The three Rs of risk management can help investors revitalize their portfolios
The financial turbulence of the last decade didn’t just damage portfolio performance; it dealt a blow to longstanding approaches about how to manage it, forcing a re-evaluation of traditional approaches to asset allocation and risk management. Institutional investors have entered a new world of higher volatility, higher correlations and rock-bottom yields, with danger looming when rates finally do rise. Further complicating the picture is a new awareness that economic regimes are less predictable, and influence assets in a more complex manner, than investors once thought.
To thrive in this unforgiving landscape, portfolios need to evolve: more diversification, the right blend of alpha and beta, and positioning that leaves them less vulnerable to market shifts. But can investors revitalize their portfolios along these lines? Yes, but they require a fundamental shift in mindset.
It’s best to start with the adoption of a risk management framework that incorporates the “three Rs”: risk factor-based allocation, regimes analysis and, crucially, risk management systems powerful enough to support the first two Rs. Investors can further benefit from setting their objectives more precisely. If investors use the three Rs to work toward specific investment outcomes—rather than just seeking to outperform a peer group or benchmarks—they may be more likely to achieve their goals.
Going Deeper
Risk factor-based allocation The poor performance of the average DB portfolio shows the weakness of asset classes as tools for diversification. Though the allocations appear diverse, they actually leave the portfolio primarily exposed to just one kind of risk: economic. To really diversify, investors need to go deeper and look at the risk factor exposures. Risk factors define the specific investment risks taken, with the goal of earning a long-term return premium. There are six macro risk factors that are intuitive, investable and relevant across asset classes: real rates and inflation, credit, political, economic and liquidity risks. Each of these factors has been rewarded at different times. Better-balanced exposures, achieved by applying a risk factor framework, lead to more consistent returns and insulate the portfolio from a shock to any one risk factor.
Regimes analysis Investors also need to think more deeply about the path of the global economy—and the possible impact of different scenarios on their portfolios. How much growth is ahead, and which economies will participate? Will inflation finally flare up? What are the chances of a deep global recession? By incorporating this analysis and considering which assets would do well (or poorly) in each regime, investors can better position their portfolios for future events. Investors, then, need to consider which possible future regimes are most relevant for them.
Risk management systems Neither of the first two Rs is possible without the third: the institutional-quality risk management systems needed to understand risk exposures (such as a rising or flattening yield curve, expansion of credit spreads or higher stock volatility) to stress test portfolios across scenarios and to hedge them against potential future regimes, such as lower economic growth or stagflation. With a more complete view of risks, investors are better able to take only those risks that they mean to take and that are most likely to be rewarded.
There’s little doubt that a new approach to risk management is needed. In the changing economic climate, portfolios demand more flexibility and a willingness to adapt. By employing the three Rs framework, institutional investors have a better chance of reviving portfolios and meeting investment objectives
Eric Léveillé is a managing director and head of the Canadian institutional business with BlackRock Asset Management Canada Ltd. eric.leveille@blackrock.com
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