Dr. Julius Agnesens
Head of Investment Solutions
& Member of the Executive Board
Risk controlled investing with Finreon Tail Risk Control®
To systematically detect the next market crash.
Finreon Tail Risk Control® is an innovative risk management system that enables the identification of market phases with low and high "crash" risk (so-called tail events). For this purpose, various market factors are systematically measured on a daily basis and aggregated into an overall signal. Based on this risk indication, the equity allocation is managed in a risk-controlled and forecast-free manner.
By consistently overweighting the equity quote in market phases with low tail risk, investors can participate in attractive market phases, while in times of crisis large losses in value are systematically reduced by lowering the equity allocation.
Finreon Tail Risk Control® enables an efficient utilization of the risk budget. The solution is ideally suited for risk-controlled and forecast-free management of the equity allocation, as a low risk equity investment and as a dynamic and cost-effective hedge against large losses.
Volatility is "normal" - even crashes! Normal stock market fluctuations are compensated with a risk premium over safe government bonds of approx. 4 -6 % p.a.. "Normal" market fluctuations can therefore be consciously borne by investors with robust SAA.
Stock market crashes (tail events) not only destroy returns, but also the capital with which future returns can be generated. During the 2008 financial crisis, the global stock market plummeted by more than 50% within one year. To recover this loss, investors subsequently had to achieve a return of 100% - this took more than 4 years. Avoiding loss of capital is therefore an integral part of good risk management.
A static equity quote regularly exceeds the risk budget of investors in turbulent market phases (phases with increased crash risk). This can not only lead to high losses, but also results in a less than optimal utilization of the risk capacity in calm phases.
The risk budget can be smoothed by dynamic management of the equity allocation. In this way, equity risk premiums can be optimally earned in calm market phases thanks to a favorable risk/return ratio. In turbulent phases with a low risk/return ratio, on the other hand, the equity quote can be systematically reduced, thus avoiding major asset losses.
Scientific research confirms - With systematic equity risk management, on the one hand the risk budget is utilized as evenly as possible, and on the other hand the return/risk ratio can be significantly improved over time.
How to detect a big crash? The Finreon Tail Risk Indicator (TRI) was developed exclusively by Finreon and allows to identify market regimes with high or low «crash»-risk. For this purpose, a broad variety of different market factors are analysed systematically and on a daily basis. The result – the risk of the prevailing market regime – is shown as a risk signal light: Red for high risk, yellow for normal risk and green for low risk. Accordingly, the equity allocation is reduced in a red regime whereas the equity exposure is increased during a green regime. Applying this strategy to the Global Equities index, a return of 8.2% p.a. could have been realised during the period January 2000 – September 2013, while a «buy & hold»-strategy resulted in a 0.6% p.a. return - and this with a significantly lower risk.
The Tail Risk Indicator can be used to control for the risk of an entire portfolio or to manage a given equity allocation bandwidth. In the case of a risk-controlled portfolio, the equity allocation, ranging e.g. between 0 % and 100 %, is controlled for by the risk signal. In the case of risk-controlled bandwidth management, the signal steers the equity allocation within the defined bandwidth. The 50/50 benchmark (50 % equities + 50 % money market instruments) corresponds to a neutral weighting and is similar to the long-term risk profile of the strategy.
Tailor-made implementation of the tail risk indicator: The investment can be undertaken via a Finreon Tail Risk Control® fund or via individual mandates. Furthermore, the signal may also be applied to different regional allocations.