800.364.2468 :: brintoneaton.com Next Generation Investment Risk Management Jerry Miccolis CFA ®,...

800.364.2468 :: brintoneaton.com

Next Generation InvestmentRisk Management

Jerry MiccolisCFA®, CFP®, FCAS, MAAA

Annual

Conference

May 23, 2012

800.364.2468 :: brintoneaton.comCompany confidential 2

Next Generation Investment Risk Management


Modernized Modern Portfolio Theory


Company confidential 3


Modernizing MPT

More realistic asset distributions Non-normal/fat tails

More representative investment horizons Multi-period/compound returns/risk drag Rules-based rebalancing

More meaningful risk measures Shortfall risk Conditional VaR

More useful dependency measures Correlations copulas


Correlation — it gets the obvious cases right

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Correlation — does it measure what matters?

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ρ = 0 ρ = 0

ρ = …you name it!

ρ = 0


We need to move from correlations…

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…to copulas

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Dynamic Asset AllocationNext Generation Investment Risk Management



DAA is a more proactive way than traditional rebalancing to exploit risk

Dynamic asset allocation Explicitly treats momentum/mean reversion Utilizes early warning signals

Signals can be internal and external Moving average algorithms Valuation measures

DAA reflects the fact that MPT is only as good as its inputs Recognizes that inputs can change dynamically Structurally sound way to:

Test your fundamental inputs Nimbly make adjustments as appropriate

Leading Economic Indicators Credit spreads/money flows


Our sector rotation strategy is an example of DAA

Stable-weighting

Exit/entry signaling Trade-offs between stability and responsiveness Three “momentum” algorithms

Each has its own strengths/ weaknesses Rules that determine which algorithm to use at different times Dynamically move between responsiveness and stability based

on market characteristics

Filtering To avoid too-frequent trading

Parameters optimized based on 1990-2007 data Tested “out of sample” with 2008-2011 data


How does this strategy compare to the S&P500 Total Return Index?

12Company confidential

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December 1991 - December 1999

S&P 500 TR Sector Rotation

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How does this strategy compare to the S&P500 Total Return Index?

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December 1991 - March 2012



How else did we test this strategy?

Rolling annual returns

Maximum drawdowns

Parameter robustness

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This strategy can be continuously improved upon

Stable-return investments in lieu of cash

Tactical moves into volatility

LEIs and other external signaling

Expand beyond US large-cap equity sectors Global/international sectors Commodities and other alternatives


Enlightened Tail Risk HedgingNext Generation Investment Risk Management



Our three criteria for an effective buy-and-hold tail risk hedge

Sudden appreciation in severe market downturns “Severe” denoting sudden, substantial, unexpected decline in

market value across most major asset classes, as in 4Q08 (i.e., when diversification doesn’t help)

Appreciation to a degree sufficient to meaningfully offset the decline No “give-back” during market recovery!

Very low cost Minimize diversion of funds from productive use No sacrifice of upside portfolio potential!

Minimal disruption to portfolio Maintain what works in vastly more likely markets “Don’t throw the baby out with the bathwater!”


Our criteria helped narrow our search

Traditional direct protection (e.g., puts, collars) violate our criteria

“Black Swan” funds violate our criteria

Promising idea: Exploit volatility spikes that coincide with sudden market declines

But, long-only volatility (e.g., VIX) violates our criteria Transitory benefit Can’t invest in directly VIX futures: Severe negative roll yield very high carry cost


Does anything meet our criteria?

Dynamic hedging Puts/put spreads/VIX futures opportunistically applied Needs constant monitoring Potentially high cost

Correlation plays “Call-on-call” strategies Not yet well developed

Long/short volatility plays Realized volatility: daily vs. weekly Implied volatility: medium-term vs. short-term Spread: implied vs. realized

Combinations


Our criteria in a picture

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S&P 500 Total Return Index Ideal Equity Tail Risk Hedge


Some combinations are promising

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Implied Vol Strategy Realized Vol Strategy Difference Strategy Combined Tail Risk Hedge


The combined effect can be game-changing

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1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011 1/1/2012

S&P 500 Sector Rotation Sector Rotation + Combined Tail Risk Hedge

Annualized Return

Annual Standard Deviation

Maximum Drawdown

S&P 500 2% 26% -55%Sector Rotation 11% 18% -22%

Sector Rotation + Combined Tail Risk Hedge 17% 14% -15%


For further reading on these ideas…

800.364.2468 :: brintoneaton.com Next Generation Investment Risk Management Jerry Miccolis CFA ®,...

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