We can’t, hand on heart, pretend to have total control over portfolio risk. This is a powerful insight.
Our profession’s history is replete with people who believe that their influence is greater than it really is, until a fateful day of reckoning, writes James Klempster, director of investment management at Momentum Global Investment Management.
Luckily, even though we cannot control risk, we can manage it.
A destination and a journey
We think about risk as being more than just volatility.
While volatility is important, it is often the manifestation of risk rather than the risk itself and we must also avoid conflating a lack of volatility with an absence of risk.
To begin with, fund managers must consider portfolio volatility during the design and build stage of a fund. The design stage is where they set up long-term asset allocations that are targeting a certain risk and return.
It is important to get the strategic asset allocation (SAA) right because it informs investors about the sorts of levels of volatility and returns they should expect.
Ongoing portfolio construction is an important means to manage volatility and risk. Building a portfolio atop of the foundations laid in the SAA process is an ongoing and ever evolving process.
Merge and diverge
Diversification is a key tool for managing volatility when building portfolios.
It works well but it is imperfect and frustrating when viewed over too short a time period because, from time to time, it seems to fail.
For example, there are plenty of months where bonds and equity move together – as we have recently witnessed – but over time this tends not to be the case.
Diversification, like returns, sometimes needs time to work.
Recognising biases
There are finer levels to diversification than just equity/bonds, though.
For example sub-asset classes and regional biases are extremely important.
Small-cap equity does not behave in the same way as a blue chip behemoth.
A low quality bond does not behave the same as a government bond. So we need to understand and have a high degree of focus into the finer elements of asset classes.
Currencies can also muddy the water hugely: a large proportion of the risk from sovereign fixed income holdings comes from the currency translation of the returns into a reporting currency.
Rough edges
Manager style is an under used means of managing risk in a portfolio.
Because managers are, by definition, different from one another, they have offsetting and somewhat complementary characteristics.
They can knock off each other’s rough edges and the combination is greater than the sum of the parts, in terms of risk adjusted return.
This is only true to a point, however.
After a certain level the benefits of using active managers erode and the portfolio becomes akin to an index fund but with higher costs.
Manager selection can also help manage beta in a portfolio but unlike styles, beta can drift up and down as different stocks drive the market.
Stacking the deck
Valuation is a means of reducing the risk in a portfolio.
If you can buy asset classes when they are inherently cheap the risks associated with that investment are lower than if it is simply bought at an average valuation or when overvalued.
Buying things that are cheap stacks the odds in your favour.
A valuation driven active asset allocation process can apply this logic across all the asset classes that might be included in a portfolio and place emphasis on assets when they are cheap and comparatively less risky, while underweighting those which are expensive.
Simplicity is sometimes undervalued today.
Daily dealing difficulties
Another very important source of potential risk, that is not reflected in a volatility number, is liquidity mismatch.
Investments that have an inappropriate level of liquidity are like a lobster pot – very easy to get into and devilishly difficult to get out.
These sorts of funds are often also guilty of other sins, such as mark to model prices and a high number of assumptions or over complexity; all of which we feel are best treated with extreme circumspection to reduce risk in portfolios.
For example, daily dealing funds that buy assets that cannot be liquidated for a number of months are a risk.
Overall the key for us is to allow our portfolios to contain risks that we are fairly or well rewarded for and remove the others.
The simplest way to avoid a risk is not to buy it in the first place.
But we have to buy some risk as we live in a world where we have to invest for our clients to deliver returns.
As a result, I would suggest focusing on ensuring that when you buy something you do it knowingly and that you are well rewarded for the risks you take.
This article was written for International Adviser by James Klempster, director of investment management at Momentum Global Investment Management (MGIM).
