Which strategies to privilege in an environment of extreme risk ?

A recent article by B. Bruder & Nicolas Gaussel, entitled, « Risk-return analysis of Dynamic Investment Strategies » distinguishes in a conventional manner, but still interesting, the different investment strategies. Schematically, we can divide investors into two groups :
 Those who buy when the prices fall (Contrarian strategies / value)
 Those who buy when the prices rise (Trend-Following strategies / Momentum) The

The article states that each strategy profile can be decomposed into two components : a component called « optional profile» +/- and a component called « trading impact » (see table below).

We notice that a contrarian strategy / value / concave has a profile similar to an option sale : the manager will earn a bit more most of the time (he cashes the premium), the consideration being that the losses, coming less frequently, are often much larger.

This strategy is therefore a priori quite vulnerable to extreme market events. In

In absolute terms, none of those two strategies is better than the other. It is simply an arbitrage between frequency and relative magnitude of gains and losses

Similarly, a trend following / momentum / convex strategy has a risk profile similar to an option purchase : We will win a bit less most of the time (since synthetically you pay the premium, through "saloon doors"). However from time to time it is possible to have very strong outperformance. This strategy is therefore less vulnerable to extreme market events

A behavioral perspective

In absolute terms, none of those two strategies is better than the other (each bearing its own risks- the risk of losing a lot from time to time, the risk of winning a bit less on the other hand in most cases -two risks for which the investor will be paid overall), it is simply an arbitrage between frequency and relative magnitude of gains and losses. The question for investors -and for the management company which sells financial products - is which of the two strategies most closely matches its preference structures its aspirations, its utility function.

A behavioral perspective is useful here. One of the findings of Kahneman & Tversky, the initiators of the behavioral finance theory in the 1970s, is that investors are generally averse to loss asymmetrically. In other words, the pain felt when losing is higher than the joy felt when winning with the same magnitude, as illustrated by the utility function below.

convex strategy seems to better correspond to long-term investors in terms of preference structures, potentially ready to give up some of their earnings to avoid losses that would be difficult to handle from an emotional point of view. Simply a covex strategy allows the investor to sleep better at night, which is far from negligible in a volatile environment !Moreover, from a long term management perspective, the question of the potential loss size is more important than the frequency of it, since only one large loss can wipe out years of small gains.

However, for a management company, offering a convex investment strategy is not necessarily the most obvious option. Incentive structures of our industry are too often focused on short-term performance: the cult of performance "year to date", year-end bonus, etc.. For a management company, it is easier to "collect" when the annual performance is higher, which is frequently the case for a strategy called concave (as shown in the previous page table, the frequency of outperformance, the "hit ratio" is higher). Similarly, in an environment dominated by the "career risk", it is easier for a manager to adopt a concave strategy: most of the time, he will get a bonus, and never mind about the years (less often) he will underperform: the bonus will not be negative, even if the loss is enormous.

A convex strategy seems to better correspond to long-term investors in terms of preference structures.

In contrast, as shown in Nassim Taleb’s book "fooled by randomness" with the characters of Nero and Louie (convex traders) who have to deal with the success (temporary) of Carlos and John (concave traders) ; the convex manager who underperforms in most cases will deal with the taunts of his concave colleagues.

From time to time, an extreme event will prove him right but it is not clear at this point , his management company still has enough money to pay him a bonus ! the frequency issue is very often more important than the magnitude both for the manager and the company.

We can see, the differences of alignment between the preferences of long-term investors and short-term interests of the asset management industry do not facilitate the matching of supply and demand for financial services. In the long run, however the company able to offer the best match regarding the needs of its clients should be winning.

An environment of extreme risk

If the preference structure of each other is an important element in choosing an investment strategy, the current environment is equally important. From this point of view, our conviction is that we have entered since 2007 in an environment where the risk of extreme events has rarely been as important: the liquidity crisis caused by the collapse of Lehman Brothers in 2008 was the most telling example. Current problems in the debt of "developed countries, the increasing intervention of government in the economy (with the risk of policy error induced) are likely to create disturbances on the same scale, with consequences that we can imagine in the financial markets.

The frequency issue is very often more important than the magnitude both for the manager and the company

We do not know whether the convex strategies will outperform or not the concave strategies in the coming years. Since the beginning of 2011, neither strategy was entirely satisfactory: the contrarian strategies performed well earlier this year (which allow them to collect...) before accusing a high volatility and significant drawdown. The trend following strategies, however, suffered earlier for not being invested in the Euro Zone, and have been penalized by the strong movement of sector rotation, and by the dollar false start during the month of January, but cutting gradually the losses help them limiting the damage (as we see our CCR Flex) and being quite well positioned if the downward trend currently affecting the market was to continue.

However, in an environment of extreme risk, the risk of buying too early using a concave strategy becomes more important and the slightest miscalculation can be very expensive. In contrast, if the worst were to materialize, a convex strategy should behave well

Thus, both in terms of risk-return ratio and in terms of psychological cost for investors, CCR Flex funds have an investment solution more attractive than ever.