Risk Update: May 2019 – Recreating Endowment Concavity.

Many of you volatility disciples may be familiar with a presentation given by Mike Edelson, CRO of the University of Chicago Endowment, at various venues over time, eg the Global Volatility Summit. There is even a link you can access at the website:

Below we have created a similar, though hypothetical, version of the chart at the core of his presentation. This chart is a simple scattergram where the x-axis represents the annual performance of the SPX index and the y-axis represents the returns of a hypothetical portfolio. The blue dots form a linear line representing a targeted return of 60% “beta” of the yearly returns of the SPX. The orange dots represent simply hypothetical returns, indicative of the common problem of negatively convex (concave) portfolios, along the lines of the actual historical returns expressed by Mr Edelson in his presentation.

Figure 1: Hypothetical Concave Portfolio vs 60% Beta Benchmark

We see this sort of concave return history over and over again. What drives it? Our best guess is the short term return objective/incentive structure that is standard across the fiduciary asset management industry: an almost exclusive emphasis on relative performance at the mean of the distribution of short term returns, as opposed to long term compounded returns. This drives the desire for a preponderance of carry and short vol type strategies. Strategies that have a high probability of performance at the mean of the short term return distribution, but strategies that exacerbate the underperformance in the wings. Strategies that have bounded upside, but correlated and asymmetric downside, or even worse, strategies that charge hefty performance fees on correlated upside beta risks, yet have potentially accelerating correlated losses on the downside. The next chart below, using the same data, is a more accurate representation we believe of how asset managers look at their return track record. An arithmetic progression of annual returns that start afresh each year. On that basis, the relative underperformance to the targeted benchmark in the tails doesn’t look too awful. There is, however, significant damage being done.

Figure 2: Hypothetical vs Targeted Annual/Arithmetic Return

Hopefully, many readers will recall our recent note breaking down the contribution to long term compounded returns by percentile of monthly returns. This is a continuation of that thought process. To recall the rough numbers, circa 40% of long term compounded returns are contributed by the mid 90 percentile of monthly returns, while 60% of long term compounded returns are contributed by the two 5 percentile wings. Well you can likely imagine the impact on compounding if, as is the case with our hypothetical set of returns, you consistently underperform your benchmark in the wings. We would argue that the correct way, far better than the representations in the above two charts, to present the return performance of our hypothetical portfolio relative to its targeted benchmark is the compounded returns. The below chart shows quite starkly the impact on long term performance when we switch over to a geometric (compounded) return progression. The negative convexity in the wings really bites over time.

Figure 3: Hypothetical vs Targeted Compounded/Geometric Return

This, of course, leads us back to our mantra: hire a good goalkeeper and put more goal-scorers on the pitch! Find good efficient protection strategies, and take more beta risk. “Supposedly” defensive strategies (defensive midfielders, hired to play defense but incentivized to score goals) that have bounded potential upside and correlated downside are destroying compounding the world over, and it will only get worse at ever lower levels of interest rates. In particular, one might want to avoid the supposedly diversifying absolute return hedge fund strategies that sound so good in their promises to make money in good times and act as a hedge in bad times, then charge exorbitant fees for the privilege.

If you want to see what absolute return hedge fund average performance might look like on a long term compounded basis, you can simply add in a 2% annual fee to our hypothetical portfolio. The results below are quite telling, and eerily similar to the HFRX Global Hedge Fund Index. Hmmmm

Figure 4: Hypothetical 2/20 Hedge Fund vs Targeted

It is always the right time to improve the convexity of your portfolio. With the renewed declines in interest rates, virtually the world over, the future risk to compounded returns from bounded topside, potentially correlated downside, defensive strategies becomes increasingly relevant. Hardly a day goes by where we don’t find ourselves in a conversation with a fiduciary asset manager who tells us that we aren’t needed in their portfolio, as they are not bearish. Our laughably inevitable response is “then why do you have a 30/40/50% allocation to inefficient defensive strategies?” Fixed Income, carry, short vol, absolute return hedge funds, credit, and so on; strategies with both bounded potential upside and increasingly likely to have correlated downside. They aren’t taking enough risk because they don’t have enough confidence in the risk mitigating properties of their defensive allocations. They are performing well, relative to benchmark, at the mean, yet significantly underperforming in the up wing, and will almost certainly underperform in the down wing. They are negatively convex.

May was an interesting month, a proliferation of potential sparks in a world of quite a bit of fire risk. As has been the ongoing theme throughout this long cycle, the Central Banks stood ready with promises of their ability to douse any emerging flames. Asset prices, both equities and fixed income, continue to hover at or near historical highs, and naturally volatility near historical lows. The ever lower yield on bond investments must surely be considered when allocating to “defensive” portions of an investment portfolio. After yet another period of positive correlation between bond and equity prices, how much risk mitigation should one rationally expect from fixed income investments at all time low yields? If you haven’t already started thinking about more efficient strategies for balancing risk in your portfolio, now is probably a good time to do so.

Figure 5: SGD/JPY ‘Seasonal’ Chart

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