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October 08, 2019
Risk as a starting point — not an afterthought
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October 08, 2019

Risk as a starting point — not an afterthought


Macro Insight

Risk as a starting point — not an afterthought

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October 08, 2019

 
 

Dazzling investment returns make good headlines─as do spectacular investment crashes.  But seldom do we read stories about funds that excel in controlling volatility while delivering strong, competitive returns. Yet managing volatility is the key to surviving a sharp market downturn.

Most investment managers designate a benchmark to evaluate returns. Far fewer designate a benchmark focused on volatility.  We are one of the few who do. Our investment process begins with risk.  Depending on client preferences, we specify a target range of volatility, e.g., 4-10%, within which we aim to maintain the fund’s volatility1.

A link between volatility targeting and higher Sharpe ratios

Studies show that volatility is negatively correlated to equity returns. As such, it makes sense to allocate to lower-risk assets when volatility is high or rising and to riskier assets when volatility is low or falling2. In fact, data supports that managers who do so often deliver a superior Sharpe ratio3, which measures the amount of return generated given the amount of risk taken.4

The advantage of multiple asset classes

Our multi-asset portfolios hold a mix of equities, fixed income, commodity-linked notes and cash. This flexibility to diversify across asset classes is critical in controlling risk.

In fact, research shows that global equities start to move in lockstep in distressed markets.5 Equity-only managers therefore have no recourse other than to reallocate between their equity holdings and cash, viewed by some as merely “rearranging the deck chairs on the Titanic.”  A multi-asset manager, in contrast, has multiple asset classes that can be rearranged to manage risk.

A forward-looking exercise

Anticipating volatility is a hallmark of our investment approach.  We continually survey macroeconomic and geopolitical conditions across the globe to identify potential sources of risk that could arise. Our goal is to adjust portfolio exposures before volatility strikes.

We use the portfolio’s equity allocation as the primary lever for adjusting its exposure to risk.   When we expect some event – such as an election, political instability or change in monetary policy -- to cause a spike in market volatility, we typically reduce exposure to equities.  Conversely, when market conditions normalize, we restore the equity allocation to a normal range, generally 50-70%6.  Display 1 shows how we have adjusted equity exposure in anticipation of various global events over the past two years. 

 
 
 
DISPLAY 1: Equity exposure adjusted as we anticipate changes in volatility
insight-riskasastartingpoint-Display-1
 

Source: GBaR strategy representative portfolio, MSIM, DataStream, Jan 1 2017 through 30 June 2019. Subject to change daily. Provided for informational purposes only and should not be deemed as a recommendation to buy or sell securities in the asset class shown above. Each portfolio may differ due to specific investment restrictions and guidelines. Accordingly, individuals results may vary. The information shown herein represents supplemental information, which supplements the composite presentation for the Global Balanced Risk Control Commingled Composite.

 
 

 

Case in point

In the second half of 2018, there was an escalation in trade tensions that we anticipated could curtail global growth. By September we had also identified that divergence in equity market performance between the US vs the Rest of the World was approaching excessive levels. The US’s outperformance was driven by a number of factors, including the perception that the US is a safe haven and insulated from trade tensions. Expecting a market correction, we decreased our equity allocation to reduce overall risk in our portfolios, positioning towards more defensive assets. This allowed us to protect our portfolios during the Q4 2018 market correction.

Final thought:  The psychological benefit of managing volatility

For investors, there is an emotional aspect of owning a fund that aims to keep volatility within a specified range. Delivering a more consistent, less volatile return stream can be of comfort to loss-averse investors, who might otherwise make rash decisions and sell prematurely.

Funds that aim to keep volatility within a pre-set range could be of particular interest to high net worth investors.  Given their aversion to volatility, they might be willing to sacrifice some upside in order to minimise sharp drawdowns.

 
andrew.harmstone
 
Managing Director
 
 
 
 

1 Volatility is a statistical measure of the dispersion of returns for a given security or market index. The Global Balanced Risk Control (GBaR) team measures volatility on a forward-looking basis using the manager’s proprietary risk management system. Volatility target is an indicative range. There is no assurance that targets will be attained.

2 Lazard, Dynamic Volatility Targeting, 2017

3 Sharpe ratio is a risk-adjusted measure calculated as the ratio of excess return to standard deviation. The Sharpe ratio determines reward per unit of risk. The higher the Sharpe ratio, the better the historical risk-adjusted performance.

4 Journal of Portfolio Management, The Impact of Volatility Targeting, Fall 2018

5 Vanguard, Dynamic correlations: The implications for portfolio construction, April 2012.

6 This represents how the portfolio management team generally implements its investment process under normal market conditions. There is no assurance that these targets will be attained.

Risk Considerations

There is no assurance that the strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall. In general, equities securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks.  Stocks of small-capitalisation companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. The use of leverage may increase volatility in the Portfolio. Diversification does not protect you against a loss in a particular market; however, it allows you to spread that risk across various asset classes.

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The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

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