Strategic Risk Management Out - of - Sample Evidence from the COVID - 19 Equity Selloff
Strategic Risk Management Out - of - Sample Evidence from the COVID - 19 Equity Selloff

Strategic Risk Management Out - of - Sample Evidence from the COVID - 19 Equity Selloff

Over the 2016-2019 period, we released a series of research papers on the topic of “strategic risk management”, or the embedding of risk management into investment strategy design. We show that key risk controls that we introduced materially helped during the sharp equity market selloff in February-March 2020, when the COVID-19 pandemic accelerated. First, faster trend following and long-short profitability stock strategies performed well during the equity market selloff. Second, responsive volatility targeting reduced positions dramatically ahead of the most volatile period in March 2020, and so improved both the return and risk profile at that time. Third, strategic rebalancing rules helpfully called for keeping an underweight in equities (not rebalancing back to target) at the end of February 2020, regardless of using 1-, 3-, or 12-month trend systems to base the rebalancing rule on. (Page 1)

In the volatility targeting analysis of Harvey et al. (2018), we argued that sizing positions in proportion to volatility, rather than holding a constant notional exposure, creates a more balanced return stream. Empirically, in case of risk assets like equities, volatility targeting resulted in a higher Sharpe ratio of returns. In this paper, we show that volatility targeting led to a reduced drawdown and higher cumulative returns for equities over 2020Q1 as well. (Page 2)

We note that the COVID-19 selloff in the S&P500 was much faster than most other selloffs. Buying puts provided a good offset, but short credit risk was more potent with a +102% return (in excess of T-bills) over this period. (Page 3)

Moving on to the dynamic strategies, also reported on in Table 1, we note that all time-series momentum (MOM) strategies did well over the COVID-19 equity selloff period. As could be expected for a fast selloff, 1m MOM did best. Position caps on equity positions (only allowing shorts) further improves the performance over this period by 5 to 9 percentage points for the three trend speeds considered. (Page 4)

It is perhaps surprising that the MOM strategies did so well over the recent selloff, while the actual performance of trend followers over this period was slightly negative on average, albeit with considerable dispersion across managers, with some doing very well. (Page 4)

First, asset managers who purport to employ trend following strategies often allocate to other strategies too, like carry, and anecdotally these non-trend strategies have not done well over the recent crisis period. (Page 4)

The simple time-series momentum (MOM) strategies introduced in our paper use as signal the past return, divided by the volatility of returns to create a value that is approximately unit standard deviation. (Page 5)

In Table 2, we see that correlation between paired MAC and MOM strategies are 0.9 or higher. However, one crucial difference is that MAC models put relatively low weight on the most recent returns, and for that reason are more gradual (and thus slower) in their response to a sudden selloff. (Page 6)

In the Harvey et al. (2018) paper on volatility targeting, we showed that sizing holdings in an asset to target a constant ex-ante volatility, rather than targeting a constant notional exposure, leads to improved risk characteristics. (Page 7)

n the Rattray et al. (2020) “Strategic Rebalancing” paper, we introduced a rebalancing rule for 60-40 stock-bond portfolios: only rebalance the portfolio back to the target 60-40 stock-bond mix if the 1-, 3-, or 12-month trend in the stock-bond relative return is above its long-term historical average of 0.8%, 2.3%, and 9.1%, respectively. Moreover, if rebalancing, only move half of the distance back to a 60-40 mix. (Page 9)

First, we examined various investment strategies and assessed how they performed during both drawdowns and recessions. (Page 10)

Second, we undertook a study of volatility targeting, which is both a risk management program (targeting constant risk exposure) as well as an investment strategy. (Page 10)

Finally, we examined an important aspect of portfolio construction – rebalancing. We argued that rebalancing is an active strategy, since assets are sold after they rise in value and bought when they fall in value. (Page 10)