From asset allocation to risk allocation

The balance between return and risk is often equated with the trade-off between health and exercise. While all investors have an appetite for greater wealth (being healthy), they also have a limited tolerance for risk (exercise). Unfortunately, risk is a difficult, often abstract, concept for investors — especially when it comes to investment selection. As a result, risk is usually ignored altogether.

When evaluating the success of an investment plan, the average investor focuses on the end result — performance. Yet return is just one factor to be weighed. At least equally important is the risk profile. Consequently, risk allocation can be an even more efficient approach to safeguarding one’s exposure than traditional asset allocation strategies that simply seek to diversify investments over a range of asset areas. Depending on a client’s risk appetite, utilizing a risk allocation strategy can be a form of insurance against extremes or used as an opportunity to generate outperformance.

Risk is real, whether it is interpreted as the possibility of losing money or the uncertainty associated with achieving a wealth target. One of the most important roles advisors play is that of a risk manager, working to maximize the probability that the client’s investment strategy will achieve its goal. The goal of a risk allocation strategy is to keep portfolio risk at an appropriate level throughout the investment process and to take risk only where it is likely to be compensated with return.

Stay prepared

No discussion about diversification is complete without first touching on one of its basic underpinnings: correlation. Correlation is represented by the correlation coefficient, a numerical measure of the strength and direction of the relationship between two series of data or variables. Values range between -1 and +1, with a correlation coefficient of +1 indicating that the two variables have a perfect linear relationship. In contrast, a correlation coefficient of -1 shows a perfect inverse linear relationship. A correlation co-efficient of zero suggests that the variables may have no relationship and may be independent.

A basic approach to achieving diversification is to combine asset classes that have low correlation in an effort to limit exposure to any particular sources of risk. The theory behind this approach is asset classes exposed to common risks should exhibit correlation, providing an opportunity to implement a risk allocation strategy to protect or drive end investment plan returns.

Correlation can change over time and should be used as a guide rather than a certainty. Correlation ebbs and flows. There are points in time (such as the period between 1995 and 2001) when the S&P 500 Index far outpaced international markets. And there are other points in time when the opposite was true. Holding both asset classes, rather than only one, has provided a superior result to holding only one or the other. Over extended periods of time, diversification can prove reliable.

Short-term mindset

However, it is fair to conclude that most clients will not want to wait 35 years to measure and realize investing success. During economically difficult times, such as those in recent memory, we have seen asset class correlations move towards +1.

In fact, the increased magnitude of correlations in the last crisis was not unprecedented, even within this time period. It is also worth noting that between those periods of high correlation are periods where correlations were weaker.

But does this mean that correlation and diversification fail us when we need it the most: during times of crisis and short periods? The answer is no. Conventionally, diversification is achieved by investing in different asset classes. Yet we cannot rely solely on correlation and asset classes to capture complex relationships between investments. Correlation is only going to articulate the average over various states; it does not capture specific events. Yet it is often during these specific shocks when investors are most concerned with their portfolio’s performance.

Take a typical pension plan asset mix:

• 36% Canadian bonds
• 35% Canadian equity
• 14% international equity
• 13% international equity, EAFE
• 2% cash

When viewing it by asset allocation alone, the portfolio looks to be well diversified; most investors would be pleased with the amount of diversification represented. But look at the same portfolio through the lens of risk and we see a different picture. Portfolio risk, as measured by standard deviation, is approximately 9.4%. When reviewing the mix from the perspective of risk allocation, it would appear equities account for 62% of the portfolio, yet are responsible for 96% of the total risk.

What does this mean? If risk drives return, the overarching results are dominated by equity exposure. Once viewed through this risk lens, the portfolio looks far less diversified. A negative shock to equity markets would have a significant effect on this portfolio.

It would be premature to declare asset allocation a failed investment approach. In fact, asset allocation remains an important factor to consider when constructing a portfolio. But it cannot be considered in isolation of other events at play. If investors think about investments solely in terms of what asset class they own (e.g., bonds, equities, small cap, large cap, international, etc.) without taking into consideration their exposures to systematic risks such as economic growth, liquidity, interest rates, inflation and political risk, they have less information about what is going to drive that asset in extreme times. In turn, a risk allocation strategy supports their appetite for higher returns while preserving capital.

Examining systematic risk

In this sense, a risk allocation strategy can be a form of insurance against turbulent events. When we buy insurance, we do so with a negative return expectation. We don’t buy insurance because we think it will increase our return. In fact, we do so with the hope that we will lose money — that we will pay out a premium on a regular basis without ever having to make a claim or get a payment in return.

Investors have to view their investment portfolios in the same light. We typically look at potential asset classes through the lens of potential returns. But when we shift the consideration to one of risk mitigation, the view includes wealth preservation alongside performance.

To help determine systematic risks, consider the following questions when building a portfolio:

• What risks is the portfolio bearing?
• Are the risks likely to be compensated?
• How can the investor hedge away the risks that won’t be compensated?
• How can the investor build diversified exposure to the ones that should be compensated?

In essence, an advisor must assess whether the portfolio in aggregate has exposure to enough differing systematic risks. Let’s take political risk. The situation in Egypt has reminded us that political instability is a risk of investing in emerging markets, yet one that varies from country to country. High levels of uncertainty and the potential for disruption in market functioning can weigh on asset prices.

Similarly, rates of inflation are starting to diverge around the world, with acceleration in some countries (particularly among emerging markets), yet stability in the others. These trends arguably speak to the growing importance of country selection, as specific risk factors become more prominent and correlations between countries retreat from the highs reached during the rapid decline and subsequent advance of equity markets from 2008 to 2010.

Geopolitical considerations are just one of many systematic risks that have to be factored in. Liquidity risk, for example, is almost always overlooked, yet it was a huge driver of asset prices during the crisis. While modelling the precise risk properties of a given asset class may be challenging, it can be quite intuitive to compare and rank the sensitivity of various asset classes to a particular risk.

To take our previous example, political risk is higher in some emerging markets (say, Egypt or Thailand) than others. When you start to think about your client’s portfolio along these dimensions and getting rough rankings correct, you start to see most portfolios are massively exposed to economic risk and credit risk, which is akin to economic risk. Once advisors compensate portfolios to account for these exposures, they start to shape them differently.

Value of professional guidance

Managing a total portfolio investment strategy requires balancing four competing forces: return, risk, costs and taxes. The average investor struggles to keep all four in balance, sometimes driven by irrational influences that can affect their performance and wealth. Most people pay the greatest attention to return, and risk is often insufficiently evaluated or overlooked altogether, despite a general understanding that risk is an inherent aspect of earning return. Even where risk is evaluated when a portfolio is built, it needs to be monitored and adjusted appropriately as circumstances change.

An appropriate risk allocation, along with overall total risk and return targets, should be thought of as the blueprint of diversifying portfolio risk, while asset classes are the bricks and mortar used to execute the design. Many tend to overemphasize asset classes without thinking about the true differences (or similarities) between them. By making a clear distinction between different risk factors in the portfolio, and taking steps to manage the exposure to each of them — through asset allocation, investment selection and rebalancing — advisors have the opportunity to help their clients navigate through uncertain times and achieve their investment goals.

Mary Ann Wiley is Managing Director, Head of iShares Distribution.

Mary Ann Wiley