RISK-FOCUSED INVESTING A Better Way to Invest Harold Y. Kim, Ph.D. haroldkim@neoriskinvestment.com November 2017
AGENDA Investing: Tradeoff of Risk vs Return The Difficulty with Returns A Better Way: Focus on Risk Equity Examples
Expected Returns INVESTING: TRADEOFF OF RISK VS RETURN In classic portfolio investment theory, the interaction of RISK and RETURN define the investment opportunity set Utility Function Optimal Portfolio = 100% Equity Efficient Portfolio Frontier 100% Bonds Risk Source: Neo Risk Investment Advisors
Expected Returns CHANGING ASSUMPTIONS Changing risk (or return) assumption can dramatically impact the efficient frontier and the optimal portfolio allocation 100% Equity Utility Function 100% Equity New Efficient Portfolio Frontier Optimal Portfolio = 30% Equity 100% Bonds Risk 4 Source: Neo Risk Investment Advisors
EFFICIENT FRONTIER The ex-post Efficient Frontier has changed dramatically over time as risk and return have changed Source: Why 60/40 Asset Mix? Institutional Investing for Individual Investors blog by Doug Cronk
ASSUMPTIONS ARE IMPORTANT! GARBAGE IN, GARBAGE OUT!
THE DIFFICULTY WITH RETURNS Difficulty with returns they are unpredictable! Well-established result in academic literature Random Walk Down Wall Street (Professor Burton Malkiel) Monkey throwing darts portfolio Underperformance of active managers versus index
RETURN UNPREDICTABILITY: EQUITIES Naïve forecast outperforms Wall Street strategists for S&P 500 Strategists' forecast error 14.7% per year Naïve fixed 9% return forecast error 14.1% per year Source: Birinyi Associates, S&P Capital IQ
RETURN UNPREDICTABILITY: BONDS Systematic forecast errors by Wall Street strategists for US 10 year Treasuries 14 of 16 year end forecasts systematically above year end yields
A BETTER WAY: FOCUS ON RISK Unlike returns, risk is persistent, and therefore predictable Risk varies greatly through market cycle Risk can be managed Focusing on risk is particularly effective in risky markets
RISK IS PERSISTENT Risk is persistent and therefore predictable Low risk generally followed by low risk ; high risk followed by high risk Well-established empirical result
RISK IS VARIABLE Risk is highly variable Can easily increase by 2x or more from benign periods to higher risk regimes
RISK CAN BE MANAGED Risk-focused investment management investing with emphasis on managing risk to acceptable (optimal) levels Risk management tools include: Dynamic asset allocation Diversification Hedging Derivatives
DYNAMIC RISK MANAGEMENT SHOULD BE A CORE FOCUS OF INVESTING!
REAP ASIA MODEL Example combining two riskfocused strategies Dramatic improvement in returns with lower risk and drawdown Benchmark Asia REAP Portfolio Ann. Rtn 9.2% 14.9% Ann. Vol 20.3% 11.7% Info Ratio 0.45 1.26 Skew (0.14) (0.13) Kurtosis 7.95 2.88 Max Drawdown -65.5% -25.2% *Benchmark: MSCI Asia Ex-Japan Index +Model returns are after management fees and transactions costs Source: Bloomberg and Neo Risk Investment Advisors 15
PERFORMANCE BY YEAR: RETURN Outperformance of REAP Asia Model driven by asymmetric response to up/down markets Large outperformance during weak markets: 2008, 2011 Marginal out/underperformance during strong markets 16 *Benchmark: MSCI Asia Ex-Japan Index +Model returns are after management fees and transactions costs Source: Bloomberg and Neo Risk Investment Advisors
PERFORMANCE BY YEAR: VOLATILITY Impact of active risk management evident realized risk is tightly managed Compare Benchmark vs REAP portfolio volatility 17 *Benchmark: MSCI Asia Ex-Japan Index +Model returns are after management fees and transactions costs Source: Bloomberg and Neo Risk Investment Advisors
EQUITY EXAMPLES: OTHER MARKETS Benefits of risk focus evident Tightly controlled realized risk Smaller drawdown Return pickup over market cycle Japan USA Europe Asia Benchmark REAP Benchmark REAP Benchmark REAP Benchmark REAP Return 3.90% 7.69% 4.55% 7.99% 5.59% 7.27% 7.10% 14.40% Volatility 22.7% 11.0% 19.7% 12.7% 19.8% 11.5% 20.8% 12.0% Return/Vol atility 0.17 0.70 0.23 0.63 0.28 0.63 0.34 1.20 Skew -0.34-0.49-0.2-0.32-0.51-0.3-0.3-0.17 Kurtosis 6.73 7.05 8.13 5.94 3 1.71 7.18 2.68-19.1% -55.4% -30.6% -25.9% -11.6% -65.5% -24.1% Drawdown -61.2% Period Nov 2001 to 2016 1999 to 2016 Oct 2014 to 2016 2005 to 2016 *Benchmark: Relevant MSCI Index +Model returns are after transactions costs, before management fees Source: Bloomberg and Neo Risk Investment Advisors
INVESTABLE VEHICLE Launched Cayman fund in Dec providing exposure to Asia riskfocused investment strategy Full liquidity: daily redemption, no gating, no lockup Low fees: 1% management fee, no performance fee YTD through Oct up 19.4% with 5.2% annualized volatility
SUMMARY Successful investing involves the trade off of risk versus return Most investors focus on return, though return is unpredictable! A focus on risk which is predictable, variable and manageable improves investment outcomes This communication is provided for information and discussion purposes only and does not constitute a recommendation or an offer to sell or a solicitation to buy any financial product or enter into any transaction. This communication is directed exclusively at market professionals, financial intermediaries and institutional investor customers and is not intended for distribution to retail customers. The information contained in this communication is based on generally available information, and although obtained from sources believed by to be reliable, the accuracy and completeness of the information cannot be assured, and such information may be incomplete or condensed.