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June 15, 2020

Risk as a starting point — not an afterthought

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June 15, 2020

Risk as a starting point — not an afterthought


Risk as a starting point — not an afterthought

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June 15, 2020


Dazzling investment returns make good headlines─as do spectacular investment crashes, such as the one triggered by the COVID-19 pandemic or the Financial Crisis of 2008-2009.  But seldom do we read stories about resilient strategies that have excelled in managing volatility while delivering, competitive returns. Yet managing volatility is one of the keys 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 strategy’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 have often delivered a superior Sharpe ratio3, which measures the amount of return generated given the amount of risk taken.4

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 managing 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.

Past performance is no guarantee of future results.

Case in point

In early 2020, to help manage volatility during the COVID-19 pandemic and unprecedented shutdown of the global economy, we reduced the equity allocation of our flagship portfolio, which has a volatility-target range of 4%-10%. This reduction comprised two elements: firstly, from late February to early March we reduced equity exposure, a position we maintained as volatility remained elevated. Secondly, in February we had implemented an enhanced tail risk hedging strategy, helping to further mitigate the impact of the extreme downside volatility.

Final thought:  The psychological benefit of managing volatility

The COVID-19 pandemic, though unprecedented in scale and scope, is just one of many events that can pose investment risks over time. Though there is no assurance that a strategy will attain its volatility target, resilient strategies that aim to keep volatility within a pre-set range will appeal to those who like the idea of ongoing, research-based risk management. Given their aversion to volatility, high net worth investors, in particular, might be willing to sacrifice some upside potential in order to seek to reduce sharp drawdowns.


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.


Risk Considerations

Diversification does not protect you against a loss in a particular market; however, it allows you to spread that risk across various asset classes.

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. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. 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 and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. 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-capitalization 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.

Managing Director
Global Balanced Risk Control Team
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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.


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.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

Except as otherwise indicated, the views and opinions expressed herein are those of the portfolio management team, are based on matters as they exist as of the date of preparation and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date hereof.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.

The information herein is a general communications which is not impartial and has been prepared solely for information and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The material contained herein has not been based on a consideration of any individual client circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

Past performance is no guarantee of future results. Charts and graphs provided herein are for illustrative purposes only.

This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This commentary is only intended for, and will be only distributed to, persons resident in jurisdictions where distribution or availability would not be contrary to local laws or regulations.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the product’s relevant offering document.


A separately managed account may not be appropriate for all investors. Separate accounts managed according to the strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.


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