Covenant began to examine risk more closely and discovered some fundamental flaws in common risk factors (see “Deeply flawed risk benchmark,” Futures, October 2014). Standard deviation measures tend to underestimate the risk at the most critical times. For instance, five standard deviation events are supposed to happen once every 100 years when assuming a normal distribution, but we have seen several five standard moves in the S&P 500 since 2000. What their research confirmed is that markets exhibit fat tails. This means that high standard deviation moves occur more often than would be predicted by normal distributions. Covenant chooses to exploit that rather than be a victim of it by offering a program targeting high returns with less money at risk.
In a recent study, Covenant wrote: “The effect of a high volatility investment on a portfolio can be mitigated by the allocation size given to that product. By normalizing for volatility, theoretically, high and low volatility investments can have equal effect on a portfolio’s total return. This leads us to a different way to view risk, defined as the difference between the anticipated worst loss and the realized worst loss. When viewed through this lens, lower volatility equals higher risk (see “Smarter allocation,” below).
The tables illustrate this by having more money allocated to low volatility strategies, the portfolio has more at risk. It would be safer to allocate less to high return strategies.
“These alleged low-risk investments have low volatility but that does not necessarily mean low risk,” Billington says. “At the end of the day, every dollar you invest in is at risk. You can lose all of it; no matter what the track record says, no matter how safe it feels, you can lose it.”
Billington says the system benefits the asset managers. “You give us a little bit of money each year until you retire, pretty good deal if I am making money on my assets. Over time we compound at about 8-10% and over 40 years you can end up with a nice amount of money.”
Billington acknowledges the value of this but says a small portion should be invested in something capable of earning high returns. “I am not saying that there isn’t a place for that.” Nassim Telab talks about the barbell investing strategy where you take the majority of your money and put it in the safest thing you can imagine and you take what is left and put it in the most aggressive thing you can imagine. That is more our philosophy.”