Risk Management beyond Asset Class Diversication

Sbastien Page, CFA Executive Vice President PIMCO Newport Beach, CA

Asset allocation is evolving into an approach based on forecasts driven by macroeconomics and risk factor diversication. The dynamic nature of markets requires both secular and cyclical investment horizons. In addition, investors should look beyond volatility as a measure of risk and explicitly estimate the risk of tail events.

hroughout my presentation, I will discuss four ways in which asset allocation is changing. These concepts are not new, but they are important and evolving trends that affect every aspect of asset allocation. First, investors have historically relied heavily on data and models to arrive at their optimal asset allocation. Increasingly, investors are recognizing the importance of formulating a forward-looking view. For example, historical asset class returns reect the declining interest rate environment that has prevailed over the past 2030 years. But going forward, the likelihood that interest rates will rise over the secular horizon should directly inuence investors capital market expectations. Another example is the debt issued by emerging market countries: It used to be much riskier than developed market debt. Today, emerging market debt in countries with relatively clean balance sheets is often considered less risky than that of certain developed markets, such as the peripheral countries in Europe. Current conditions matter, and too often, datadriven models ignore the current state of the world. Data and models are extremely useful, but only to the extent that they help create a forward-looking view. Second, investors have traditionally diversied portfolios among asset classes. But investors are now realizing that asset classes are just containers for underlying risk factors. Therefore, diversifying among risk factors directly may be more efcient than diversifying across asset classes. Think of the macronutrients that food can be broken down into: protein, fat, and carbohydrate. Similarly, corporate bonds, venture capital, private equity, hedge funds,
This presentation comes from the Global Investment Risk Symposium held in Washington, DC, on 78 March 2013 in partnership with CFA Society Washington, DC.

and real estate can all be expressed as combinations of nancial macronutrients: equity risk, interest rate risk, spread risk, and others. Third, asset allocation has historically been a static process for many institutional investors. They would specify a xed time horizon of typically three or ve years, formulate a strategic asset allocation, and then leave it alone until the end of the xed time period. Increasingly, especially in the wake of the global nancial crisis, investors are realizing that asset allocation must be a dynamic process. The passage of timefor example, the number of times the Earth goes around the sun has very little to do with how abruptly the nancial markets can experience regime shifts. Valuations and thereby, long-term expectations about capital marketscan change signicantly along a three- or ve-year horizon (consider the changes in equity valuations in late 2008). As a solution, investors with rigid investment governance and no clear mandate to follow a dynamic process can outsource the process to external, multiasset mandates, such as a global tactical asset allocation strategy. Fourth, the investment industry has been using volatility, measured as the standard deviation of returns, as a convenient risk measure to compare investment choices. Investors like to use the Sharpe ratio, which is an investments excess return over cash divided by its volatility, to determine the optimal asset mix. But it is becoming evident that minimizing exposure to large losses, or tail risk, is what really matters. After all, large and permanent losses are ultimately far more relevant to the investor than transitory swings in valuations. The standard deviation of returns also fails to differentiate between downside and upside exposure to loss in asymmetrical probability distributions. As a result, there has been a gradual shift away from volatility
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as the dening measure of risk toward different measures of tail risk. Andrew Lo provides a great example of why volatility as a risk measure can be misleading in Risk Management for Hedge Funds: Introduction and Overview.1 Lo created a hypothetical investment strategy that doubled the Sharpe ratio on the S&P 500 Index. The strategy used monthly data from 1992 to 1999 and did not require any skill or knowledge of the future. The simulation was simply to sell deeply out-of-themoney put optionsessentially, sell insurance and collect cash premiums. The strategy reduced volatility as measured by standard deviation but signicantly increased tail risk. This case is an extreme example of how the Sharpe ratio can be misleading. Because it uses volatility as the measure of risk, strategies characterized by potentially large but infrequent losses will often look unreasonably favorable in a Sharpe ratio context. This strategy is also an illustration of my rst point: Tail risks might not be reected in a historical data sample but can be present in a forward-looking perspective based on a fundamental understanding of the investment.

Diversifying Using Risk Factors

One of the most important ways in which asset allocation is adapting to the current state of the world is the increased use of risk factor diversication. In the stock market, the key risk factor is broad equity beta. One example of an approach to risk factors for asset allocation is to think in terms of broad equity beta rather than in terms of domestic versus global or small-cap versus large-cap equity asset classes. Then, the approach denes risk factors on an incremental basis that are net of the broad equity beta, such as industry, country, value, momentum, size, and risk tilts. In bonds, the equivalent of the broad equity beta is duration, dened as sensitivity to interest rates. The duration risk factor drives most of the volatility among different bond asset classes. Bond market investors will also look at credit spread duration, which is the sensitivity of the portfolio to changes in the level of credit spreads. The corporate bond asset class provides a simple illustration of the risk factor approach to investing. In risk factor space, the corporate bond asset class becomes at least two key risk factors: (1) interest rate or duration exposure and (2) credit spread exposure. These two risk factors move in different
1Andrew

directions during macroeconomic shocks, with spreads generally tightening when interest rates rise and vice versa. As such, credit spread exposure may act as a diversier to a Treasury-centric bond portfolio. Also important to bond investors are exposures to the slope of the yield curve. Duration measures the sensitivity of a portfolio to a parallel shift in interest rates. But changes in the slope of the yield curve can be construed as a separate risk factor linked to the macroeconomy. For example, when upside economic growth surprises occur, the yield curve typically steepens because market forces push the long end of the curve up whereas central banks, which generally control the short end of the yield curve, are often slow to react. Private and illiquid asset classes (i.e., alternative assets), such as private equity, real estate, and hedge funds, often have signicant exposure to the same risk factors that drive stock and bond volatility. Returns on alternative assets depend on changes in interest rates, as well as the way in which investors value risky cash ows, as reected in equity market valuations and credit spreads. In addition, liquidity and some specialized factors can play a role.2 The lack of mark-to-market data often lures investors into the misconception that these asset classes represent something of a free lunch. Their relatively high returns appear to come with low risk and signicant diversication to other asset classes in normal times. This misconception arises because return indices for privately held assets often are articially smoothed, which is a result of the lack of a true mark-to-market mechanism in these asset classes and which biases both volatility and correlation with traditional asset classes downward. To address this problem, risk models for private asset classes should rely on public market proxies and should adjust for reporting biases in the series of illiquid return indices. Models that use transformed risk factor returns to account for the lag structure of the index can be particularly useful. Overall, keep in mind that the models used to estimate risk factor exposures for alternative assets are not as precise in their explanation of volatility as the models used for stocks and bonds. Often, the models for alternative assets include a signicant amount of idiosyncratic risk (nonfactor-based risk).
2See

W. Lo, Risk Management for Hedge Funds: Introduction and Overview, Financial Analysts Journal, vol. 57, no. 6 (November/December 2001):1633.

Asset Allocation: Risk Models for Alternative Investments, PIMCO Analytics, Quantitative Research (May 2013): www.pimco.com. September 201353

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Table 1 shows risk factor versus asset class correlations based on monthly data from 31 March 1997 through 31 May 2011.3 I calculated the average cross-correlation for the risk factors I have described and compared them with the average cross-correlation for a typical list of asset classes used by an institutional investor. In addition, I conditioned my estimate of correlation between quiet and stressed markets. There are two insights to gain from this table. First, the average cross-correlation for risk factors is much lower than that for asset classes, and second, it is more stable. That said, note that taking the average typically masks correlation shifts for specic risk factor pairs. On the basis of the way I have dened risk factors (using market proxies), some factor pairs become more correlated during market stress (for example, equity and spread risk) whereas others become less correlated (for example, equity and duration or equity and momentum). So, even in risk factor space, correlations can be unstable. For asset classes, there is a jump in the average cross-correlation from 30% during quiet markets to 59% during turbulent markets. This rise in correlation comes primarily from the various equity and equity-driven asset classes. The well-known observation from this analysis is that asset class diversication tends to disappear when it is most needed: during periods of market stress. Table 2 shows the asset allocation and the risk allocation of an average endowment. From an asset class perspective, the endowment portfolio is well diversied among both traditional investments and alternative investments, such as hedge funds, private equity, real estate, and venture capital. Only 28% of the endowment is directly invested in public equities. But when the asset classes are decomposed by risk factor, 78% of the endowments overall risk stems from broad equity risk.4 The model can be used to calculate the risk contribution with the following equation: xi = i i i , p , where xi is the risk contribution for factor i as explained by three components: i is the risk factors beta (exposure), i is the risk factors volatility, and i,p is the correlation between the risk factor and the entire portfolio. Each of these three components contributes to the high percentage of equity risk:

Table 1. Risk Factor vs. Asset Class Correlations, 31 March 199731 May 2011
Full Sample Risk factor correlations Asset class correlations 4% 40 Quiet 3% 30 Stressed 4% 59

Notes: To calculate stress correlations, I scaled observations by the covariance matrix. The 15% outliers were categorized as stressed. All other months were categorized as quiet. Sources: Based on data from Windham Portfolio Advisors, PIMCO DataStream, Barra, MSCI, Barclays Capital, Dow Jones, and Standard & Poors.

Table 2. Average Endowments Asset Class vs. Risk Allocation

Asset Class Cash Distressed debt Domestic bonds (investment grade/high yield) Domestic equity Emerging market equity Energy and natural resources Global equity Global/emerging market bonds Hedge funds Private equity Real estate Venture capital Asset Class Commodities Corporate spread Equity Emerging market currency High-yield spread Municipal spread Other Market Value Allocation 3% 2 8 12 7 9 9 1 20 16 8 5 Risk Allocation 5% 4 78 3 3 3 5

Notes: The asset allocation percentages shown are based on the Average Endowment Portfolio as of 30 June 2011 for endowments > $1 billion. Percentages do not equal 100% because of rounding. Source: Based on data from the Average Endowment Portfolio from the 2011 NACUBO-Commonfund Study of Endowments (NCSE). This study is based on information collected as of 30 June 2011.

3For

an earlier version of this analysis, see Sbastien Page, The Myth of Diversication: Risk Factors vs. Asset Classes, PIMCO Viewpoints (September 2010): www.pimco.com.
4Many

authors have proposed similar examples. See, for example, Vineer Bhansali, Beyond Risk Parity, Journal of Investing, vol. 20, no. 1 (Spring 2011):137147.

Equity beta is often greater than investors assume because other asset classes, such as real estate, contain indirect equity risk. The equity risk factor is more volatile than most, if not all, other risk factors. Because of the risk-on/risk-off effect, the equity risk factor typically exhibits positive correlations with other sources of risk premiums in the portfolio.

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But important caveats apply to such analyses. First, the percentage of portfolio risk that is contributed by the equity risk factor does not relate directly to the actual riskiness of the portfolio. Imagine a portfolio with 95% cash and 5% equity. Almost all of this portfolios risk would come from equities, but its volatility would be lower than, say, a long government bond portfolio.5 Second, the model ignores nonlinearities: Correlations and volatilities change over time, and therefore, equitys contribution to risk also changes. Last, the model decomposes volatility. A superior approach to risk decomposition would be to decompose tail risk directly. A tail-risk decomposition often shows similar, or perhaps more extreme, results in terms of the concentration of equity risk.

The Role of Macroeconomic Fundamentals

In addition to improved portfolio diversication, one of the key advantages of the risk factor approach to investing is that it serves as a link between macroeconomic fundamentals and asset returns. To illustrate this concept, my colleagues Niels Pedersen and Helen Guo and I compiled historical forecasts and realizations of GDP and ination based on quarterly data going back to the early 1970s. We estimated macro surprises, which we dened as the differences between what was forecasted at the beginning of the period and actual realized GDP and ination during the period.6 Then, we tried to explain returns to key risk factors using the macro surprises based on the following equation:
GDP Factor return i ,t = i + i GDPt

+ iINFL INFLt + iINT GDPt INFLt + i ,t , where i is the intercept (approximately, the mean return over time because the surprise variables are approximately zero mean), GDP GDPt is a GDP i

between growth and ination. As an example of the interaction effect, the impact of an ination surprise on yields may be more pronounced if it is accompanied by a positive shock to GDP growth because it may signal a more permanent increase in the path for future ination. Lastly, i,t is the usual error term used in regression analysis. Our initial analysis of the differences between macroeconomic forecasts and subsequent realizations yielded two observations. First, realizations are much more volatile than expectations; on average, investors do not make extreme forecasts, but economic uctuations in the world tend to be extremeat least more extreme than expected. Second, expectations tend to follow realizations. Investors have a tendency to extrapolate recent developments in the fundamentals of the economy. Our main idea was that fundamentals can be mapped to risk factors based on the differences between expectations and realizationsthat is, the surprises in key macroeconomic drivers of risk factor returns. Overall, the power of our approach lies in estimating the deltas from general market consensus, which drive the sensitivities of risk factor returns to macroeconomic fundamentals. Risk factors can, in turn, help explain asset returns in general because different asset classes are exposed to those key risk factors. Note that this type of model is meant primarily for scenario analysis; it is not a model to implement systematically as a quantitative strategy. Table 3 shows the sensitivities of a few of the primary risk factors to GDP and ination surprises. As an example, assume GDP growth at the end of the year is 1% higher than consensus expectation at the beginning of the year. The model predicts that the short interest rate will rise by 50 bps, or 0.5 times that 1% surprise; the 10-year yield will increase by 20 bps, or 0.2 times 1%; credit spreads will contract by 20 bps, or 0.2 times 1%; equities will return 3.9% above their expected mean return, which is 3.9 times 1%; and so on. Table 3.  Model Estimation: Sensitivities of Factor Returns to Surprises
GDP Surplus Short rate 10-year yield Credit spreads (Baa) Equities Commodities 0.5 0.2 0.2 3.9 2.7 2.2 6.3 Ination Surprise 0.7 0.4

beta times the growth surprise, iINFL INFLt is the ination beta times the ination surprise, and iINT GDPt INFLt measures the interaction effect
5Also

note that when a risk factor helps decrease portfolio risk, the correlation effect can generate negative risk contributions, which is not easily shown in pie charts but is important in understanding risk budgets.
6Forecast

data were obtained from the Survey of Professional Forecasters. For more details on this section on the role of macroeconomic fundamentals, see Sbastien Page, Niels K. Pedersen, and Helen Guo, Asset Allocation: Does Macro Matter? Part II, PIMCO In Depth (May 2012): www.pimco.com.

Note: Surprises are dened as Expected (GDP and Ination) Realized (GDP and Ination). Sources: Based on data from Page, Pedersen, and Guo, Asset Allocation: Does Macro Matter? Part II, PIMCO (2012); Haver Analytics; Survey of Professional Forecasters (conducted by the Federal Reserve Bank of Philadelphia). September 201355

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There are a few qualifying factors to mention. First, the short-term interest rate right now is almost entirely driven by Federal Reserve Board policy. The Fed is committed to holding rates low for the near term. Hence, in the current environment with the ongoing quantitative easing, the Fed is forcing that coefcient below 0.5. In addition, in our research, we were unable to nd a meaningful relationship between credit spreads and ination. The relationship varies signicantly, for example, depending on which decade is observed. Lastly, we found a negative coefcient between equities and ination surprises, which typically generates a lot of debate. Conventional wisdom has held that over the long term, equities will hedge against ination. But some academic studies have shown that the equity beta is negative in the short term and that it can be negative in the long term. Empirical evidence reveals that equities are not a very good hedge for ination, at least not historically or across countries and especially not relative to commodities.7 Commodities generate a response to ination surprises that is levered six times the magnitude of the ination surprise. Of course, commodities are also a component of the U.S. Consumer Price Index. Table 3 demonstrates the links between macro fundamentals and asset returns; portfolio managers can build similar tables to generate estimates of asset returns under different scenarios for macro fundamentals. Table 4 shows that, as expected, equities are much more sensitive to GDP surprises than to ination surprises. A similar table for bonds would show that bonds are much more sensitive to
7See

ination surprises, all else being equal. The bottom line is that the risk factor framework goes beyond serving as a template for thinking about diversication; it helps form views on returns as well.

Tail-Risk Hedging
Tail-risk hedging is another avenue through which investors are adapting their portfolios to the current market environment. Figure 1 shows two probability distributions built using the risk factor model. I mapped a simple 60/40 portfolio to its underlying risk factors, and given the portfolios current exposures, I created probability distributions by simulating risk factor returns. I used a simulation that captures fat tails in the data. Specifying regime probabilities and then sampling according to those probabilities is one way of creating a forward-looking probability distribution. Although it was not done in this case, risk factor returns can be oversampled during periods of rising rates or during periods of high market volatility if tails are expected to be fatter. The dark-gray area of Figure 1 shows the traditional portfolio distribution, and the lighter-gray area shows the portfolio hedged with an S&P 500 put option that costs 100 bps with an assumed 22% implied volatility. The unhedged traditional portfolio has signicant negative skewness, or large losses, that the normal distributionillustrated by the linefails to predict. Hedging the portfolio, although it can be costly, eliminates this fat-tail risk. When they use volatility as their risk measure for example, when comparing Sharpe ratios investors implicitly assume a normal probability distribution. Understanding this assumption is critical. Under a normal probability assumption, the likelihood of a large gain is exactly the same as the

Nicholas J. Johnson and Sbastien Page, Ination Regime Shifts: Implications for Asset Allocation, PIMCO In Depth (October 2012): www.pimco.com.

Table 4.  Scenario Analysis, Equities

Real GDP Growth Surprise 4% Equities 4% (2) 2% () Ination Surprise 1% (/2) 0% 1% (/2) 2% () 4% (2) 2 17% 13 11 9 6 4 0 2% 9% 5 3 1 2 4 8 1% /2 6% 1 1 3 5 8 12 0% 2% 3 5 7 9 12 16 1% /2 2% 7 9 11 13 16 20 2% 6% 11 13 15 17 20 24 4% 2 14% 19 21 23 25 27 32

Notes: This is a hypothetical example for illustrative purposes only. Equities are proxied by the S&P 500. Surprises are dened as the differences between the scenarios and the market expectations from the Survey of Professional Forecasters at the beginning of the year. The sample period is 19702011, subject to data availability. The risk-free rate is assumed to be 0.1%. represents the estimated standard deviation of the respective surprise. Risk factor returns are assumed to be linear functions of surprises in the regression for simplicity, although other nonlinear relationships could be present. For example, although low ination surprises have positive implications on equity returns in general, extremely low ination/deation surprises could be correlated with low equity returns. Sources: Based on data from PIMCO, Haver Analytics, and the Survey of Professional Forecasters.

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Figure 1.  Probability Distribution of a Traditional Portfolio vs. a Hedged Portfolio Using the Risk Factor Model, 31 January 200030 June 2012
Probability Density

50

40

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10

20

30

40

50

Annual Return (%) Traditional Portfolio Traditional Portfolio Hedged

Normal Distribution
Notes: This is a hypothetical example for illustrative purposes only. The portfolio is 60% MSCI World Index, 40% Barclays U.S. Aggregate Index. Source: Based on data from PIMCO.

likelihood of a large loss. But empirically, negative skewness is present in most markets and, in particular, in strategies that involve selling volatility. Because it is difcult to diversify across underlying risk factors and because key macro factors drive most of the asset returns, it can be very difcult to diversify away fat tails. Often, the only way to eliminate tail risk through diversication is to de-risk the portfolio by, for example, loading up on Treasuries (although it can be argued that in the current environment, Treasuries are closer to becoming a risk asset than they have been historically). Another way to eliminate tail risk is to directly protect the portfolio using nonlinear instruments in this case, a put option. My colleague Vineer Bhansali, who oversees PIMCOs quantitative investment portfolios, calls this tail-risk hedging. Tail-risk hedging is becoming part of the asset allocation decision for many institutional investors as they begin to think about asset allocation in nonlinear terms. For example, if an investor is able to hedge tail risk, through direct or indirect hedges, and protect part of the portfolios downside risk, this protection can directly increase the investors risk tolerance. As a simplistic example, perhaps the allocation to equities can be increased to 70% if losses of 15% or more can be hedged. Hedging tail risk comes with a cost; it is not a free lunch. Hence, hedging is ultimately a matter of investor preference. An investor can choose to de-risk the entire portfolio or hedge the portfolio, pay the costs, and then perhaps nance that cost
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with a larger exposure to high-risk assets. These are examples of rethinking asset allocation in nonlinear terms, not just in terms of asset class or even risk factor diversication. I like to use seatbelts in cars as an analogy. Seatbelts were not mandated by law until the 1970s in the United States. Tail-risk hedging in asset allocation is evolving in the same way. At some point, most investors will think of downside risk protection in their portfolios as a natural part of asset allocation, just as using seatbelts for safety protection has become a routine part of driving.

Conclusion
In the wake of the nancial crisis, investors have become skeptical of nancial engineering and risk management in general. Today, I have presented four trends in asset allocation and top-down risk management that I encourage all investors to pay attention to. First, rather than relying on a backward-driven view generated by historical statistics, investors should formulate a forwardlooking view driven by macroeconomics. Second, investors should focus on risk factorbased diversication in addition to asset classbased diversication. Third, investors must recognize the dynamic nature of markets and make asset allocation decisions on a cyclical and secular basis rather than a calendar-year basis. Finally, risk should not be dened solely as volatility; investors should seek to explicitly measure and manage tail-risk exposures.
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Question and Answer Session

Sbastien Page, CFA
Question: Is the pricing of the S&P 500 put used in your example of tail-risk hedging at the money or out of the money, and does the degree to which it is out of the money vary over time? Page: The put is approximately 15% out of the money. If I assume that the implied volatility is 22% and that I am spending 100 bps, I can back out the strike price. These factors are the moving pieces in pricing the put. An investor can have a xed budget for protection of, for example, 100 bps a year. The expected return might be better than 100 bps because the option is expected to pay off occasionally. So, the total cost of the put might be less than 100 bps, ex post. If the budget for protection is xed, then the strike price will move based on the cost (implied volatility). Or the strike price can be xed if the investor is concerned with limiting losses to, for example, 10%; in that case, the cost of the put will vary over time. Either the strike price will be xed and the cost of the put will vary or the cost of the put will be xed and the strike price will vary. Question: Are investors overpaying for tail-risk insurance and overestimating the need for itbased on the events of 2008 and 2009, similar to the way GDP estimates are based on recent growth gures? Page: The cost of tail-risk protection changes over time. Currently, with the short end of the Chicago Board Options Exchange Market Volatility Index (VIX) at 14, hedging tail risk is not very expensive by historical standards. But the VIX curve is steep in the sense that options
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that are further out of the money are more expensive. Investors have a few options when it comes to hedging tail risk. They can decide hedging is too expensive and de-risk instead. They can also decide to implement tail-risk hedging when the cost is low or when they think they will need it as an active investor. These last two scenarios are akin to saying, I am going to put my seatbelt on right before the car crashes. The alternative is, of course, I am going to wear my seatbelt at all times; the investor will bear the costs but reap the benets and harvest more risk premium in other parts of the portfolio. In general, tail-risk events tend to be different from one another. The tech bubble was very different from the 2008 crisis. Both of these events were very different from the Long-Term Capital Management event, and September 2011 was its own outlier. Each crisis is different. If investors do not want to ght the last war, so to speak, they will need to be careful when dening a tail event ex ante and constructing the protection portfolio from that perspective. But most crises do share some common characteristics. One key characteristic of nancial markets is that correlations rise as equity markets sell off. For example, an investor can plot the correlation between equities and credit spreads, which over time is roughly 20%. But when the monthly data are partitioned for 10% or 20% losses in the equity market, the correlation between the two can go all the way to the upper 90% range. This increase in correlation in the tails facilitates proxy

hedging. One strategy to address both the cost question and the question of how to effectively construct a protection portfolio is to diversify the hedges by including not just an equity put but also CDS tranches, puts on high interest rate currencies, derivatives on interest rates, and so on. The outcome is that tailrisk hedging is an active management process. Question: What is the average length of a turbulent regime, and how does that compare with the average length of a quiet regime? Page: There is a wide variation in the range of durations for both turbulent and quiet episodes. One turbulent market might last for four or six months, whereas another lasts for a year and a half or two years. The duration of the regime also depends on how the regime is dened. Dening the regime based on the VIX and dening it based on another risk index will result in different regime lengths. All I can say with a high degree of condence is that risk tends to cluster. To use a facile example, if Lehman Brothers defaults today, the probability that the world will be volatile for the next few months is higher than it would be if Lehman does not. Question: Can you comment on the inclusion of hedge funds in a portfolio diversied by risk factors? Page: If I combine a lot of hedge funds into a broad fund of funds, alphas and idiosyncratic risk may get diversied away. Risk factor analysis often reveals that broad hedge fund portfolios essentially provide a collection
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of betas: equity risk, interest rate risk, spread risk, and maybe some liquidity exposure. Hedge funds are not an asset class per se but strategies that invest in a combination of risk factors present in other asset classes. Investors should look for nonbeta returns in hedge funds: a manager that engages in a longshort strategy, a specialized strategy, or in general, trades and exposures that are uncorrelated with the key risk premium in public markets. The bottom line is that risk factor analysis reveals that when allocating to hedge funds, for the same expected return, it is preferable to seek volatility that is uncorrelated with the key betas in a portfolio. At the very least, if an investor has a collection of hedge funds that produce only an array of beta returns and no net alpha, the risk factor framework will highlight that situation more efciently than a nice, multicolored asset allocation chart. Question: Will you clarify the time horizon over which you measured the sensitivity of

stocks and commodities to ination? Would commodities still be as sensitive to ination if another time period had been chosen? Page: In our research, my colleagues and I used quarterly data and rolled it over one-year periods, which does create issues with the econometrics, but we corrected for the autocorrelation bias. Each beta should be thought of as a one-year horizon, beginning in the 1970s. This analysis is time-period specic. Much of the high-ination tail risk in our data is from the 1970s, when ination was driven by oil shocks and, overall, the world was quite different. Nonetheless, although it will not be exactly the same, I expect the coefcient for commodities in the future to continue to be high and positive, given their explicit economic links to ination. Many investors assume that equities will hedge ination over the long run. But the negative equity beta to ination is prevalent in the literature, even at longer-term horizons. There are decades during which equities failed to keep up with ination.

Historically, there is no statistically signicant positive beta. To be sure, the relationship between equities and ination is complicated because ination is often linked to growth concerns. During inationary periods that are purely monetary phenomena, stocks may indeed provide a hedge. After all, if twice the supply of money is printed, then stock prices should simply double in nominal price. For example, during the 192123 period of hyperination in Germany, stocks protected investors against hyperination. But during many other periods in history, the beta between stocks and ination was negative. One of the hypotheses that has been suggested to explain this negative beta is that poor economic growth leads to an increase in government spending, which leads to unsustainable debt-to-GDP ratios, which, in turn, lead to monetization of the debt through ination. There are other explanations, and the topic remains controversial in both academic and practitioner circles.

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