Systematic risk and how to avoid it.
- Lepus Proprietary Trading
- Jan 5, 2017
- 3 min read
We are all very aware of the collapse of the “system” back in 2008. The GFC was the worst in history. Some of you may have had super funds, managed funds or ETFs that tracked indexes which were subject to the downturn. Especially if you were retiring at or around this time looking to draw down on your retirement savings you would have seen a sharp depreciation in the value of your investments.
Remember, at the time of the downturn no one was expecting the recovery to be so fast. The crash of 1929 left the world in a depression for a decade. And, the last major crash of 1987, 17 of the 18 major OECD economies experienced a recession in the early 1990s. Australia took 2 years to recover leaving interest rates jacked up.
Before we go on let’s talk about Modern Portfolio Theory (MPT). MPT is a concept created in 1952 which describes portfolio construction to suit risk adverse investors. The underlying insight of MPT is that individual investments risk/ reward should not be considered stand-alone but as a constituent of the entire portfolio. In other words, a portfolio with diversified assets or investments has less overall risk than a single investment.
However, the performance of the constituent assets alone is not a complete picture. We also need to consider each asset’s correlation to the others. This means to be truly diversified each asset would aim to have a correlation coefficient less than 1, preferably toward zero.
That said, what happens when you are exposed to an overall system failure as in 2008? As we know the banking system runs everything and especially the US banking system influences the world. This overall risk of the market or the “system” is called Systematic Risk. Where the usually uncorrelated assets in a portfolio becomes correlated and the overall portfolio is subject to loss.
How do you avoid this?
Many and EFTs track an index and to reduce cost will only revisit the constituent shares or assets occasionally. Most are also "long only" which means sharp down turns in the market catch the fund off guard. Additionally, managed funds have redemption periods which makes it hard for an investor to control where ETFs may not have the liquidity to trade.
To avoid systematic risk the approach to managing the fund needs to be daily or hourly. This, of course, increases the cost of having extremely skilled traders watching the assets and trading accordingly. Listed Investment Companies (LICs) can offer such a strategy however LICs tend to have the same liquidity problem. Additionally, pricing the units in the LIC can only be accurately calculated when the Net Tangible Assets (NTA) is released, usually on a monthly basis. If you do not want to be involved in an LIC there is another alternative.
Managed discretionary accounts (MDA) can offer highly skilled traders, real-time modification to trades and the ability for an investor to exit at any time.
Small derivative based investment companies which operate their own prop desk may offer an MDA so investors can trade the firm’s strategy. This is one such way to be involved in active trading which is not subject to systematic risk. Taking this approach, a small allocation of about 10% of an investment portfolio is usually all you need and is an uncorrelated alternative investment as it may not track an index, i.e. an absolute return fund. Additionally, MDAs do not have redemption periods so investors can have more control over their involvement. And finally, an MDA can offer transparency for investor who want to know exactly the positions/assets they are trading.
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