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(A Less) Risky Business

Meet Tang Hujun, Tactical Asset Allocator at the World’s Second Largest Sovereign Wealth Fund

How much risk is too much, and how much hedging is too little?

It’s the central question for any investor or asset manager, and the livelihood of Tang Hujun, Managing Director of Asset Management for the China Investment Corporation (CIC). He oversees the tactical asset allocation team that is responsible in part, for determining the acceptable level of risk on the approximately $900 billion of foreign reserves entrusted to CIC, China’s largest sovereign wealth fund.

CIC was established in 2007, at a time when China was looking for greater engagement with overseas financial markets. It was fortunate to escape the worst consequences of the then-burgeoning global recession, and has seen a more than quadrupling of funds under its management over the past decade. With the increased responsibility comes increased risk, and that is where Mr. Tang comes into the picture.

Mr. Tang detailed his thoughts on the global investment environment at the 3rd China International Insurance Asset Management & Investment Summit 2018 on May 24th in Beijing. During his presentation, and a follow up interview with Duxes, he outlined his work at CIC and his views on asset allocation and risk management, offering a window into the thought process of a high-level investment analyst.

The journey to asset manager has been a smooth one for Mr. Tang, characterized by the accumulation of qualifications and experience. After studying at Fudan University as an undergraduate, he obtained an MBA from Boston College, and a Master’s of Financial Engineering from UC Berkeley. During his stint as Director of Asset Allocation Research at Mellon Capital Management, prior to joining CIC, he helped develop quantitative models for global macro strategy.

The fit with CIC is, in many respects, a natural one. CIC’s mission is to maximize its return at an acceptable level of risk, and unlike pension funds and insurance companies, it doesn’t have explicit cash outflow obligations. This open-ended timeframe equips CIC, and by extension Mr. Tang, with a relatively high risk tolerance and low liquidity requirements. However, the flexibility is accompanied with high expectations; CIC’s target return is Global CPI (excluding China) + 3%, and as a result its investment approach is equity-centric. Equity investments are most prone to volatility, making his role at CIC ever more critical.

CIC’s target return is Global CPI (excluding China) + 3%, and as a result its investment approach is equity-centric. Equity investments are most prone to volatility, making his role at CIC ever more critical.

Risk is ever present for any investment, but the primary concern for Mr. Tang is hedging “tail risk” that is especially prevalent in CIC’s equity-driven portfolio. Tail risk refers to portfolio risk that occurs at the tail of a distribution of investment outcomes, defined by some asset managers as a 15% plus drop in the equity market. Tail events are infrequent, but hardly unprecedented; the Asian financial crisis, Dotcom bubble, Housing bubble, and European debt crisis, are some examples from the past two decades. The frequency of tail events can confound mathematical models; just ask Mr. Tang, and he will tell you that the world is a more chaotic place than one would expect based on statistics.

“Most people regard the stock market as a normal distribution,” he explained, “but in fact, tail risks are not subject to a normal distribution. A normal distribution may dictate that a certain event will occur once every 100 years. In the real world, tail events can occur every 5-6 years.”

”A normal distribution may dictate that a certain event will occur once every 100 years. In the real world, tail events can occur every 5-6 years.”

Drivers of such instability are often geopolitical developments that are beyond the ability of any individual, or team of dedicated individuals, to predict with absolute confidence. It is nearly impossible to build mathematical models for geopolitical risk, and historical data is not predictive. So he and his team rely on consultations with management, human judgement, advanced math, and a mix and match method, to keep risk tolerable. For him, dealing with risk is not a theoretical matter; it requires a hands-on approach.

Mr. Tang and his team conduct back tests to ensure that the drawdowns are reasonable for assets purchased. By pursuing tactical tail risk hedging, that is, constantly adjusting the tail hedging positions to mitigate tail risk, he aims to protect CIC’s portfolio from a catastrophic economic or political series of events.

“Now, as a fully invested sovereign wealth fund, we cannot rely on the good market timing that characterized CIC’s early trades,” he noted. “I am constant looking ahead, trying to prepare for, if and when a 2008-type economic crisis happens. Under that scenario, without the proper hedging practices, CIC’s portfolio would be badly hit.”

Two tools at his disposal are: “cross-hedging”, the bundling of safe haven assets such as government bonds, gold, and currencies that have a negative correlation with equity, and “direct hedging”, the purchase of equity put-options, which are guarantees to sell equity at a certain price, even following a market collapse. Cross-hedging is not 100% guaranteed to be successful, as the negative correlation is not dependable in every scenario. Direct hedging, in contrast, successfully hedges risk, but it is too costly to employ uniformly. The key therefore, is to “dynamically adjust” the tail hedging position, depending on his own view of the tail probability and magnitude, in reaction to geopolitical events and macroeconomic developments, so as to turn the risk level high and low as one would a water faucet.

The key is to “dynamically adjust” the tail hedging position, depending on his own view of the tail probability and magnitude, in reaction to geopolitical events and macroeconomic developments, so as to turn the risk level high and low as one would a water faucet.

Underpinning his approach is the understanding that prudent, balanced investments are generally superior in the long run to extremely risky investments. This can be explained by the “compound interest effect”; as time progresses, by avoiding major loss, the prudent investment will outperform extreme volatility, as the volatile investment will have a low base to build from following a major market loss. To cite an example provided by Mr. Tang, in the event of a 50% drop in the equity market the first year, the more volatile investor of two investors who doesn’t hedge would lose 50% on his investment. The following year, if the market completely recovers, he will earn 50% of his investment back, but end up with only 75% of his original investment. The less volatile investor who does hedge, and as a result loses 20% initially, and makes back 20% the second year, would end up with 96% of his original investment. The compound interest effect is counter-intuitive, but a confirmed mathematical proof. In short, extreme swings on an investment actually depress its overall return.

It would be tempting for a long-term investor with high risk tolerance such as CIC to forgo hedging for maximum returns, but the hedging kills two birds with one stone: it protects CIC’s investment against tail event scenarios, and it also ensures that the investment will continually benefit from the compound interest effect.

“Even after giving up some upside through hedging,” he explained, “the compound effect can substantially improve returns. If there were no compound effect, investments would simply involve losses and gains, but by avoiding huge drawdowns, we can take advantage of compounding in the long run.”

“The compound effect can substantially improve returns. If there were no compound effect, investments would simply involve losses and gains, but by avoiding huge drawdowns, we can take advantage of compounding in the long run.”

As for the future … that’s not entirely up to him. No doubt, Mr. Tang will continue to make informed tactical investment decisions based on the best available data, relying on advanced methodology, but 15 years in the field have taught him that future projections are never ironclad. As he noted during his talk, global economic indicators are positive in 2018, GDP growth is solid, corporate earnings are robust, and inflation is relatively low in major economies, but tail risk is always on the horizon.

“Managing tail risk is like buying car insurance,” he said about his job. “We get to decide how much premium we would like to pay, much like a driver can based on how often he drives, how good a driver he is, and other factors.”

But as the buyer for a vehicle constantly in operation, with real time rate adjustments of almost infinite complexity, Mr. Tang’s work never ends.

For further information, please contact:
Ms. Cindy Cui
Tel.: +86 21 5258 8005 Ext. 8253
E-mail: cindy.cui@duxes.cn
Website: http://www.hfsseu.com

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