New strategy targets commodities risk in equity portfolios

Mountain Pacific Group LLC, a money management boutique led by Ronald G. Layard-Liesching, is plans to measure and manage the commodities-related risks embedded in institutional investors' U.S. equity allocations. The strategy is getting its first looks from institutional investors., including the San Francisco City and County Employees' Retirement System, which is considering a recommendation to hire Mountain Pacific to manage a commodities overlay for an S&P 500 (excluding tobacco) portfolio. Investment consultants who have learned of Mountain Pacific's approach call it intriguing. The notion of deconstructing equity beta risk into its various components will be an area of increasing focus in the study of portfolio management, predicted Alan Kosan, a managing director and head of alpha investment research with investment consultant Rogerscasey Inc. Conceptually, the approach “is very sound,” said Valter Viola, president of Holland Park Risk Management, which advises the San Francisco system. Its focus on risk may place it outside the mainstream of institutional investment strategies, but this could prove a case where innovation yields attractive payoffs, he said.

ADDING ALPHA

In a recent interview, Mr. Liesching said actively managing those uncompensated commodities-related risks — which the Mountain Pacific team blames for a quarter of the steep equity losses U.S. institutional portfolios suffered in 2008 — can help investors add alpha while lowering volatility. One institutional investor, who asked not to be identified, said the strategy is either “insane or brilliant,” while noting that it offers sufficient potential to be worth further study. Mr. Liesching, who co-founded currency specialist Pareto Partners Ltd. in 1991, predicts that the novelty factor won't last long — he expects a flood of other managers to offer their own strategies to hedge against equity volatility dynamically over the next few years. The recent financial crisis exploded the conventional wisdom that investors can diffuse equity beta risk by diversifying into alternative betas, he noted. One veteran investment consultant, who also asked not to be identified, agrees, calling strategies focused on fine-tuning specific risks the “leading edge” of product development, if only because traditional portfolio management has proved so flawed. The challenge for those new strategies will be finding those early adopters, he said. In this case, necessity could prove the friend, rather than the mother, of invention. Equity beta is “the monster risk” in U.S. institutional portfolios, whether one looks at the chunky allocations to long-only U.S. equities or smaller allocations to private equity, real estate or hedge funds. Still, with so many investors looking to recover from severe funding shortfalls, abandoning equities isn't an option, Mr. Liesching argued. Instead, investors need to manage that equity risk actively, said Mr. Liesching, who noted that a growing number are looking to pivot away from returns-focused strategic asset allocations and adopt more-dynamic strategies, focused on managing various risk factors. Identifying and managing those risk factors is where the battle is being fought now. The new approach to portfolio management today “is to "X-ray' investments to find the real risks” or — put another way — to “tease apart” risk into its various components, Mr. Liesching said. Institutional investors want to “measure the actual factor risks they have, and manage [those] risks actively, if they are large,” he added. “Everybody is starting to realize that they have to view the world on a factor basis,” but how to proceed from that point — how, in effect, to “operationalize that concept” — is the next major step, Nathan Shetty, Mountain Pacific's director of research, said in a separate interview. Mountain Pacific has worked over the past year or two to fill that gap. It was the firm's director of client service, JoAnne Svendsgaard, who came up with the idea of examining whether fluctuating commodities prices have a big impact on the short-term volatility of U.S. institutional investors' hefty equity allocations and, if so, whether that volatility can be managed.

A DECISIVE YES

Mountain Pacific's research suggests the answer to both questions is a decisive yes, Mr. Shetty said. (Mr. Liesching said the conclusion applies to natural-resource-rich nations such as the U.S., Canada and Australia but not necessarily to resource-poor nations such as Japan.) To measure embedded risks in commodities, the Mountain Pacific team developed a quantitative tool for examining the impact of price changes in six commodities sectors, including energy, grains and industrial metals, on 10 equity sectors, including utilities, industrials, consumer staples and materials, Mr. Shetty said. The team's statistical analysis and factor modeling yielded unexpected results. For example, a hike in energy prices was “almost a wash” since gains of energy-producer stocks were offset by losses borne by companies that consume energy, Mr. Liesching said. By contrast, base-metal price movements had a considerable impact on equity volatility. On the whole, embedded commodities exposure often accounts for more than 30% of monthly equity volatility, and explains almost 25% — or 9 percentage points — of the 38.49% plunge in the S&P 500 in 2008, Mr. Liesching said. Having determined the specific commodities-related equity exposures of an institutional portfolio, Mountain Pacific then relies on “alpha signals” — based on the concept of risk asymmetry, or skew between positive and negative risks for specific commodities sectors — to go long or short (or neutral) those commodities, using a variety of vehicles, Mr. Shetty said. Douglas Appell is a reporter at sister publication Pensions & Investments.