Risk Mitigation Strategies

Investors are facing much greater uncertainty around geopolitics, trade, macroeconomics, and inflation. This new risk regime has the potential for more frequent market dislocations, volatility spikes, and prolonged drawdowns, leading to the need to revisit old assumptions about diversification and the best ways to reduce risk in asset allocation.
 

We find institutions need returns that are not only uncorrelated to growth assets, but also include a defensive component that works during times of market stress. This is an ideal use case for incorporating hedge funds into an overall plan allocation. We believe an actively managed mosaic of hedge fund managers with multi-faceted return drivers is key to building a risk mitigation strategy that can reduce volatility and limit drawdowns. 

Our approach to building a custom risk mitigation strategy includes three risk mitigant layers: the primary, the secondary, and the core layers.
 

Primary Layer

The primary risk mitigant layer is comprised of the first movers, most effective in sudden volatility spikes or equity drawdowns. This layer includes a long volatility strategy with high positive convexity relative to equity drawdowns, paired with a complementary extended duration treasuries allocation to benefit from “flight to quality” behavior. However, the long volatility strategy may show negative carry characteristics in more stable markets, and the treasuries exposure adds duration—making it riskier in rising rate environments. While these paired strategies differ with respect to their risks, they both aim to manage risk on the downside during exogenous market events.

Secondary Layer

The secondary risk mitigant layer helps the primary risk mitigant group as the timeline extends. This group seeks to mitigate risk throughout various volatile market environments, not just during sudden market shocks. Trend following strategies are included in this layer to help identify and capture positive returns during short to medium-term negative trends in a systematic way—but are at risk when markets whipsaw.

Core Layer

In the final layer, the core strategies act as “always on” diversifiers to traditional asset classes while contributing positive expected returns throughout a full market cycle. Alternative Risk Premia managers with expertise in defensive strategies are a prime example of a core strategy. These types of strategies may systematically generate excess returns through exposure to specific risk factors. However, they are typically less effective during periods of muted risk premia differences.

The multi-layered approach we employ offers distinct risk and return characteristics that adapt to changing market conditions. Unlike static solutions, our dynamic allocation to these layers allows us to shift defensive and offensive qualities, ensuring adaptability to ever-evolving market environments.
 

As shown in the factor return curves below, the outcome is a dynamic diversification strategy that has the potential to deliver the highest returns during global equity, bond, and hedge fund market drawdowns, while still remaining in modestly positive territory during rallying markets.

Another feature of a risk mitigation strategy is its potential to act as a liquid, diversifying asset in a portfolio allocation that can help offset drawdowns in illiquid private market allocations. In this way, it can help to balance out some of the volatility and illiquidity risk that comes with large private market.

With many institutions dealing with the denominator effect, we have found that a risk mitigation strategy allocation can act as a liquid source of funding when private asset capital distributions slowdown and institutions need to fund their private capital commitments.
 

As a leading global hedge fund advisor for nearly three decades, we offer institutional investors a number of services,  including custom portfolio risk analyses, tailored risk mitigation solutions, and an “extension of staff” knowledge transfer.