Risk Management is at the core of Blue Diamond’s investment process. We define risk differently than many other managers because our main goal is capital preservation. And we define capital preservation, not in terms of absolute or nominal returns, but consistent real returns. Risk, for us, means price risk and we define it in terms of the price of an asset class versus its “fair value”. In other words, we believe that the more expensive an asset class becomes in relation to its fair value, the more risky the investment. This approach to risk differs from the traditional way of looking at risk just as volatility.
Our research shows that volatility is not a meaningful indicator for future returns. Volatility indices typically peak just before positive market trends. However, in the past, the distance to fair value served as a reliable leading indicator:
- Distance to Fair Value typically peaks just before large draw downs
- Distance to Fair Value has its low just before positive market trends
Next to the “implied risk management” in our investment philosophy, that we are not buying into expensive asset classes in the valuation model and the valuation and momentum tend to be uncorrelated, we use volatility to manage the size of the single positions. The valuation portfolio as well as the momentum portfolio is run with a maximum volatility target, as well as the whole portfolio. Asset classes amongst each other are treated defensively; this means we assume a “worst case” volatility between them.
