Investors who became accustomed to ultra-low volatility and annual double-digit returns received a shock in February.

US and Japanese shares fell by about 10%, Chinese shares by about 9% and Eurozone shares by about 8%. Australian shares fared slightly better, losing just 6% over a few trading sessions. It occurred amid rising global concerns that strong economic growth in the US would force the Federal Reserve to hike interest rates at a faster-than-expected pace.

This sudden change in market sentiment also saw a surge in option volatility: the Cboe Volatility Index (VIX) jumped from roughly 18 on the afternoon of February 5 to over 50 before the market opened on the morning of February 6. (The VIX spent much of the last year trading between an ultra-low 10 and 12 compared to its historic average of about 20.)

While investing with a long-term perspective is important, the reality is that many investors cannot simply ride out the impact of a sustained downturn or excessive volatility.

Loss averse investors (counterintuitively, including younger investors) are prone to lock in losses by selling, while older investors nearing retirement or drawing down savings suffer catastrophic sequencing risk.

Explicit portfolio protection and hedging strategies remain crucial strategies for many investors. These strategies must be efficient and effective, but just as crucially, they must also be reliable.

The last thing an investor needs is to find out after the next crisis that the operational capability of their risk manager failed just when it was needed most. Here are our top questions that investors should ask of their risk manager to ensure they can expect reliable implementation of their protection:

1. Does your risk manager have competing priorities?

Conflicts of interest abound in the financial services industry. Some can be managed while others are best avoided entirely.

For example, some fund managers that offer risk management overlay strategies (such as options or futures) for institutional clients may run their own products and hedge funds. In situations of high market stress and dislocations, the question is what is the risk manager’s priority–their flagship fund or a client’s overlay?

This is a particularly sensitive area when it comes to options market-based strategies because, in periods of significant market losses, liquidity in option markets can quickly dry up. A client of a fund manager may be inadvertently competing in the market against their own fund manager.

Another example involves banks. Bank relationships are, by nature, transactional—they are trying to make money from their clients on each transaction. When markets are stressed, clients are most vulnerable to market pricing.

2. Is your risk manager available in time zones outside of your home territory?

Risk and market movements don’t wait for Australian hours. Boutique fund managers offering risk management strategies may not have trading desks around the world or 24-hour trading desks in Australia. The proverbial ‘two men and a dog’ operation may be at a significant disadvantage when they wake up and find the market has dramatically moved as happened in February.

3. Does your risk manager have the experience and global relationships to handle large market dislocations?

Proven experience managing substantial risk exposures for the largest financial institutions through major crises should be sought after characteristics of a preferred risk management partner.

When the next crisis occurs, you want to be assured that you are being managed by a seasoned professional with global relationships. The last thing you want to find out after the fact is that your risk manager was not up for the task.

4. Does your risk manager have limited bandwidth to handle your requests, especially in stressed periods?

Risk management ability should be based on systems and processes built from the ground up to handle large derivatives trading volumes–the type which have been proven over the long-term by managing the risk exposures of some of the largest financial institutions in the world.

It requires an interconnected global platform and specialist team to ensure that risk management is applied when it needs to be and won’t fall down because of poor technology, key person risk or another weak link in a short chain.

5. Does your risk manager have the team depth and experience to analyse a broad set of instruments and strategies?

Does your risk management team consist of just a handful of people or one individual, who perhaps has other duties (such as picking stocks)? Is the risk manager’s team only able to provide solutions with a singular focus—for example, put options? Risk management is highly technical, particularly when markets are stressed, and requires a well-resourced and experienced team to deliver.

Being prepared means the design and set-up of robustly tested strategies (prior to any market event) is your best defence. The ideal risk management partner will have a deep team of various experienced specialists providing knowledgeable advice on solutions that are agnostic to particular instruments. Instead, solutions should focus on the most efficient path to providing highly predictable outcomes with honest assessments of the pros and cons of each of potential strategy.

Why Milliman

Milliman Financial Risk Management (Milliman FRM) employs over 150 professionals operating 24 hours a day from three global trading locations (Sydney, London and Chicago). The team is composed of actuarial rigour, capital markets experts and purpose-built technology.

Whether large or small, our clients are all granted global presence monitoring their risk exposures in real time. Milliman FRM provides advisory, hedging and consulting services across US$153 billion in global assets (as of December 31, 2017) to some of the world’s largest firms.

Milliman emphasizes the following key elements in the delivery of world class risk management services:

• A fiduciary partnership not in competition with its clients
• Global execution capability managing risk 24 hours a day with local market presence in each major trading time zone overseen by established capital market practitioners
• Purpose-built technology powering one of the world’s largest risk management platforms
• Experienced specialist staff comprising actuaries, derivatives experts, academics, quantitative software developers, consultants and portfolio managers, providing research and implemented consulting
• Dedication to full transparency and client service

For more information about Milliman FRM’s risk management services, contact Milliman Head of Fund Advisory, Michael Armitage, at [email protected].

Disclaimer

This document has been prepared by Milliman Pty Ltd ABN 51 093 828 418 AFSL 340679 (Milliman AU) for provision to Australian financial services (AFS) licensees and their representatives, [and for other persons who are wholesale clients under section 761G of the Corporations Act].

To the extent that this document may contain financial product advice, it is general advice only as it does not take into account the objectives, financial situation or needs of any particular person. Further, any such general advice does not relate to any particular financial product and is not intended to influence any person in making a decision in relation to a particular financial product. No remuneration (including a commission) or other benefit is received by Milliman AU or its associates in relation to any advice in this document apart from that which it would receive without giving such advice. No recommendation, opinion, offer, solicitation or advertisement to buy or sell any financial products or acquire any services of the type referred to or to adopt any particular investment strategy is made in this document to any person.

The information in relation to the types of financial products or services referred to in this document reflects the opinions of Milliman AU at the time the information is prepared and may not be representative of the views of Milliman, Inc., Milliman Financial Risk Management LLC, or any other company in the Milliman group (Milliman group). If AFS licensees or their representatives give any advice to their clients based on the information in this document they must take full responsibility for that advice having satisfied themselves as to the accuracy of the information and opinions expressed and must not expressly or impliedly attribute the advice or any part of it to Milliman AU or any other company in the Milliman group. Further, any person making an investment decision taking into account the information in this document must satisfy themselves as to the accuracy of the information and opinions expressed. Many of the types of products and services described or referred to in this document involve significant risks and may not be suitable for all investors. No advice in relation to products or services of the type referred to should be given or any decision made or transaction entered into based on the information in this document. Any disclosure document for particular financial products should be obtained from the provider of those products and read and all relevant risks must be fully understood and an independent determination made, after obtaining any required professional advice, that such financial products, services or transactions are appropriate having regard to the investor's objectives, financial situation or needs.

All investment involves risks. Any discussion of risks contained in this document with respect to any type of product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved. There are also risks associated with futures contracts. Futures contract positions may not provide an effective hedge because changes in futures contract prices may not track those of the securities they are intended to hedge. Futures create leverage, which can magnify the potential for gain or loss and, therefore, amplify the effects of market, which can significantly impact performance.

An investment in an underlying portfolio, whether with or without Milliman Managed Risk Strategy (MMRS) is subject to market and other risks and no guarantee or assurance is given by Milliman AU or any company in the Milliman group that the use of MMRS in connection with an underlying portfolio will not give rise to losses or that the performance of the MMRS in relation to the underlying portfolio will remove volatility completely or to the extent depicted in an illustration or fully replace losses in the underlying portfolio or to the extent depicted. While generally assets used in connection with the MMRS are liquid, this may not be the case in all circumstances. Further, during periods of sustained market growth, the return to clients from the combination of an underlying portfolio and MMRS should be less than if a client had no MMRS.

Past performance information provided in this document is not indicative of future results and the illustrations are not intended to project or predict future investment returns.

Any index performance information is for illustrative purposes only, does not represent the performance of any actual investment or portfolio. It is not possible to invest directly in an index.