Risk Cannot Be Destroyed

Newfound Research |

During graduate school I had a moment of clarity.

At the time, I was pursuing my Master’s in Computational Finance, a multi-dimensional financial engineering degree focused mostly on establishing the theoretical and mathematical foundations of derivatives pricing.

The thought that popped into my mind – an idea that forever changed the way I viewed investing – was this: “derivatives are all about packaging risk.”

Every derivative we priced had a constant theme: it could be used by someone to isolate a particular risk, package it into a contract, and trade the exposure away at a price.

As a simple example, let’s consider an airline company. A big risk to an airline company may be a sharp rise in fuel costs. To insure against this risk, an airline might buy a call option on the fuel. If fuel prices go above a certain price, the company will receive a return from the option that offsets the increase. If fuel prices go down, they will let the option expire and just buy the fuel at the lower cost. For this benefit, they pay an upfront fixed fee, much like an insurance premium.

In buying the call option, the airline has packaged up their risk to increasing oil prices and paid a counter-party to take it off their hands. Risk isolated, packaged, and successfully traded away.

It would seem, from the view of the airline, that their risk exposure has been reduced.

But let’s consider the view of the counter-party. The counter-party will earn a fixed up-front premium but will have to cover any price increases above and beyond the agreed upon price. Who might do this? Perhaps an oil producer looking to supplement revenue in the event of low future prices, thereby increasing the likelihood that they can cover the cost of production. Fuel producers have just as much incentive to hedge against falling fuel prices as airlines do to hedge against rising fuel prices.

So in the eyes of the oil producer, they’ve isolated part of their exposure to declining fuel prices, packaged it up, and sold it off.

Which tells us something important: risk was not destroyed. It did not magically disappear. Instead, the companies simply swapped risks.

Granted, each company may have improved their future financial stability in certain oil price regimes. However, they now have new risks in other oil price regimes.

The airline now bears the risk that fuel prices fall and they pay an expensive insurance premium for nothing.

The fuel producer now bears the risk that fuel prices rise and they fail to capture the total profit opportunity.

At first, these risks may not be quite as scary compared to bankruptcy. However, consider an investor that buys the oil producer precisely because of its sensitivity to oil prices. The investor essentially hedges against the producer’s bankruptcy by diversifying his stock portfolio. He does not necessarily need the company to do this for him. The investor could very well by mightily disappointed if oil prices rally and the company’s stock fails to move in unison[1].

As it turns out, neither party reduced their total risk profile: they just changed which risks they were exposed to.

Over time I came to view the broader finance industry in the same light.

For example, a start-up company raising a round of financing is effectively selling a call option: diluting the upside potential for current shareholders (so taking on opportunity risk) to isolate and get rid of immediate bankruptcy risk.

Investors that allocate from stocks towards bonds do the same thing. They trade upside growth opportunity for greater certainty of capital preservation. In other words, they trade downside risk for upside risk. In our whitepaper Achieving Risk Ignition, we use a simple framework to show that investors targeting a 10% long-term volatility profile may hold an extra 20% allocation to fixed income simply because of a few tail risk scenarios in stocks, reducing their long-term expected return by -0.74% a year.

The concept that risk cannot be destroyed is an important one for investors to understand.

Diversification does not destroy risk. You simply change the risks you are exposed to.

Similarly, incorporating a tactically risk-managed investment strategy – like those offered by Newfound – does not destroy risk.

Consider that Newfound uses a momentum-driven approach. Investing in a Newfound strategy may help you reduce your exposure to negative momentum risk (i.e. that risky assets sustain large drawdowns in crisis scenarios), but it will increase your exposure to whipsaw risk.

So if you can’t destroy risk, why bother with tactical strategies?

There are two reasons.

The first reason is that some risks are tolerable while others are not. Consider, again, our first example. If the price is right, the airline is perfectly willing to pay the premium to insure against rising fuel prices. Why? Simply because the cost of the fixed premium won’t put them out of business, but fuel prices rising too far and too fast might. The risk of lower profit is better than the risk of bankruptcy.

Most investors are willing to sacrifice upside potential for greater assurance of capital safety. They’ll bear the risk of not making as much as they could have to insure against the risk that they lose more than they can afford to.

The second reason is that diversification does not come from exposing oneself to a variety of asset classes, but rather from allocating across a variety of risk factors.

A purely passive investor exposes himself fully to negative momentum risk – especially in environments where correlations approach one - but has no exposure to whipsaw risk.

A purely momentum-based tactical investor will have much less exposure to negative momentum risk, but potentially significant exposure to whipsaw risk.

The investor who combines both a passive and a tactical approach within her portfolio, on the other hand, has spread her risk budget more evenly among negative momentum environments and whipsaw environments.

Neither approach to risk management is better than the other. There are just different. But they are not just generically different, but are different in a very valuable way. Namely, they tend to excel and struggle in different types of market environments.

Take 2013 as an example. The SPDR S&P 500 ETF (SPY) returned 32.3%. An investor that managed risk via diversification by allocating 40% of the portfolio to the iShares Core U.S. Aggregate Bond ETF (AGG), would have effectively paid 13.7% for this risk management, lowering the return from 32.3% to 18.6%. However, the tactical momentum investor[2] would have done great, capturing the entire 32.3%.

2015 has seen the opposite. SPY is up 3.5% YTD. A 60/40 diversifier is up a respectable 2.3%, while reducing the max drawdown from 11.9% to 7.2%. The tactical investor is down 4.0% due to the whipsaw in the latter half of the year[3].

By using both approaches, investors can maintain their focus on risk management while being less exposed to the success or failure of any one approach.

[1] There is actually a very interesting and nuanced debate in academia about whether or not companies should hedge these types of risks at all.

[2] Assuming a simple 50-day/200-day moving average crossover is used

[3] All returns are hypothetical and do not represent any portfolio that has at any point been managed by Newfound Research.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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