Rise of Credit Risk Offset Portfolios

There’s a slew of new terminology popping up in papers and on the alternative investment conference circuit of late around portfolios which engage strategy types designed to perform well in a crisis. Of course, this has been the main selling point of managed futures (we cover that in depth on our new website here). But investments are sold, not bought and shoehorning managed futures into the ‘crisis performer’ box hasn’t been selling so well of late. For one, there haven’t been any crisis periods, much less normal volatility levels. And two, many in the managed futures space don’t like to be called crisis performers, feeling that sort of simplifies and belittles the diversified approaches they take.

Lump it all together: the continued (now, perhaps, more than ever) need for some protection during a crisis, the lack of any managed futures highlights in 7 of the last 8 years, and some in the managed futures space bristling at being labeled crisis period performers… and you set the table for a rebranding/shift of the conversation. Enter the concepts of ‘Crisis Risk Offset’ and ‘Risk Mitigation’ portfolios.

In layman’s terms, it’s portfolio diversification with a focus on Managed Futures type crisis period performance and long Treasury Bonds. It’s the same thing many institutional investors have been doing for decades. But give it a new name, and the approach seems to be clicking with institutional types via Financial Times:

The Pension Consulting Alliance, a US consultancy, has emerged as a leading proseletyser for the trend, coining the term “crisis risk offset”. So far it has convinced about half a dozen of its 35 US pension fund clients to carve out money for a CRO programme, including the retirement plans in Rhode Island and Hawaii.

Vijoy Chatttergy, chief investment officer of Hawaii’s state’s retirement system, (who is invested in this approach) says this is not the same as hedging via Institutional Investor.

Sometimes people confuse this with hedging; this is an offset,’ he says. ‘if our portfolio has a drawdown less than the markets, then we’ll consider this successful.”

This approach has many names: portfolio insurance, credit risk offset portfolios or risk mitigation. But do they all mean the same thing? Here’s how Institutional Investor describes these sort of portfolios.

With yields at historic lows and interest rates on the rise, pensions and other institutions are looking to dial up their use of other diversification strategies, often by creating a subportfolio of CTAs, alternatives risk premia strategies, and long-duration Treasuries to create a so-called offset when equity markets get rocky.

But maybe it isn’t the rebranding, but fears of another 2001 or 2009 that has them looking for true diversification. Neil Rue, managing director of PCA says investors still have market crashes in the back of their minds:

Neil…points out that investors suffered two major bear markets in the noughties, and noted that “people have grown weary of these gyrations.” “Two decades ago all these [pension plans] were well-funded. But demographics and volatile markets have flipped the dynamic, so [the pensions are] now paying out more than they’re receiving and, more often than not, find themselves in very challenging funding situations,” he says. “If we have another 2008 or 2001 then there is a much higher chance these [pension] schemes could fail.

Leave it to the biggest Managed Futures manager, Winton Capital (who coincidentally doesn’t want to be identified as a CTA) to cast doubts about using this rebranded version of Managed Futures exposure.

David Harding, the head of Winton Capital and one of the industry’s biggest names, warned in an investor letter late last year that using simplistic trend-following strategies for protection was akin to the portfolio insurance idea that proved so destructive on Black Monday. “When an institution allocates to a momentum strategy in the hope of cushioning itself from stock market downdraughts it is really commissioning someone to sell stocks on its behalf into a falling market; no different to the failed portfolio insurance strategy that was implicated in the 1987 crash,” he wrote. Mr Harding declined to comment beyond the letter.

We can see where Mr. Harding is coming from. A generic Trend Following strategy working on stock indices or individual stocks, can and will add to the selling pressure in a down market (just like it did in 2008). But the question of scale remains, and the question of whether these types of models are just the flea on the bear’s back or some sort of larger insect pushing the bear down. When you consider that there’s just $340 Billion (our numbers are different than those quoted elsewhere, here’s why), versus $10s of trillions in global stock market value, it would seem momentum strategies are more of the flea. But when considering these types of strategies are also being employed ‘in-house’ at various institutional investment firms, and those assets likely not reported – there’s the possibility it’s much larger. If it is/will be a crowded trade on the way down, we’re not sure that means avoid the trade (as Harding suggests). If the trend followers will be pushing things down further, we want to be in the trend followers to participate. And I’m quite sure Harding will participate via his systematic models, as well, despite his PR line.

So…. whether you call Crisis Risk Offset, Risk Mitigation, or plain old Managed Futures, we believe you’re on the right path to dynamic portfolio diversification. Where we differ in approach, is that you don’t need the fancy name and pre-packaged portfolio to make it work. You can register for our database and find programs with the statistical profile – including S&P correlation, down capture, Sortino Ratio, and more – you desire. Then use our portfolio tool to see how a combination of programs may improve that statistical profile even more. There’s even a tool which shows you how the portfolio of Alts offset your risk… (pun intended).

Better yet, give our team a call at 855-726-0060 and have them help you build a portfolio of managers to provide some of this “risk mitigation” or “crisis offset.” Despite the new terminology, they’ve been doing it for years.