I was reading an occasional blast email from my friend Tom Brakke, when he mentioned a free publication from Redington, a UK asset management firm that employs actuaries, among others. I was very impressed with what I read in the 32-page publication, and highly recommend it to those who select investment managers or create asset allocations, subject to some caveats that I will list later in this article.
In the UK, actuaries are trained to a higher degree to deal with investments than they are in the US. The Society of Actuaries could learn a lot from the Institute of Actuaries in that regard. As a former Fellow in the Society of Actuaries, I was in the vanguard of those trying to apply actuarial principles to risk management, both when I managed risks for insurance companies, worked for non-insurance organizations, and manage money for upper middle class individuals and small institutions. Redington’s thoughts are very much like mine in most ways. As I see it, the best things about their investment reasoning are:
- Risk management must be both quantitative and qualitative.
- Risk is measured relative to client needs and thus the risk of an investment is different for clients with different needs. Universal measures of risk like Sharpe ratios, beta and standard deviation of asset returns are generally inferior measures of risk. (DM: But they allow the academics to publish! That’s why they exist! Please fire consultants that use them.)
- Risk control methods must be implemented by clients, and not countermanded if they want the risk control to work.
- Shorting requires greater certainty than going long (DM: or going levered long).
- Margin of safety is paramount in investing.
- Risk control is more important when things are going well.
- It is better to think of alternatives in terms of the specific risks that they pose, and likely future compensation, rather than look at track records.
- Illiquidity should be taken on with caution, and with more than enough compensation for the loss of flexibility in future asset allocation decisions and cash flow needs.
- Don’t merely avoid risk, but take risks where there is more than fair compensation for the risks undertaken.
- And more… read the 32-page publication from Redington if you are interested. You will have to register for emails if you do so, but they seem to be a classy firm that would honor a future unsubscribe request. Me? I’m looking forward to the next missive.
Now, here are a few places where I differ with them:
- Aside from pacifying clients with lower volatility, selling puts and setting stop-losses will probably lower returns for investors with long liabilities to fund, who can bear the added volatility. Better to try to educate the client that they are likely leaving money on the table. (An aside: selling short-duration at-the-money puts makes money on average, and the opposite for buying them. Investors with long funding needs could dedicate 1% of their assets to that when the payment to do so is high — it’s another way of profiting from offering insurance in of for a crisis.)
- Risk parity strategies are overrated (my arguments against it here: one, two).
- I think that reducing allocations to risky assets when volatility gets high is the wrong way to do it. Once volatility is high, most of the time the disaster has already happened. If risky asset valuations show that the market is offering you significant deals, take the deals, even if volatility is high. If volatility is high and valuations indicate that your opportunities are average to poor at best, yeah, get out if you can. But focus on valuations relative to the risk of significant loss.
- In general, many of their asset class articles give you a good taste of the issues at hand, but I would have preferred more depth at the cost of a longer publication.
But aside from those caveats, the publication is highly recommended. Enjoy!