The turbulence in financial markets over the past few quarters has renewed jitters about a market crash — a prospect that seemed to catch many investors off guard. The truth is that market crashes happen far more frequently than we care to admit, and they can have a dramatic impact on long-term total returns. Despite this, surprisingly few asset owners integrate crash risk into the design of their portfolios. In fact, just six years after the 2008–’09 financial crisis, a recent survey at a forum hosted by Institutional Investor suggested that only one third of asset owners manage crash risk explicitly.
For investors, valuation and management of crash risk should be an ongoing focus for several reasons. Some are readily apparent. By the time the risk of severe losses becomes evident, it may be too late to do much about it. As market prices adjust, both liquidating risky assets and hedging may seem unpalatable. When it comes to managing through a crisis, we may not be able to rely on either the agility or the staying power of our institutions.
Other aspects of crash risk are more subtle, however. Crash risk influences portfolios even when there is no apparent threat. Recent studies have shown that crash risk is a material component of the premiums that draw investors to equities and other risky assets. In the current environment, marked by low rates and investor caution regarding the equity outlook, asset owners faced with high absolute-return targets may find it difficult to avoid taking on significant amounts of crash risk. How else to generate the required performance?
In addition, the difficulties in assessing crash risk are insidious. A variety of strategies seem uncorrelated in benign markets, though they exhibit higher systematic risk when markets are under stress. If performance is assessed based only on calm conditions, investors may overestimate the diversification benefit or mistake a risk premium for alpha. Further, reported returns of strategies that afford manager discretion in valuing positions may not fully reflect economic losses suffered during market drawdowns.
These features of crash risk have broad implications for asset owners. Some — hedgers — may wish to reduce their exposure. Others — that is, harvesters — may wish to embrace it to earn premiums associated with underwriting the risk. Both groups of investors should examine whether they’re modulating crash risk transparently and efficiently.
In the current market environment, investors are stretching for returns. This behavior leads them to reallocate out of conventional asset classes into alternatives and private equity, where many believe returns may be higher. But in doing so, investors may be substituting apparent equity market exposure for risks that are more subtle.
Certain alternative strategies — for example, merger arbitrage and relative value hedge funds — may appear to offer great Sharpe ratios and diversification from equity-centric portfolios. Yet such strategies may also have substantially greater crash risk exposure than conventional risk analyses would suggest. Investors might actually increase risk through the very act of diversification, which they think is reducing it.
This situation is where the opaque nature of some alternative investments and discretionary marking of private equity has a real impact. If certain hedge fund styles and other strategies deliver downside exposure that is not so readily apparent, then investors struggling to meet ambitious performance targets may end up overallocating to this type of risk. And investors should consider whether opaque and relatively costly hedge fund investments are the optimal way to gain downside exposure, assuming that is desired.
Ultimately, some of the alpha that hedge fund and private equity strategies offer may not be alpha after all. It is likely to be a risk premium earned for taking on downside exposure that isn’t immediately apparent. If investors crowd into such strategies, the risk premium may come under pressure. As a result, investors may end up not being fairly compensated for the risk of holding concentrated positions.
The bottom line is that asset owners need to be realistic about returns in the current environment. It may simply not be realistic to aim for an 8 percent nominal return target. Failing to acknowledge that concern may lead to dangerous distortions in investor portfolios. As investors reach for returns, they should search for hidden downside risk that may be ingrained in popular alternative strategies. For many, it may be more prudent to wait out the current environment than to take concentrated bets on expensive sources of downside risk with dubious diversification benefits. Regardless of their particular investment allocations, every investor should be asking, How much crash risk do I have, and from what sources?
Seth Weingram is a senior vice president and strategist at Acadian Asset Management in Boston.
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