Solid risk management can alleviate big stumbles.
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
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
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
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.