Strategic Risk Management

CHAPTER 1Seeking Crisis Alpha

INTRODUCTION

The idea of risk management is to provide some protection during adverse events. However, the cost of that protection must be balanced against the benefit. For example, in a strategy that uses costly long put options to eliminate the downside, the portfolio’s return should not be greater than the risk-free rate. By contrast, we focus on the idea of crisis alpha, which uses dynamic methods that lower risk and also preserve excess returns. In this sense, they provide alpha when it is most needed—during crisis periods.¹

Trend following is one technique that works especially well with a crisis-alpha strategy. Theoretically, trend-following strategies sell in market drawdowns (mimicking a dynamic replication of a long put option) and buy in rising markets (mimicking a dynamic replication of a long call option). This resembles a long straddle position and induces positive convexity. While it is possible to purchase the long straddle directly, that is expensive. Implementing a trend-following strategy is not expensive, but it is not as reliable as taking option-based insurance.

Much of our book focuses on these costs and benefits. We assess the after-cost performance of different strategies (including option-based strategies) in various risk-on events.

Our starting point is a deep dive into time-series momentum (trend-following) strategies in bonds, commodities, currencies, and equity indices between 1960 and 2015. Over the last few years, ...