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After years of ever-increasing focus on returns to the extent that even fixed income allocations got caught in the vortex, there is a sobering reassessment of the risk profile across a portfolio.

After years of ever-increasing focus on returns – to the extent that even fixed income allocations got caught in the vortex – there is a sobering reassessment of the risk profile across a portfolio. Traditionally that relies on measures of volatility (standard deviation) even though there is broad recognition of the flaws of this one-dimensional metric.

Few private investors have a portfolio that represents the underlying indices, particularly outside listed equities. Where there is a high level of active share in the equity portfolio, even it will have a lower correlation with the index. It makes it almost impossible to provide oversight of risk beyond managing elements of the weight and mix in equities and then working on the assumption the other parts of the portfolio will behave differently. In reality, almost everything became correlated through this drawdown.

Large institutions manage risk on the basis of specific exposures often with the oversight of external risk management firms. This prevents internal bias, which invariably blinds the institution or advisor on issues that may not fit in with their preferred investments or views. These institutions are also able to use the options market, derivatives or active currency overlays to offset specific positions.

Much of this is impractical for a private portfolio but it does not absolve the advisory sector from considering what risk process is inherent in client portfolios. An approach could be ‘Equity Equivalent Exposure, EEE’ where assets with equity-like risks (for example, high-yield debt or hybrids) are proportionately in the equity pool. Illiquidity and lack of market pricing signals should not be criteria, rather the position in the capital structure, refinancing risk or sector bias is in the mix of factors that may designate a correlation to equity.

Aside from data, there are other ways to consider incorporating a risk framework.

• Is the portfolio aimed at absolute return or benchmark-relative? Arguably this is the most important question to ask an investor, while ensuring that they understand totally the difference in what they will experience.
• What is the time horizon over which the portfolio is required to last? High volatility in returns undermines the compounding effect in a portfolio, and it should be proven that the volatility is compensated by higher returns.
• Another path is to be clearer on the diversity across the portfolio. In an attempt to pick outsized winners, and having impatience with anything that is lagging expectations, portfolios have lost dispersion of what they represent.
• Are positions sized appropriately to their expected risk-return trade-off?
• Does the portfolio assume macro conditions and how securities will behave given those circumstances? Can this be verified or is it based on assumptions that sound rational but are not supported by evidence?
• What assets are under-represented in a portfolio and does that match the macro landscape? Over the past few years, there has been a consistent commentary on low economic growth while risk assets dominated portfolios. Even if the coronavirus is a ‘black swan’ event, the conditions prior to its outbreak already pointed to a heightened sensitivity to a setback.

Higher correlations in risk assets – rising P/Es, narrowing credit spreads and increasingly risky capital structures – have been followed by extremely high correlations as a hallmark of this current period.  It was near-impossible to avoid such exposure.

Yet if portfolios are being reconsidered for the coming years, it would be remiss to return to the same position without recasting the risk framework.