By focusing on drawdown and thresholds of loss, investment risk becomes a simple concept that can be understood and easily measured. "In investing, risk is the potential for loss and, within a portfolio, the best way to measure loss is through drawdown which looks at the difference in an investment from its market peak to trough given a specific time period," says Jerry Murphey, president and CEO of FolioMetrix.
Murphey recalls trying to apply tactical risk management solutions after the 2001 market shocks. "It was clear that financial markets would continue to move faster than investor expectations and financial advisors would need tactical risk management."
Murphey founded FolioMetrix in 2009 to develop a solution, and in 2013, the firm launched RiskX, a line of liquid alt funds dedicated to tactical management. In a conversation with Money Management Executive, he discusses the concept of tactical and the challenges of developing a new market offering.
One industry opinion is that if the financial and economic crises hadn't happened, there wouldn't be any interest in alts. Do you believe that?
All industries mature, and old technologies are replaced with new ones. Understanding and knowledge grow, and innovation champions new and better ways. This is the evolutionary nature of all things and it is especially true in business. Back when travel by horse was the main means of transportation, the first automobiles where considered an "alternative" form of travel. The financial crisis only exposed opportunities for improvement, and any improvement over traditional methods is always considered an alternative to those methods in the early stages. There is only interest in supposed "alternatives" because what was common and mainstream needed an enhancement. Really, "alternatives" are just the tool for the job; what has great interest is "alternative returns," and those are being proposed via alternative investments.
You've noted that Morningstar didn't start tracking alternatives / tactical until 2013. So is the market still figuring out these categories?
There is a good amount of confusion around defining alternative investments and how to add them to a portfolio to achieve better diversification. In addition to this there is a negative connotation about the meaning of tactical as some form of market timing.
The Webster definition of tactical can be summed up as the weapons and methods used on the battlefront; the small-scale actions serving a larger purpose. Being tactical is adapting to the immediate environment as a part of the long-range strategy. Tactical risk management isn't contradictory to strategic investing, or even asset allocation. It is utilizing what is happening right now, in real time, to meet a strategic mandate for individual investors - which is to do something to help avoid emotional and financial pain. Cerulli reported that 82% of financial advisors surveyed said that they wanted their portfolios to be more tactical, obviously based on this definition. Whether you call it alternatives or tactical, the truth of the matter is there is a renaissance to evolve how portfolios are diversified and this is a good thing for investors.
You've also noted many firms rely on older technology to diversify portfolios. What are they doing wrong, and what modern solutions exist?
Back in 1994, Morningstar created the style box which conveniently categorizes investments by their market capitalization and relative price. This system provides a simple way to observe and understand different investments in an effort to achieve diversification. However, during times of extreme market declines, the diversification between different asset classes and categories fails. In addition, traditional portfolio optimization averages the experience of individual investors and ignores the effects of emotional crowds and in-horizon risk, which is the risk an investor experiences while achieving their investment goals. Every day new systems are coming to market that factor these elements into an individual's investment portfolio.
What sorts of market signals can be tracked to determine risk? How do you take that information and build a tracking algorithm?
The pursuit of alternative returns and the leverage of technology and innovation have created thousands of ways to analyze what is happening in the markets. There is no limit on what can be tracked and quantitative methods make it even easier. We leverage technology to aggregate what the tactical universe is doing and in many cases try to directly "plug in" to data from the creators of many of these market signals. What is even better with quantitative strategies is that they can be tested backward in time to study how and when they take action, which we consider the in-sample experience. What we place a large amount of value on is the in-sample experience, i.e. tracking models and running conceptual strategies in real-time. Our analysts spend a lot of time on not only testing how something might work historically, but we also have a great interest in creating what we call prototype models to study and potentially implement because every single day, we get a new data point.
How do you program against sentiment in risk management? How do you account for the human aspect that can affect the market without warning?
You can't fight the current all of the time and sentiment is built into what happens with every tick of the market, so the idea of tactically adjusting risk exposures really has market sentiment built in because what is happening in the markets incorporates sentiment. If everything in the market was mechanical and quantitatively based, the "perfect algorithm" would exist. However, we work with many strategists that incorporate some degree of behavioral finance into their process. Some of our managers explicitly do this as a last step in their investment process while others have incorporated it as the inspiration for the design of their strategy.
What are risk mitigation strategies that can be applied in a portfolio with a one-click approach? Is there a demand for that from managers?
The reason that we focus 100% of our energy on tactical strategies is because the market has somewhat gotten it wrong with how to incorporate them. Massive failures have happened by trying to be tactical at the end portfolio level. The advisor who built a diversified portfolio (whether active, passive, or both) and who then tries to apply a systematic way to vary the client's total exposure to systematic risk leaves what might be a great portfolio design hinging on just one methodology to manage overall risk.
Furthermore, the actual implementation of a system where advisors might be making short-term, tactical portfolio adjustments is far from efficient. Someone pays the transaction costs and in many cases, the advisor would need to spend an enormous amount of overhead to actually implement. We've packaged tactical strategies in easy-to-use mutual funds because they are a "one-click" delivery mechanism, they drastically cut the transaction cost, and they allow what can be very active methodologies to be scaled within a pooled vehicle. We have helped advisors to learn how to add tactical strategies to client portfolios and to build a diversified allocation into them.
What are some of the considerations in building a tactical index?
Well, first we had to write a definition of tactical that was actually binomial in the fact that a strategy or product either is or isn't. Secondly, we found that the yes/no question also needed a consideration for what we call tactical willingness; just because the strategy design includes a provision for being tactical doesn't mean that the manager is actually willing to do so. The biggest hurdle is tying together our research database, several data sources, real-time updates, analyst research, and an output to make it all useful. The index is a byproduct of all of our work and is being built more for a benchmark than anything else. By doing the research and collecting the data we are able to not only sort through the universe to provide clarity on tactical strategies, but we are also able to take that list and give a feeler for how the average is working and further enhance our work.
What were the internal challenges in developing your product offerings?
The fact that we have built something that didn't exist anywhere else was a challenge. Also, it has required us to build a culture that is not necessarily like any other institutions in the same space.
How did you enter the market and build up your business?
We started by developing a tactical equity and fixed income strategy that could be easily added to the equity and fixed income sleeve of any portfolio for better diversification in up and down markets. This approach was effective but our research identified many other strategies that we believed would benefit investors. Today we have 20 strategies replicated with 11 40-Act mutual funds. RiskX top managers include Louie Navellier and his unconstrained growth approach to stock picking, Beaumont Capital who combines sector rotation of the nine sectors within the S&P with global multi-asset class sector rotation and Validus Growth Investors.
Each of these managers have a unique methodology to mitigating risk and when combined and added to the equity sleeve of a traditional portfolio have the potential achieve diversification in up and down markets. Our business strategy is to help advisors integrate tactical risk management by providing information, education, training, and the essential portfolios in every format.
Can you talk about your experiences with regulators? What are the challenges you face?
Research is not necessarily regulated, portfolio construction is typically under SEC , and mutual funds are regulated by FINRA. This makes the process of delivering a turnkey solution to clients challenging, as at any given moment, depending on the task, we are operating under a different set of regulatory requirements.
The challenge is that we are doing something outside of the norm that isn't easy to grasp. Regulators like things to be neatly defined within the guidelines that they are used to seeing. A tactical strategy, replicated in a mutual fund where we've fused together several managers is a difficult concept. We are looking out for the end shareholder, but the idea of dynamically adapting products, tracking error, risk mitigation, and the overhead cost to deliver a turn-key solution can lead to misunderstanding.