or lack thereof of many institutional pools of capital and private pools of capital over the latest Market regime and I guess the resounding observation is that if you look at the S&P 500 in excess of the risk- free rate which is kind of the real Return of the S&P uh we're currently in the 97 percentile of rolling 2015 10year average Horizons the reason that's important is that um you basically over the last century of evidence you've never been happier than you are with equities from this point you know in time exactly um however it's not the first time that we've been here and so it's always worth looking back into history and when you hear somebody say we're kind of as as good as we've ever been I think the natural and human inclination is to maybe fade that that that that return Source or look elsewhere well I think that's prudent and called for I don't know if it's necessarily wise to abandon equities so I think there's a call for both and so the last time we were here was actually in the tech bubble and obviously that would have been a great time to spend the subsequent 15 years more or less hiding under your desk waiting for those Equity Market values to kind of come back it would have been a fantastic time to embrace some of the um diversifiers or you know alternative diversifiers that we're going to talk about later in this piece but I think just as importantly and perhaps uh maybe even more so interesting is the last time we were here before the tech pubble you have to go all the way back to the post-world War II recovery period And in that post-world War I recovery period you actually see um that not only did we visit this level but we kind of continued to crash through alltime highs for the better part of the subsequent decade and people kind of call into motion the the decade of American exceptionalism or this kind of great economic experiment there's plenty of parallels to both the tech bubble and the late you know post World War II recovery period today so I think the the moral for investors is there's not necessarily strong intuition for fading equities and there's certainly plenty of reason to to have pause or concern about the future for equities given the starting point where we are today so rather than abandoning equities and embracing a hedge or rather than over hedging the portfolio uh we call for approach that effectively looks to barbell those risks so continue to participate in equities and perhaps even increase your exposure to equities but at the same time find really Capital efficient asymmetrical ways to participate in downside markets such that you can maintain your upside capture in markets over the long run but ideally significantly improve your downside performance at the total portfolio level yeah that's real helpful Patrick thanks um Cedric can you comment on what institutions are doing with their Equity allocations today right um always a really interesting topic to discuss and uh yeah I think you you laid it out really nicely Mark and I think Patrick's comments are are spoton you know equities appear to be at elevated valuations but I think kind of the Hidden question is sort of like okay how comfortable are we with that and even if we do think there were elevated valuations which frankly we may not be right for reasons related to Ai and Enterprise adoption as you mentioned Mark I think the the question is should we be fleeing equities and somehow making a change to our strategic asset allocation which is generally going to be fairly heavy in equities to kind of extract the equity risk premium which has been very robust going going back more than a hundred years and I think that having talked a lot about this internally uh we do not believe and we're not telling our clients that we believe that you should really make major changes to your ass allocation and we are not advising that you dump a big portfolio or big chunk of your Equity portfolio and you know the reason is is I think fairly straightforward um things can remain an elevated valuation for a while or maybe things that go into your valuations are based on a metric that may not be relevant going forward right but the other issue is simply suppose that you're right so suppose that you decide to reduce Equity exposure and maybe the market goes down and you feel really good about your portfolio the problem with that is that it's really hard to time jumping back in and we have lots of examples in history in which which you have people who have made maybe a pretty good call to drisk from equities but then simply Miss what could be a generational rebound and I'm thinking about times like March of 2009 you had a very sharp drawn equities a lot of people got out equities and then they didn't rrisk for quite some time and gave up you know really one of the most robust periods for equi so getting the timing right is really quite tricky and so that's why why kind of as a matter of policy Our advice and the way we manage our own portfolios is to have an asset allocation and stick with it and if you have large draw Downs then that's probably a good time to sort of rebalance into uh things like equities or other dislocated assets thanks Cedric um Patrick you talk to institutions all the time can you comment on some of the traditional ways investors have looked to mitigate Equity risk yeah of course um so you know right now I'm sharing a screen which is showing a very simple metric but I think it's an important one and one that's really driving a lot of allocation decisions and concerns going forward so what we're looking at is kind of a rolling one-year realized correlation between stocks and bonds here we're using us bonds and the S&P 500 and what you generally observe over the long run is that recently investors have kind of rightfully anchored to a negative correlation assumption between stocks and bonds and that when stocks falter typically bonds bolster the portfolio this has given rise to allocation Frameworks such as 6040 risk parity style Frameworks where the compensation or lack thereof from one bucket is typically picked up by the other uh this is obviously very self-serving to clients because bonds are effectively infinitely scalable very liquid and ubiquitous you can find them in every Market the downside of this is that this hasn't always been the case bonds aren't necess necessarily an entirely reliable hedge throughout time in fact we saw from the 60s through the late 90s a fairly persistent positive correlation between stocks and bonds and we saw that obviously slip away and and flip negative for the subsequent you know 17 or so years but postco we've actually seen that relationship flip back to being positive and we can posit a new a number of theories as to why that might be the case I think the presence of inflationary concerns is certainly Chief among the uh reasons for why we might be seeing that today but I think most importantly rather than try to estimate exactly what this relationship will be going forward is to understand where that diversification comes from historically the reason bonds have been diversifying historically is that crises have historically been deflationary in nature at least over the recent regime but that hasn't always been the case going back to the 70s Etc um what we saw in 2022 is actually a perfect counter example of that that was a significant draw down in equity markets 20 plus percent but it was actually driven in part by inflationary concerns and the subsequent rising of rates and that kind of repricing of the duration bet as it existed both in bonds and equities led to a concurrent draw down in both of those interesting little factoid in 2022 we saw many 6040 portfolios approach a GFC level of total draw down very different composition of that draw down but the pain was just as acute and so investors really need to think about our framework for this with clients is that we think of bonds just just like we think of gold just like we think of the the long US dollar bet we think of those as transitory diversifiers and that there's a good reason to hold them and they should be diversifying long term but they don't have to be diversifying in other words the transitory nature of that diversification is that they're only diversifying if another coincident macro factor is also true so bonds are diversifying if the crisis is deflationary um gold is diversifying if the crisis has a macro geopolitical risk associated with it or it's inflationary and the long you dollar is defensive provided that the response to a given crisis is kind of favoring uh flight to Quality and the US dollar is viewed as a honic currency all of those bets well reliable historically aren't necessarily reliable going forward because we don't know how those other macro factors might change conversely and I think we'll get into this later in this webinar is we we find a number of ingredients that we would call structural diversifiers so things that are diversifying because of the nature of how they how they run so for instance long volatility is something that is structurally negatively correlated to equities because it's related to uncertainty because markets are designed and expected to go up over time when they quickly go the opposite direction uncertainty tends to Cascade fairly reliably and so being long a volatility instrument tends to have a much more reliable negative correlation much more stable long-term correlation profile and you'd see the same thing for something like a multi-asset trend following program wherein the correlation profile is a byproduct of the way that systematic model works so anyways we find this kind of transitory structural diversification dichotomy is useful for clients as I think about you know so this isn't a call to abandon your bonds or abandon your gold it's a call to additionally diversify into these structural return sources that's fantastic thanks Patrick um let's turn to you m neat um Patrick touched on it a second ago um but if institutions you know really need Equity exposure and bonds um are less than 100% reliable what else is out there thanks Mark yeah that's a that's a great question because when we look at our portfolios of our institutional clients that we interact with we we see diversification but the diversification exists in the growth bucket it could be allocation to Global Equity where you get exposure to a lot of countries it could be uh credit with Equity to get you to return Target Etc or real assets as such where we see limited diversification is on the downside protection pit right most people tell you hey I've got exposure to ig bonds or treasuries and that's going to protect me but that's about it gold and dollar probably something at the margin that they think about but not a core downside protection allocation in their portfolios so when we're kind of thinking about this problem uh uh we were thinking about we need a second line of defense uh like Patrick said not replace bonds but work alongside bonds and it needs to have therefore two unique characteristics right one it should work in environments where bonds might not working and therefore it's diversifying to Bonds in the portfolio and two it shouldn't really hold cost you for holding over a a long enough Horizon which means it shouldn't take you off Target on a return goal just because you have an allocation to it and we spent around two years looking at around 200 strategies of varied complexity trying to understand what are the few things that can get this done uh these two objectives like working in different environments and also not costing to hold over a strategic Horizon and at the same time we should be able to understand when they work and when they fail they shouldn't be black boxy that when we allocate to it we cannot even ass certain hey when will this piece of my portfolio not do well versus do sorry do well and I think active long wall and cross asset Trend would two things which I we we we think are really great to have in portfolios they're very complimentary and we'll cover that in a second uh but the first and the most important bit is which Patrick uh touched on is that they're not exposed to the same macroeconomic risk like gold or or or or the US dollar or even bonds bonds being the primary ones are exposed to right like 2022 uh a shock and inflation expectations or higher inflation and uncertainty bonds didn't really work well but now if you look at long active long wall and cross asset Trend they're not really exposed to the same macro risk wall long wall will protect you when wall spikes that wall spike can happen either in a growth shock inflation shock or just uncertain like we having the past few months around tffs it's it's it's uncertain and W wall is going to protect you if there's any impact in the market it's not really driven by a macroeconomic specific macroeconomic outcomes and like Patrick said therefore it's more structural a hedge in the portfolio trend on the other hand is has an ability in Cross asset space to go long and short the right amount the right kind of asset classes the asset classes that are working in a particular environment right so think about 2022 again if if there inflation Shock episode commodity commodity is trending higher bonds are not working cross asset Trend can reduce dynamically your exposure to Bonds in your portfolio by going short bonds and increase exposure to something like Commodities which is protecting you in that particular environment right so it's it's it's like dynamically getting you in the right kind of asset classes which are working in that draw down scenario moreover I think they also very unique in the kind of uh shocks they protect you against like they're very complimentary you could think about long wall as being a faster twitch reaction to a shock in the market is a steep draw down that happens for something unforeseen that goes that happens I might remind you of August last year or September last year when the the Japanese Central Bank interest rate change or expectation thereof was triggering a deep sell off in markets and and that was a Shock episode and wall spiked to a pretty high level right and therefore anybody's going to long wall be protected in those episodes uh now trend on on the other hand is going to protect you from more protected draw Downs where markets are grinding lower uh and there's a peak to truff kind of draw down not necessarily A sharp sharp drop in the markets right and therefore a combination of these two will protect you different kind of uh draw downs and like I said they're again complimentary to duration because it's they're not exposed to uh the macro risk that duration might be and the third and the most important thing which is also very relevant is when you allocate to the mix of these two they might not cost you to hold over a strategic Horizon which is important right because every time you think about structural uh defensive allocation you think the cost associated with it and long wall does have a cost associated with it uh but the thing is that when markets are trending higher and trend is working for you to kind of get you to markets which are going and generating a positive return and short markets with generating negative return that return component is going to cover the cost of your protection and also we'll cover this in a second that the long wall we would recommend doing actively and not passively and why we'll just discover that a little bit later uh but even that small cost that comes with active long wall your trend is going to cover that when markets are trending higher and therefore over long enough Horizon it might not really cost you to have this in your portfolio one caveat to that I just want to make sure that to get everybody's attention to when when we talk about a combination of these two uh not costing you over a strategic Horizon we do not really mean to say that there wouldn't be 1 month 6 month month one year periods where it might or might not work as expected but over a very long strategic Horizon which which is where we think investors should be focused on when they're constructing their outcome portfolios to meet their long-term goals that's over that kind of horizon we think it's it's probably going to be very cost efficient to hold over long long strategic Horizons a combination of these two yeah thanks I me I I think it's it's important also to highlight that our research more or less landed on a kind of an elegant combination of two indices really uh 60% allocation to um SG Trend and 40% to something like Eureka hedge long ball um it's it's just been a great uh solution in combination um and before I I know you were about to talk about some of the nitty-gritties um on maybe active Vault but before we do that I remember Patrick you made a great point about uh these strategies holding cash balances um can you make that point again please sure yeah the one of the benefits of long volatility and multi-asset trend is that the implementation of those strategies is derivatives based and um you can achieve a great deal of as much volatility as you'd like on a fairly small Capital outlay so that means if an investor is to buy a fund for instance that is both long volatility and long multi asset Trend inside of one pool of capital you can do that in a very Capital efficient stacked manner but at the same time that that fully funded investment may still be sitting on after the both of those deployments maybe a 70% or higher cash balance so that means as rates go up as the risk-free rate hurdle becomes more difficult to beat you're actually not only long uh volatility and Trend but you're also long that risk-free rate and you're getting about 70% of that back on top of the return so you should really think about an allocation to these Alternatives is what we call a Cash Plus alternative so really the the quote unquote financing of that isn't the risk-free rate I would think of that as roughly a quarter of the risk-free rate is what we're looking to hurdle through these active return sources and for what it's worth historically they they they more than have yeah that's a really good point Patrick thanks for that okay um so just now that we sort of landed on a sort of a benchmark um for this alternative diversifier 6040 Trend in longv MN can you walk us through a little bit more on the manager selection front yeah certainly I I think we strongly believe that active managers can really add value in this particular space and their reasons for for that belief let's start with long wall for example right holding passive long wall can be really expensive think about how much it cost to hold a passive put option over a long period of time and it can get really really expensive so active managers have several tools that they use to reduce the cost of being long volatility while also giving the same kind of downside protection and to name a few for example they might have conditional la long volatility processes right we we understand that volatility is mean reverting and therefore when the wall is high it might be very expensive to buy protection where wall is lower it's cheaper Etc managers can scale their exposure to Long volatility so that they can they can be long volatility at an opportunistic time and get you the exposure Without Really costing it too much the other thing that they sometimes do is get the right instrument what is the most efficient instrument of der exposure that can get you that long wall is it going to be puts is it going to be vix futures or what what is the right kind of instrument at any particular time which is going to be cheap enough and and very efficient to get you the long wall exposure an active manager can make that decision even in time wearing Manner and get you get you the right kind of instrument to get get long volatility and the third is they can also exploit inefficiencies in the market right they could take exposure different points on the wall surface or even go long volatility on single stock names rather than index U and exploit that cost advantage to just lower the cost of really holding a long wall exposure so like I said there multiple tools at the disposal which can get you the same kind of protection but but at a fraction of a cost so therefore we really ProActive Management in this space now let me come to Trend trend is a very interesting uh space as well and we in that space we pray for a multi- manager implementation and a study that we did basically if you kind of look back around which manager in the trend space outperformed uh consistently over every year on year you'll be very hard to find one or two managers that always doing better than the others usually who whoever is performing the worst or the best keeps on changing over time right and that is because everybody has a unique unique processes to identify which asset classes to go long on short in in Trend uh and sometimes one process captures that that whole effect better than the other and sometimes the other which works better so we rely on a manager selection process to kind of create a mix of Diversified managers so that they they can work well as a combination and not really pick that this this one manager is the best for example um and also we also look at priting exposures to alternate uh Trend which is like not really your traditional stocks bonds can be something beyond that which can also be useful uh to have in your portfolios but more we we find that more uh active manag able to do that much better than uh than anything that we found thanks Samy I really like uh the point you made about using active processes in the VA space I think I've seen uh a lot of talk about Bank qis products is a great way to you know buy this structural long B but um the active processes um I think they end with a better result um Cedric can we go back to you uh from your seat um what is the ideal way to implement something like this right and this is something that's prompted quite a bit of discussion because there are different can fact different ways to implement this and I kind of want to uh pick up on something that Patrick had mentioned about uh effectively using uh some overlays right in in implementation and so as we kind of talked about before we are not recommending that clients deviate any in any material way from their strategic ACI allocation which for a growth oriented portfolio will have equities that's just the way it's going to be um now again could you have a couple tweaks here and there sure but again your strategic asset allocation is meant to be over that strategic Horizon that Amit was talking about so ideally when you're implementing a kind of diversifier solution when you're combining Trend and a kind of active long volatility you're not going to do anything that reduces the equity beta in your portfolio because the equity beta is over the long term going to be The Driver um kind of the main return engine for your portfolio that allows you to do whatever it is you want to do at that strategic Horizon and so our very strong belief is that from an efficiency standpoint it's best to sort of maintain your Equity beta and kind of layer in um this kind of combination of multi- acid Trend followers and active volatility that gives you the kind of the growth engine and then when Equity markets pull back either in kind of a Sharp kind of move or kind of more of a protracted 2022 style move then your the U expectation is that your alternative risf fire portfolio um you know makes money that you can then sort of use Harvest uh gains and redeploy into the after class that sold off right so again our view is it's really best to try to keep your overall portfolio Equity exposure pretty close to where your strategic long-term Target is yeah thanks edric that makes a lot of sense okay uh now we're uh gonna go back to to Patrick and I've been really excited about this part of the webinar because I know Patrick you've got some pretty interesting data followed by this you know really fantastic animated graphic that I think is a centerpiece of this webinar so over to you great well thanks Mark um just to set the table a little bit in terms of the data that we're looking at um here are the the indices that market mentioned earlier is kind of comprising a rough Benchmark of of what the alternative diversifiers program would be you know at the Crux of that program so the First Column we're looking at the Eureka hedge long volatility index and what you'll realize is we get a fairly modest um to elevated fall you know about about 8 to 10% I would say on the individual manager level you would tend to get much higher volatility so there's quite a bit of diversification in inent within the index itself but the characteristics I think are the most important here so you should expect a low sharp ratio I mean Equity markets are designed to go up over time you're delivering a persistent negative correlation and hopefully a Time varying negative beta or exposure to those markets you should also expect to see positive skew and skewness you know is potentially a complex statistical item but I just like to think of it as What's the magnitude of the winners versus the losers and most return streams are pretty close to zero or even slightly negative over time you can see here the magnitude can be 3 48 times the the right side or the upside observation relative to the size of the downside observation which means earlier I had mentioned that kind of point about asymmetrical returns we really look for asymmetry in the form of skew um but I think most importantly is that that that correlation to S&P column you can see were significantly and persistently negatively correlated to the S&P and yet have managed to deliver a positive return full sample and this is over a period in which equities have realized a 765 sharp ratio Which is far above their much longer term average of2 to3 so we have to really put that in the context of long volatility is an area where if you are skilled and and and active you can actually seek to make money on an absolute basis not just a total portfolio context and then the next column is this multi-asset trend or this kind of slow twitch muscle for the protracted declines here we see a better average return which is to be expected um but ultimately you know I think one thing I would note is that the 2010 to 2019 period if you look at a centy of evidence for the trend risk premium that was actually the toughest decade that we had ever seen so you know what's really nice is over this kind of longer observation period that we're using a decent portion of that is actually a really tough environment for these ingredients to outperform equities or provide value relative to equities not only because equities have done so well but because these ingredients in leaning against equities have actually had quite a few headwinds in generating returns and you can see in the third column we've generated kind of a synthetic monthly rebalanced Benchmark where you're 40% exposed to the long volatility um style of investing and 60% exposed to the SG Trend you see the combination has a higher sharp ratio which implies there's significant diversification therein uh you still get a decent Vault profile I would say if you were accessing this Visa V uh Russell or um an individual manager you would you would probably expect to generate a bit higher volatility a bit more conviction and uh more Capital efficiency But ultimately these benchmarks are useful because you can see the positive skew wins out as well as the negative correlation wins out so you can get positively skewed negatively correlated returns and I think with manager selection you can really seek to pretty meaningfully hurdle this Benchmark over time and then of course the last column is just the astonishing and and you know pretty strong Equity performance that we've all come to know now what we're doing on this slide here is taking those return streams from the previous page so both the Hedge which is that 6040 uh Benchmark of SG Trend in Eureka hedge as well as just a pure 100% investment in the S&P and so effectively we're replicating what what Cedric had referred to as an overlay style of implementation now in the First Column we're doing 100% exposure to the S&P a 20% exposure to this hedged return source and then we're rebalancing on a monthly basis now what rebalancing accomplishes is that when that defensive hedge fund program delivers a convex return or a defensive return stream in the case of like a 2022 from Trend you can effectively rebalance those proceeds into historically cheap equities and that's a really animportant effect it helps you kind of springboard it's a kind of a self motion engine where