Bull markets breed investor complacency. Comforted by market euphoria, investment managers and financial advisers often forget lessons learned from previous downturns and high-risk trades tend to become more commonplace.
Risk and volatility are often used interchangeably in the same sentence, partly because modern portfolio theory defines risk as volatility and tells us that there is a proportional relationship between volatility and expected return - investors must accept uncertainty if they are going to generate returns more than the ‘risk-free’ rate. However, as a measure of risk, volatility reflects realised movement in returns and not what the future risk/reward may look like. Volatility is a measurement of what has already happened – it is measured after the event has occurred and is therefore of limited use.
Risk can be further broken down into its component sources as follows: Liquidity, Market, Credit, Interest Rate and Concentration risks. Often portfolio constructors view a portfolio as a mixture of returns derived from different investment styles and philosophies that play out in the funds that compose the portfolio. As we see after every major market set back there are certain funds and portfolios which significantly underperform the risk category in which they have been positioned – this shows us that on each occasion the investment manager has not afforded sufficient analysis to the underlying components of risk. The results for investors can be ugly as witnessed by the performance of many funds and managed portfolios during the Great Financial Crisis or the exogenous shocks of 2020. Where such events occur, there are implications for attaching financial advisers too, under the FCAs 2015 thematic review which sought to align portfolio risk with investor suitability.
Often, portfolio construction tools use realised volatility based on historic and backwards looking returns and historic asset class correlations. This, along with the lack of prescriptive asset allocation and in-depth research of underlying funds, will result in suboptimal portfolio construction. This all-too-common approach implies at a basic level, that the resultant portfolio makeup will be based on realised volatility that depicts the past behaviour of asset class returns, not the full interplay of risks that is essential in the 21st century.
Using an example to annotate our point – consider Market Risk. Many managers adopted a standard backwards looking volatility model before the pandemic related downturn of 2020. At that time, the low realised volatility across all asset classes over the preceding decade, prescribed high allocations to higher risk assets such as equities and particularly within small capitalisation equities. As the Covid-19 shock rippled across markets, those portfolios that had possibly enjoyed higher returns in a low volatility environment, stood more exposed to the market shock because of their composition. Another example is that of Credit Risk experienced by portfolios with exposure to Mortgage-Backed Securities in the pre-2008 Global Financial Crisis era. Portfolio construction based on realised volatility and returns for the decade prior would have allocated a higher portfolio allocation to sub-investment grade fixed income. In both examples, a higher level and quality of risk analysis carried within the portfolio, supplemented by prospective forwards looking analysis of key factors such as Macro, Technical and Geopolitical readings would have helped to deliver better returns for investors.
Of course, there is no way of knowing the future, but a better understanding of risk certainly helps navigate it more smoothly and benefits investors and the financial advisers alike. An investment manager’s role is not to predict the future but to read the signs carefully, draw conclusions, develop investment views, assign probability, and adjust risk accordingly.
At Alpha Beta Partners we view the forwards looking components of risk as key building blocks in our investment process. The investment process, from its design through to implementation carefully considers constituent risk attributes. We view a portfolio as a blend of risks and our proprietary Dynamic Asset Allocation is designed to incorporate a view of these future risks. Our forwards looking view formation process considers the Macro, Fundamental, Technical and Geopolitical data and helps us identify and manage potential future risks. The implementation stage then further breaks down the risk into constituent risks whilst maintaining alignment with our views.
These are a few examples of how a portfolio should be viewed as a blend of risks. Management of the constituent risk components, across each of Liquidity, Market, Credit, Interest Rate and Concentration Risk will help deliver a better performing, more efficient portfolio that truly aligns with an investor’s suitability assessment. Adopting the Alpha Beta approach to portfolio management delivers a portfolio which stands to perform better over time and a client relationship which is more sustainable and enduring.
