Category Archives: Financial risk management

Milliman FRM market commentary: March 2017

S&P 500 dividends have increased at more than two times the rate of inflation over the last 30 years.

The S&P 500 CAPE ratio sits above its pre-crisis peak. Year-over-year PCE, the Fed’s preferred measure of inflation, climbed above 2% for the first time since 2012. An ocean of excess reserves diminishes the Fed’s ability to respond to inflation. Risk management, like insurance, is only a benefit when implemented ahead of a risk event.

To learn more, read Joe Becker‘s full commentary at MRIC.com.

Goal tolerance: When goals meet risk tolerance

There are clear reasons why risk tolerance drives the financial advice process. It produces a simple number, which makes it relatively easy to recommend investment products while maintaining a compliant paper trail. But such a heavy reliance on risk tolerance can also produce significant problems.

Risk tolerance is too often thought of as an unchangeable number even though there is little academic guidance on the most effective way to measure it, leading to widely varying estimates (and subsequently portfolios) between advisers.

Placing a greater emphasis on clients’ objectives and wrapping this around their risk tolerance can produce higher levels of engagement and offers a more accurate pointer to investor behaviour. Milliman’s Wade Matterson and Craig McCulloch offer some perspective in this article.

Super funds need a balanced view of investment returns and risk

Lower investment return targets on top of higher investment risk can create disengaged investors in Australia’s superannuation industry. In this article, Milliman’s Michael Armitage offers perspective on how super funds can “pursue more innovative strategies to match risk and return to suit different groups” to meet the needs of individual investors.

Here’s an excerpt:

Older members and those with larger balances, who are more sensitive to risk (both volatility and maximum drawdown), need special attention.

Rather than automatically reduce investment return targets or increase investment risk, some funds are exploring alternative options beyond 70:30 style default funds. No single approach is perfect, but whatever strategies are chosen, they should ultimately increase the probability that members meet real (not assumed) goals.

The Future Fund may be a unique example (no members and no inflows), but it has taken a far more absolute return approach than typical super funds–even with the knowledge that government could start drawing down funds from 2020. Similarly, some super funds are taking a greater risk parity approach (that goes deeper than simply gearing up bonds) by focusing on the amount of risk in each portfolio allocation rather than the specific dollar amounts invested.

Maritime Super has also recognised the role of risk–last year, it applied a futures-based risk overlay (managed by Milliman) aimed at controlling extreme volatility and limiting capital losses to its default MySuper option. Its membership is older and has higher value balances than many other industry funds.

Other funds are now using futures to tilt their portfolio allocations based on relative valuations over the short term. This type of implementation management can potentially better manage risk and marginally improve returns.

These are just some of the innovations currently taking place as funds differentiate themselves and leave herding behaviour behind.

Is a comfortable retirement possible in the superannuation world?

The ASFA Retirement Standard states that an average Australian couple requires about A$640,000 in their superannuation fund at retirement (or AUD 545,000 for a single person) to live comfortably. According to Milliman’s Jeff Gebler and Wade Matterson, “The personalised nature of each superannuation member’s retirement journey means a one-size-fits-all approach simply cannot deliver the necessary information, products, and risk management strategies required to achieve everyone’s desired outcomes.”

In the article “Why the industry’s ‘comfortable retirement’ measures are wrong,” Gebler and Matterson discuss the need for enhanced benchmarks based on available data and communication strategies to deliver better financial outcomes that individuals can live with comfortably.

Boring derivatives

In public, and particularly in the news media, the word “derivatives” always seems to be spoken with ire or disgust. Stories involving derivatives are usually aimed at shaming greedy “Wall Street types” or describing the calamitous damage inflicted by an ill-conceived derivatives position. Wherever derivatives are mentioned there is likely a picture or graphic containing either handcuffs or a face-palming trader. Even Warren Buffett called derivatives “financial weapons of mass destruction.” But is there really cause to be terrified of derivatives as a whole? Part of the problem is that “derivatives” is a very large asset class, describing all assets whose values are derived from a notional amount and an observable event (e.g., default of a particular company) or underlying value (e.g., an interest rate or stock price). Thus “derivatives” have the potential to be very complicated. But because it is such a large asset class, maybe some derivatives are very simple. Maybe some derivatives are liquid and accurately priced. Maybe some derivatives are regulated. Maybe some derivatives allow for very cost-effective risk management. Exchange-traded equity index futures are that type of derivative. They are boring derivatives.

When investors execute equity index futures contracts they are agreeing to either buy (long) or sell (short) the value of the underlying index at contract expiration for the price as stipulated in the contract. For instance, if an investor were to take the long position in an S&P 500 futures contract, when the S&P 500 futures price was 1400, at contract expiration they would be required to pay:

(1400 – S&P 500 value at contract expiration) * contract multiple, where “contract multiple” is a standard contract term essentially defining the notional of the contract

Should the S&P 500 be higher (or lower) than 1400 at contract expiration, this value would be negative (or positive), indicating a negative (or positive) payment be made by the investor. Another way of saying this is that the investor would realize a gain (or loss). The reason for this is that the investor previously agreed to pay 1400 for something that is now worth more (or less) than 1400.

The potential gain or loss from a contract of this sort could grow quite large. It is because of this potentially large loss that margin is required to engage in futures trading. The amount of margin required is set by the futures exchange. As markets fluctuate and unrealized losses (or gains) become large, additional margin deposits may be required (or excess margin may be withdrawn). Open contracts can be, and in practice usually are, settled prior to expiration by entering into exactly offsetting positions, thereby realizing any previously unrealized gain or loss.

From a risk management point of view, the potential benefit of utilizing equity index futures contracts comes from the fact that large exposures can be acquired for minimal cash outlays. Margin requirements are roughly reflective of the exchange’s view of volatility and the investor’s open positions. In this way, an investor’s required margin is the amount roughly equal to that necessary to cover a large, unlikely, one-day loss on open contracts. For instance, in order to get an exposure the equivalent of $100,000 to the S&P 500, the required margin might be $10,000. By engaging in net short positions in equity index futures, investors can greatly reduce their broad market equity exposures without having to liquidate their equity holdings.

Equity index futures contracts are exchange-traded, meaning an exchange facilitates all trading. Margin is required of net long traders and net short traders. As markets move, gains accrue on one side, washing out losses on the other. The margin requirements protect the exchange and virtually guarantee each investor’s ability to settle their potential liability. As such, it’s very likely that equity index futures will remain boring derivatives. That’s exciting.

I can’t believe it’s not beta

Traditionally, hedge funds have sought to achieve outsized returns relative to the level of market risk in their portfolios while simultaneously maintaining a low correlation with the market at large. In other words, they seek high alpha and low beta. Proprietary investment strategies and relaxed reporting requirements have helped to make these goals possible, but also aiding the endeavor was a lack of appropriate investable benchmarks against which hedge funds might be measured. However, the emergence of hedge fund replication strategies (subscription required) might help institutional investors to more accurately assess the performance of hedge funds and correctly identify and quantify the components of their returns. Furthermore, hedge fund investors suspicious of the relative value of investing in single funds or funds-of-funds (“I can’t believe it’s not beta”) may now have a lower-cost avenue for accessing hedge fund beta.

Hedge fund replication is the general name for strategies attempting to replicate, or beat, the returns of hedge fund indices using assets that are potentially more liquid and transparent. For instance, a replication strategy might attempt to achieve returns similar to a particular hedge fund index while only investing in equities. Successful strategies would achieve returns very similar to their target indices, creating lower-cost, investable hedge fund beta.

Potential investors should consider carefully before allocating assets to hedge fund replication strategies as there are potential downfalls. First, the replication strategy may or may not perform as expected, meaning that an investor may or may not be able to access hedge fund beta. Second, although fees associated with replication strategies are generally lower than direct investment in hedge funds or hedge funds-of-funds, they are still rather high, typically comprising either a 1% to 2% management fee or a 15% performance fee, according to a recent Pension and Investments article. And finally, investors should consider their goals in making any asset allocation. Hedge funds, or hedge fund replication strategies, may provide diversification, but at a significant cost. Further, if risk management is the end goal, and diversification simply a means for achieving that goal, it is important to remember that diversification relies on correlation and, as correlations vary over time, diversification alone may not prove an effective risk management tool. Focused risk management strategies may be more effective in meeting those goals at a much lower overall cost.