One of the biggest issues with risk when it comes to investing is that investors will invariably think about it in binary terms; what is the level of risk? Is it too high or too low? Of greater import, however, is understanding the composition of risk.
Given where the funds industry is today, as end investors’ return expectations increase they become increasingly limited in the type of risk that they can take. This has the unintended consequence of decreasing the efficiency of the overall portfolio as it becomes more and more concentrated in one type of risk.
The job of any good fund manager, of course, is to pursue risk intelligently using effective risk management tools in such a way as to maximise returns for the lowest possible amount of risk; hence the importance of the Sharpe ratio when assessing portfolio managers.
SEI is a fiduciary manager with approximately USD190 billion of assets under management. In a recent commentary written by James Smigiel (pictured), Co-Chief Investment Officer and Managing Director, Portfolio Strategies Group, he refers to striking the right balance of specific risk exposures — with the goal of increasing returns, both at the asset class and overall portfolio levels. Doing so, he says, “can not only mean increased returns in favourable environments, but also limited losses during unfavourable ones”.
The title of the commentary – Risk Management: The Intelligent Pursuit of Risk – is one of a series of commentaries that SEI is writing to help investors think differently about risk.
“Typically, the way the industry deals with this today is that the more aggressive investor gets more concentrated in equity risk. They are, in effect, doing two things: as they increase their risk exposure (in response to having a higher risk tolerance), they tend to also increase the concentration of risk in their portfolio. They are putting their eggs more and more in the equity basket.
“Without going into too much detail, the commentary speaks to the need for investors to think about not only the overall level of risk and recognising that there are different types of risk, but also the composition of risk. It’s easier for the more conservative investor to achieve a diversified risk profile, but it’s significantly harder for more aggressive investors to achieve that same level of diversification,” says Smigiel.
The default setting within the human brain is to avoid risk. It’s hard wired into all of us. This makes investing, and actively taking risk, a complex, counterintuitive process. Lots of academic research has been done on loss aversion to illustrate the extent to which investors will hold on to losing positions for dear life, and endure far more pain, as compared to holding winning positions. This naturally leads to a risk averse stance but it needn’t be that way.
Risk management, as Smigiel points out in the commentary, does not equal risk aversion. In the paper, he writes: As such, risk management not only works to minimise risk exposures that fail to adequately compensate investors, but also encourages risk exposures that we believe are more likely to be rewarded.
This can only be made possible by understanding the composition of risk. Different asset classes have different risk profiles. A seemingly well diversified portfolio of 60% equities and 40% bonds might not appear to have a high risk concentration on the surface, but if the equities bucket is heavily weighted towards a small number of stocks, then depending on the prevailing market conditions the portfolio might actually have 80 or 90% of the portfolio’s aggregate risk within those stocks. This changes the optics of the portfolio’s risk profile.
This is something that SEI is working to try and educate investors on.
“When investors look at their portfolio they do so in capital terms; they can see they have 60 per cent of their assets in equities, 40 per cent in bonds and they regard that as a diversified portfolio. We are trying to change the conversation a little bit and challenge our clients to think about what that means in risk terms.
“Somebody recently drew the analogy by comparing a pint of stout with a pint of whisky. They are both pints but they have dramatically different levels of alcohol – and therefore present very different risk profiles to the drinker!” comments Smigiel.
Ultimately, risk management is about knowing what risks are contained in the portfolio. The reason risk management does not equal risk aversion is, says Smigiel, “because the answer is not always to simply lower the aggregate level of risk, it’s about maintaining a diversified set of risks.”
Risk management is also about working directly with the client so as to understand their goals and objectives and compose a portfolio that is best equipped to meet those goals. One of the insights that Smigiel shares, which ties in to the earlier point on behavioural finance as it relates to loss aversion, is that if the client has short-term lifestyle goals and longer term legacy goals, just separating their portfolio in to two buckets can make a significant difference in terms of helping them think about risk. Indeed, SEI pioneered goals-based investing.
“We have found it surprising how powerful just bucketing a client’s portfolio can be,” states Smigiel. “The shorter-term portfolio in a period of market stress will not decline as much as the longer-term portfolio and the client knows that their short-term needs are being taken care of. Even if their longer-term portfolio is down -30 per cent, it’s easier for them to accept as they know they won’t be reliant upon it for a number of years.”
If, however, one were to take those two portfolios and meld them together, the combined portfolio might only be down -20%, even though it is the exact same portfolio. But because the portfolio is presented as one bucket, giving an aggregate risk, the investor is unable to mentally separate the two. All they see is -20%. The alarm bells start ringing and they might rush to liquidate the portfolio. This is the issue of simply looking at the level of risk and not the individual composition of risk.
“Risk management sometimes means you accept a less optimal implementation in order to make sure the client sticks to the programme. A portfolio can’t be optimal for the client if they sell out. The optimal portfolio is going to be one that they stick with, and sometimes that means nothing more than breaking up their portfolio into two, three buckets. It has a big impact on investor behaviour,” states Smigiel.
In other words, risk management is the art of aligning individual risks within the portfolio with the client’s goals and objectives. For example, short-term lifestyle goals, long-term legacy goals, and intermediate goals such as their children’s education, a wedding etc.
“You then assign the appropriate risk level to those goals, not at the aggregate portfolio level, but at the individual goal portfolio level. This makes it optically easier, from a portfolio construction perspective, for investors to understand risk. And it makes it more likely for them to stick to the plan. They might be happier to take higher risk and make the portfolio more concentrated at the longer-term end of the portfolio,” adds Smigiel.
This is why investors might choose to have 30-year bonds at the far end of the barbell. The longer the duration of bonds the higher the interest rate risk and therefore the higher the level of compensation. It doesn’t matter what rates do over the short term so it diminishes the extent of loss aversion an investor might feel.
“Understanding how different risk premia interact with one another is really important. Equity market risk premiums, credit risk premiums, interest rate premiums all have different interactions with each other. A lot of people have fixed income allocations in their portfolios. But if you dig a little deeper into what that allocation looks like, you might find that it’s all credit, which is going to be highly correlated to equities and offer precious little diversification benefits.
“It’s not simply a case of understanding what risk premia you have in the portfolio, it’s understanding how those different risk premia interact together. Ideally, in a perfect world, you would want to build a truly diversified portfolio of risk premia; that’s the Holy Grail,” concludes Smigiel.