The Second Leg Down

Chapter 2“Safe” Havens and the Second Leg Down

Modern portfolio theory has its formal origins in the work of Markowitz (1952). Here, risk is synonymous with volatility. The wilder the path that your portfolio takes, the greater the uncertainty in the final outcome. There are only two ways a static portfolio can become riskier. Either the individual assets in your portfolio become more volatile or the correlation between them goes up. Volatility and correlation are both encapsulated in the covariance matrix of asset returns. Assume that the entries in your covariance matrix move fairly smoothly through time. It should then be possible to react to changes in portfolio risk. You can dynamically reduce your allocation to the assets that have the largest instantaneous impact on portfolio risk. These assets are said to have the greatest marginal risk relative to the portfolio. Many asset managers, particularly quantitative equity hedge funds, argue that they can “target” volatility by seamlessly changing their portfolio weights over time. But how can these funds react to situations where a systematic risk factor moves with practically no warning? The law of large numbers doesn't help you much when all of the assets in your portfolio are exposed to a small number of risk factors. As we will show in this chapter, the nature of risk can change dramatically over time, leaving dynamic rebalancing strategies exposed. Safe looking assets can become risky in both absolute and relative terms. ...