CFM president: Risk is constant; choose which kind to carry

Amanda White

By

19/05/2017

Investors should be trying to build robust portfolios that are uncorrelated to equities markets, instead of spending time trying to understand the next crisis, a gathering of some of Australia’s largest institutional investors has heard.

The investment industry spends an inordinate amount of time trying to understand the most recent crisis and that isn’t very productive, said Philippe Jordan, president of Paris-based systematic manager CFM. Instead, it should accept that there is a constant level of risk.

“In the past 55 years, there were 430 financial crises,” Jordan said. “Crises are all around us, yet everyone thinks they live in exceptional times. The world is a messy place, it’s always been a messy place – that is its natural state of being,” he told delegates at the Investment Magazine Fiduciary Investors Symposium, held in the Blue Mountains, New South Wales, May 15-17, 2017.

“Collectively, we are underwriting risk. That’s what we do – the reason you’re getting paid 7 per cent and a nice Sharpe ratio (0.4) is because it comes with the nasty characteristic of negatively skewed returns, so you must expect that crash,” he said of equities markets.

If the investment industry is in the business of underwriting risk, as Jordan describes, the next question is what type of risks to own, at what price, and what outcomes are tolerable.

“As terminal owners of assets, the last thing you do about black swans is worry about them,” Jordan argued. “You need to build portfolios to be robust. When the market goes bad, you’ll still own it. If we have the knowledge, we will own the asset at the worst of times, because we get a premia for owning it, on average.

“How can we collect as underwriters the right amount of premium? You have to shake your portfolio constantly, really understand the underlying risk, and keep reshaping the risk. The last thing I would do with a black swan is try to hedge it – that’s giving the premia away that you should be collecting.”

Jordan’s answer is to look at other risk premia, such as for currency and credit, and build a portfolio of premia that aren’t largely negatively skewed.

“Equity beta has done so well for such a long time on such a large scale, it should always be the anchor of a portfolio. I would have one upgrade, I’d own it at constant volatility but people don’t do that; we own it at whatever the market gives us,” he said. “So if equity beta is the anchor, then alternative beta should be pretty significant. It should be double digits. It has a chunky place.”

Jordan points to long-term trend following, currency carry, credit (without the beta) and implied volatility on stocks as robust, low-correlated alternative beta building blocks.

Alternative beta, which takes advantage of the deep structure of the market – like value, momentum and quality – has the advantage of being only about 20 per cent of hedge fund fees, he said.

“In the traditional hedge fund business, we are working with much smaller data sets, engaging a lot more innovation and looking for payoffs in terms of risk that are much higher and have a low capacity because they are transient.”