Q. Can you describe Generation’s “three-pronged” approach to risk management?

The most crucial step in the risk management process is at the client level. By assessing a client’s investment objectives and risk tolerance, our portfolio managers and advisors work closely with the client to set a desired asset mix—specific weightings to income and growth (i.e., equities)—and to select mandates/strategies to guide the investment of their portfolio. If appropriate, an allocation to income can add ballast for the equity portfolio, which tends to be more volatile.

Integrated into all of our growth and income strategies, the principal goal of our risk management system is to mitigate the market corrections that generally follow business cycle peaks, periods of market euphoria, or events such as the 2010 European debt crisis. Our risk management system, comprised of three proprietary and distinct models, monitors the following sources of risk:

1. Valuation Risk

Markets can enter periods of euphoria where embedded expectations in stock prices become detached from reality. Extreme periods of euphoria, such as the dot-com bubble, are rare. Markets typically fluctuate in a band around fair market value. When market expectations reach the upper end of this band, risks become elevated as stock prices cease discounting any potential impediments to growth or profit margins (i.e., they are ‘priced for perfection’). At these junctures, borrowing costs and options prices are typically at their lowest, making hedging inexpensive. As recently as March, 2020, we noted that market expectations were lofty and left the market exposed to any deterioration in the economic growth outlook.

To guard against valuation risks we monitor embedded expectations in markets around the world. When valuation risks are elevated, we may raise cash and/or employ strategies to hedge portfolios. Our valuation model, a systematic discounted-cash-flow model called TVM^TM, aggregates securities valuations so we can calculate fair market value estimates for the major global markets.

2. Economic Risk

Since 1965, two-year rolling losses of 20% or more have always been closely preceded by a business cycle peak. Furthermore, equity markets tend to be more volatile following business cycle peaks than during periods of economic expansion. Our Economic Composite (TEC^TM) monitors the business cycles of the major economies around the world and is a composite of several economic variables. The cornerstone of TEC^TM is the interest rate term structure (i.e., three-month yields less ten-year yields). Our research has shown that inversion of the term structure is a reliable tool for predicting business cycle peaks and has a longer lead time than other economic variables.

TEC^TM alerted us to a U.S. business cycle peak in March 2019, the first warning since the U.S. economic expansion began in 2009. Business cycle peak alerts were received for many other economies around the world around the same time.

3. Market Risk

Sizeable market drawdowns can occur outside the natural ebb and flow of the business cycle. Historically, the catalyst for these drawdowns has been geopolitical events, currency or debt crises, commodity price shocks, or extreme changes in capital flows. In the instance of a currency devaluation or border dispute, traditional macroeconomic or valuation models are of little use.

As fundamental stock pickers we typically eschew technical analysis as the evidence is overwhelming that most technical analysis does not work. However, we recognize that markets can discount future events that are not perceptible via traditional tools. Market trend analysis—the study of market momentum and key levels—may be the only reliable tool to forewarn of potential risk. As a complement to our Economic Composite and valuation models, our Relative Indicator of Momentum (TRIM^TM) is an algorithm which generates a moving average based on combining market volatility and momentum to model transition points that forewarn of a potential shift from a bull market to a bear market (a market decline greater than 20%).

Developed in 2009, the first test for TRIM^TM came during the European debt crisis, a multi-year crisis that began in the EU at the end of 2009. The crisis, caused by the inability of several Eurozone members to refinance their debt or utilize traditional monetary tools, erupted as most of the world was emerging from the Great Recession and stocks were undervalued. Neither a macroeconomic nor valuation lens forewarned of the steep corrections experienced throughout the crisis. However, TRIM^TM gave us warning signals for many of the hardest-hit countries like Greece, Portugal, and Spain. These markets experienced substantial corrections following their TRIM^TM warnings.

Q. What makes Generation’s risk management approach unique?

The defining feature of our risk management approach is the integration of separate valuation, economic, and market momentum risk models into one comprehensive risk management system. We believe this is a unique toolset. For example, most CTAs look at market momentum or technical indicators but do not have tools to monitor valuation or economic risks. Many long-only value managers are cognizant of valuation risks but ignore market momentum. Macro-driven or thematic funds look for broad economic trends but are not focused on bottom up or market valuations.

Our risk management framework gives us the ability to act quickly and nimbly. For example, we entered 2020 with a market hedge and healthy cash position due to heightened valuation risk and a recession warning from TEC^TM. After the severe correction in March due to concerns about the economic consequences of COVID-19, we covered our short position near the bottom of the market, added new undervalued long positions, and then reinitiated our short position after the markets rallied substantially.

Most long-short equity strategies operate with a constant hedge based on targeted volatility or a specified net exposure, typically fluctuating within a fairly narrow band, depending on market conditions. None of our strategies have a targeted volatility or net exposure. Strategies that always have hedges in place are the primary reason why hedge funds underperform during bull markets. Our strategies can go through prolonged periods with no hedge in place if none of our risk management systems are providing warning signals.

Our strategies have the flexibility to utilize individual shorts, ETFs, options, or simply hold cash to protect our portfolios should our tools suggest concern about a market correction. Many other investors do not hedge at all. In fact, mutual funds are generally prohibited from using hedging instruments or diverging materially from their explicit benchmark. Even alternative strategies can be relatively boxed in with respect to the instruments they can use to hedge their portfolios.

Q. What do you mean by a “parallel process?”

We like to think of our risk management tools as a ‘shield’ around our fundamental positions. As described above, we stick with our high-conviction ideas and often hedge systemic risks to mitigate overall market-led drawdowns and reduce volatility. In this sense, our risk management system is separate, or run in parallel, to our fundamental investment process.

Our research has shown that the best course of action is to stick with high quality, undervalued positions even through severe market downturns. As good as our tools may be at identifying potential risk events, the duration, magnitude, or second order effects of market corrections are virtually impossible to predict. For example, if stocks were sold in advance of a pending recession, but that recession proved to be shallow, stocks would likely recover quickly. Positions may have to be reestablished at prices higher than they were sold–a ‘whipsaw’. Or as seen in the dot-com bubble and the March 2020 COVID-19 corrections, only certain sectors of the economy may be hurt with others benefiting (value stocks in the former, technology stocks in the latter). It may seem counterintuitive, but for these and other reasons, it is best to stick with positions—provided they are of high quality and financially strong—while hedging systemic risk.