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Watch Your Step

Solid risk management can alleviate big stumbles.

Josh Charney, 08/22/2012

Sometimes the best way to make a buck is by not losing one. When it comes to alternative mutual funds, most don't gain as much as the market during rallies, which is all right as long as they don't lose much when the market falls off a cliff. A smoother ride bodes well for investors, in terms of owning the fund (investors can more easily avoid getting in at the peaks and out at troughs), and in terms of building wealth for their overall portfolio. (A 50% loss requires a 100% gain to break even.) 

Not all alternatives' risk-management processes are created equal, however. For example, the average long-short equity fund lost 15.4% in 2008, which seems fairly reasonable given the S&P 500 tanked 37.0%. But 42% of long-short equity funds fell more than 20%. Clearly, more attention should be paid to how management handles risk, but more specifically, how they work to avoid large drawdowns.

Managing Risk From the Bottom Up
One new fund that has a systematic process to reduce drawdowns, or peak-to-trough losses over a period of time, is Aston/River Road Long-Short ARLSX. This fund's investment process is fairly typical for long-short equity funds, but its drawdown process really separates it from the crowd. Management selects stocks of all capitalizations using bottom-up fundamental analysis. The long side of the portfolio takes the best ideas from River Road's internal analyst fund, while the shorts are selected by Matthew Moran and Daniel Johnson. The fund's net long equity exposure typically ranges from 50% to 70%, but if the portfolio starts losing money, management will focus on reducing the fund's net exposure. If cumulative fund losses, tracked at end of day closing, reach 4%, 6%, or 8%, the fund's maximum exposure is reduced to 50%, 30%, and 10%, respectively. Management also has discretion to initiate the drawdown plan intraday.

While it's easy to plan on cutting losses, it's more difficult to determine when to put the risk back on as market conditions improve. When the Russell 3000 50-day moving average turns positive, this fund moves to a minimum net market exposure of 30%. When the moving average is positive for 10 days, management will move the fund's exposure to at least 50%.

Thus far, the fund's process looks promising. On Aug. 2, 2011, the fund breached its 6% loss limit and implemented its risk-management process. Net stock exposure was reduced to 30% until Oct. 17, when the exposure was subsequently increased. During this time frame, the fund lost only 3.1%, compared with 4.8% for the long-short equity category. Buffering losses has helped the fund significantly outperform its peers. Since its May 4, 2011, inception (through Aug. 21), the fund is up 5.7%, while the long-short equity category average is down 2.6%.

A Lock-Down on Risk
Aston/River Road Long-Short ARLSX, however, isn't the only fund available with a sold risk-management process. Turner Spectrum TSPEX is one of the more intricate risk-management processes available in the 1940-act space. This mutual fund has eight distinct long-short equity sleeves, which are run by eight different teams of analysts. Each strategy is equally weighted and relies on fundamental analysis. Analysts are strongly encouraged to factor risk management into their decision-making, but if any of the eight sleeves loses 5% intramonth, portfolio manager Matthew Glaser moves half the strategy's positions to cash (reducing gross exposure) while bringing net equity exposure down to zero, hence, locking it down. 

The lock-down strategy has helped the fund avoid large drawdowns. In August 2011, for instance, the fund's consumer goods, small-capitalization, and diversified long-short equity sleeves were locked-down. The fund fell 3.6% that month, slightly more than the category average but substantially better than the S&P 500 (which fell 5.4%). The fund's lock-down system is intended to be used as a last resort tactic--management encourages the underlying portfolio managers to avoid lock-downs by penalizing their bonuses if one occurs. 

An Alternative to Stop-Losses
At AQR Managed Futures Strategy AQMIX, management believes that stop-losses, which are frequently used by trend-following futures traders, cause overreactions to large drawdowns. This means that stop-losses cause trend-followers to cut their losses when a trend reverses, but they also prevent trend-followers from profiting once the trend has re-emerged. Therefore, instead of using stop-losses, this fund systematically cuts up to 50% of the portfolio's risk across every position (reducing the target portfolio volatility from 10% to 5% volatility) in up to five equal slices, evaluating the risk environment at each step (using short-term volatility forecasts). If the models predict that risks have been mitigated, the fund will increase exposure in a similar fashion. Though this fund launched less than three years ago amid a hostile market environment for trend-following strategies, it boasts a decent short-term track record relative to its peers. Since its inception, through Aug. 21, the fund lost 0.1%, compared with a 2.5% drop for the average managed futures fund. AQR has been managing similar trend-following strategies in the hedge fund space since 1998.

The Case for Automatic Risk Controls
Risk controls should be well thought out, and various contingencies should be determined well ahead of any serious event. A manager should lay out a proper plan for when his portfolio takes a dip. If done properly, he could potentially sidestep market dips.

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Josh Charney is an alternative investments analyst at Morningstar.
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