Risk Mitigation Framework

Market downturns are not infrequent. Indeed there have been 9 major financial downturns since 1986 including the Asian crisis in 1998, dot com crisis in 2001, the global financial crisis in 2007-2008 and the more recent supply chain crisis that started in late 2021. These are environments that can trigger explicit loss of wealth that may be hard to recover from not just in retail portfolios but in institutional ones as well.

While a well-financed typical pension plan, an endowment or a family office portfolio may have solid lines of defense (e.g. actuarial smoothing, funding surplus, bonds and private assets), investors may and likely will still face sustainability challenges during such extended market downturns, with top-of-mind issues being liquidity, contribution increases and dry powder. After all, these lines of defense can mitigate risks partially, but not fully particularly during extended drawdowns such as the current one we are in.

What is the solution? It is adding another line of defense, called a Risk Mitigation Solution. But what exactly is a risk mitigation solution and what risk does it look to mitigate? It is a solution that mitigates the risk of increased contributions or reduced distributions for a pension or any long-term portfolio. In order to do that it aims to mitigate the volatility caused by whatever is the largest driver in an institutional portfolio. In most cases this is equities, although it could be bonds or another exposure depending on the unique construct and driver of the specific portfolio in question.

The challenge however is that there is no single magic bullet that can provide protection for all market downturns. Those instruments and strategies that provide higher protection during market distress periods come at a visible cost; they are expensive to hold during regular market environments. The other challenge is there is not one single solution that works during all market stress periods. Every crisis is slightly different with its own specific profile and without a crystal ball it is hard to know what will work and to what extent in the next downturn. Lastly, just holding an instrument or a set of instruments that provide good protection doesn’t mean they can be liquidated when needed. As markets tank so do portfolios which drains available liquidity in the portfolios and what can be sold easily under normal market conditions such as certain types of bonds become less liquid during distress periods. Hence liquidity becomes very valuable during such periods as not only it creates a buffer to the drawdown but also provides dry powder that can be deployed to buy highly distressed instruments such as equities or private assets. Also each institutional portfolio is slightly different and the risk that requires mitigating does change from portfolio to portfolio as well as within the same portfolio over time. In short mitigating risk in the long run isn’t as easy as it sounds.

What is the answer then? While no single “magic” solution exists, research and history suggest that a multi-asset multi-strategy risk mitigation portfolio solution that gradually but dynamically adjusts to changing market conditions can provide effective protection, liquidity and dry powder during extended market downturns while delivering some positive returns during normal market conditions.

EKR advises institutional investors to create such a self-sufficient risk mitigation solution that does the following:

1. Provides a level of protection in down markets with low to zero equity beta thereby mitigating negative returns in an extended/deep equity downturns and provides a level of convexity;

2. Delivers higher long-term risk adjusted returns at the total portfolio level vs. the base portfolio by reducing the longer-term volatility of the broader portfolio. It is self-sustained and therefore doesn’t create a net loss during benign market environments and lowers the funded status volatility;

3. Has enhanced liquidity given the very liquid instruments used in structuring the solution which is easily implementable and tradeable. Therefore, it creates dry powder at the most needed time which is usually at the bottom of the markets.

Please connect with us to discuss our Risk Mitigation Framework in more detail.