6 Essential Principles To Balance Your Investment Risk

Jun 26 2015 | 10:07am ET

By Greg Silberman
Chief Investment Officer, Atlanta Capital Group

In a previous article – How to Generate 6% Yields in a Volatile World – I noted that our old foe Russia was rattling her saber and concluded:

“War causes surprises, and surprises cause volatility, and volatility causes havoc on client’s portfolios.”

In that article I explained why investors are so hungry for yield and why capital preservation is foremost on their minds.

In this article, I explore how to hedge a private credit or other net long portfolio from downside risk.

Private Credit in 2008

Private credit, also known as Asset Based Lending (“ABL”), was the strategy du jour leading up to ‘08.

The problem with ABL was that during the crisis, even though they were senior secured notes, they became illiquid in principal AND interest. Which meant many went into default creating a long drawn out bankruptcy procedure.

In many instances the claims were settled for pennies on the dollar so that everyone could go away equally dissatisfied.

In addition, because ABL was considered a ‘safe’ investment there was a turn (or two or three) of leverage applied to the loans, meaning collateral became unstable, tripping covenants and called in when liquidity was completely absent.

To hedge ABL like investments in a down [equity] market you need an investment that:

• Marks to market in an uncorrelated way to the rest of your portfolio BUT;
• Is highly liquid (when the rest of your portfolio is not) and;
• For the best of both worlds is highly convex meaning as markets move lower your hedge moves higher in an exponential way.  

Protecting the Downside

When it comes to downside protection we are left with a few options - none of them perfect.

The two approaches we discuss are constant downside protection and dynamic downside protection.

Constant Hedging

You can view downside protection as insurance in which case you expect to lose your premium and hopefully never collect on the policy … that would be bad.

In an insurance environment convexity is your friend i.e. you want to pay as little in insurance premiums for as much coverage possible.

Hence the best time to buy this kind of insurance is when markets have been moving higher for a LONG time and volatility has flat lined. Kind of like now.

With volatility so cheap one can achieve a 3x or even 5x return from as little as a 1% investment (assuming you are willing to lose all one percent). We cannot recommend any specific products but conceptually:

a) levered VIX ETFs may be effective or
b) One could also buy far out of the money put options and roll the expiry to achieve the same result

Real World Observations of Constant Hedging

My observation with clients and these types of insurance is that they take ‘forever’ to work (if at all) and more often or not the client sees one, two or three percent of their portfolio disappear in ‘premiums’ every year and asks the proverbial why am I doing this?

In other words these kinds of program are HARD to stick with even though they would be effective in the long run.

Dynamic Hedging

The second approach to maintaining downside protection is to employ more capital in a strategy that opportunistically increases or decreases risk exposure. In this category I would place:

• Trend followers such as managed futures and some global macro
• Volatility Arbitrage which engages in various option arbitrage strategies to reduce the cost of being long volatility (insurance premium) over time.
• Intermarket risk signals – for example, indicators that my friend Michael Gayed at Pension Partners developed such as Lumber vs. Gold. Lumber is more economically sensitive than Gold due to its use in real estate. When Gold outperforms Lumber it is a sign that investors are becoming more risk averse.
• Realize that managed futures as well as other strategies based on any number of indicators are essentially forms of market timing and can be prone to giving false signals.

That seems to be the case now - many such indicators are flashing red yet (so far) the market has whistled higher.

Perhaps the suppression of short term interest rates by the Federal Reserve is contributing to these false/positive signals – I don’t know.

How we would go about creating a downside protection program:

1. Know yourself – undertake a deep analysis of your own make up and investment philosophy.

Can you stomach the constant erosion of a small percentage of your capital that a constant hedging program will yield?

2. Diversify your hedge exposure by using a number of different strategies such as global macro, managed futures, volatility arbitrage, dynamic beta [intermarket signals for example];

3. Use outside managers as well as direct trading;

4. Use intermarket indicators that suit your trading discipline to scale up or down your overall hedging program;

5. Given how ‘cheap’ volatility is today consider having a small persistent exposure to a Long VIX position with as much convexity possible;

6. Don’t be Dogmatic and expect markets to do what you want – have the patience of your convictions BUT understand the max loss your hedging program can deliver and be COMFORTABLE with it.

How would you build downside portfolio protection?

Greg Silberman is the Chief Investment Officer of Atlanta Capital Group. Atlanta Capital Group specializes in creating custom private market solutions for RIA/Family Office clients and is an active acquirer of independent wealth management practices. Mr. Silberman regularly writes about private market opportunities and trends. If you would like to read his regular posts, please connect on Linkedin, Twitter or via Atlanta Capital Group.

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