putting risk to work - amazon web services · 2017-03-13 · liquidity risk geopolitical/currency...

Better thinking. Together.®

Putting Risk to WorkA Guide to Risk Budgeting

Marina GrossSenior Vice President, Portfolio Research & Consulting Group

June 20, 2012

FOR INVESTMENT PROFESSIONAL USE ONLY

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The word ‘risk’ is derived from the early Italian ‘risicare’, which means ‘to dare.’

risk


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Agenda

• Intro to Durable Portfolio ConstructionSM

• Three benefits of targeting risk

• Define risk budgeting

• Review the risk budgeting process

• Demonstrate the results

• Summary

3 FOR INVESTMENT PROFESSIONAL USE ONLY

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Durable Portfolio ConstructionSM

Durable Portfolio Construction is a framework for building investment portfolios that can stand up to increasingly unpredictable market conditions, allowing investors to stay focused on their long-term goals.


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The principles of a durable portfolio

1. Putting risk firstA greater focus on risk management – minimizing bad decisions

2. Maximizing diversificationAn open mind with rigorous analysis

3. Risk-managed alternativesHaving a more complete set of portfolio tools

4. Smarter use of traditional assetsYou still need long-only stocks & bonds

5. Consistency of processHave a portfolio construction process – and communicate it


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Three reasons to focus on risk

• Risk is the key determinant of investment returns

• Investors tend to be more sensitive to risk and more likely to react to it

• Risk has historically been a far more stable variable than return


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Risk is a more stable input than returnRolling 5-year returns and risk of four common investments

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Past performance is no guarantee of future results. U.S. Bonds are represented by Barclays Capital U.S. Aggregate Bond Index, Int'l Developed Markets Bonds are represented by Citigroup WGBI Non-USD Denominated Index, Global large-cap equity is measured by MSCI World Large Index, Global small-cap equity is measured by MSCI World SMID.


U.S. bonds Int’l developed market bonds Global large-cap equity Global small-cap equity

60-month rolling: January 1997 – December 2011Annualized return, %

60-month rolling: January 1997 – December 2011Annualized standard deviation,%

12/01 12/03 12/05 12/07 12/09 12/11-10

-5

0

5

10

15

20

25

30

-10

-5

0

5

10

15

20

25

30

12/01 12/03 12/05 12/07 12/09 12/11

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Defining risk budgeting

An approach that allows you to harness risk and use it to your advantage, rather than one in which risk happens to you and you figure out how to deal with the consequences:Recognizing that not only does an investor have a risk tolerance, a maximum threshold he/she is willing to accept, but it needs to be translated into a quantity. That quantity serves as the allotment that gets “spent” in pursuit of the best available investment returns. This limitation encourages those making the expenditure on behalf of the client to maximize the output for each unit of risk.


The Budgeting Process


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The budgeting process

Start the budgeting process

Analyze assets based on their function

Manage the portfolio to that budget

Benefits and results


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• Create a portfolio with a predefined level of risk, as measured by standard deviation

• Take a comprehensive approach towards diversification – both in terms of factorsand performance patterns

• Build foundation with risk reducers:Core assets that consume a modest amount of the budget and provide stability

• Use the remainder of the risk budget to pursue opportunities you deem most attractive (mindful of the risk contribution split between the two)

• Every asset in the portfolio should have one of two purposes: To reduce risk or enhance returns






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• Determine which assets to use as risk reducers & return enhancers

• Use quantitative and qualitative inputs to screen each asset’s role in portfolio terms

• Allocate the predefined volatility budget mindful of the opportunity set, trade-offsand how much each asset “costs”

Concentrated positions

Security-specific risk

Liquidity risk

Geopolitical/currency risk

Credit risk/default risk

High quality

Low duration

Hedged

Volatility constrained

Low correlation

Return EnhancersRisk Reducers

Although these assets have displayed these characteristics historically, there is no guarantee that they will continue to in the future.


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The size of the budget determines the ratio of risk reducers to return enhancers

Risk Budget

Risk reducersInvestments that are intrinsically

low-risk or that have capped or hedged risk in some way

Return enhancersDirectional bets or investments

believed to have the greatest earningpower but at a highercost


The above chart is hypothetical and is being shown for illustrative purposes only. Although these asset classes have displayed these characteristics historically, there is no guarantee that they will continue to in the future.


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• Insomuch as you’ve established this budget, you then manage the portfolio to it going forward

• If risk parameters are violated –alter mix of risk reducers/return enhancers to bring it back in line

• This effort steadies the risk of the portfolio while allowing the allocation/asset mix to change



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Result of the process:• Serves as a guide by which the portfolio

is set and managed going forward

• Enforces discipline

• Encourages critical and dispassionate decision-making

• Provides justification for making more purposeful allocation decisions

• Necessitates a focus on maximizing portfolio efficiency

• A funnel through which expectations are set and results are explained

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Global Gov’t/Credit Return enhancersRisk reducers

Risk Budget

Risk/return balance of a traditional portfolio60%/40% equity/fixed moderate portfolio: 11% risk and 5% annualized return


The above chart reflects the historical performance of a moderate/balanced portfolio from 1/1/1997 to 12/31/11 where Global Government Credit is represented by Barclays Global Aggregate Bond Index and Global Equities is represented by MSCI World Index. The illustration is hypothetical and being shown for illustrative purposes only. Although these asset classes have displayed these characteristics historically, there is no guarantee that they will continue to in the future.


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Global Gov’t/Credit

Risk Budget


Return enhancersRisk reducers

FOR INVESTMENT PROFESSIONAL USE ONLYFOR INVESTMENT PROFESSIONAL USE ONLY


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Global Equities


Risk Budget





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Global Equities


Risk Budget




The graphic above reflects the historical performance of a moderate/balanced portfolio from 1/1/1997 to 12/31/11 where Global Government Credit is represented by Barclays Global Aggregate Bond Index and Global Equities is represented by MSCI World Index. The illustration is hypothetical and being shown for illustrative purposes only. Although these asset classes have displayed these characteristics historically, there is no guarantee that they will continue to in the future.

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10% risk40% return10% risk40% return

Risk Budget





The graphic above reflects the historical performance of a moderate/balanced portfolio from 1/1/1997 to 12/31/11 where Global Government Credit is represented by Barclays Global Aggregate Bond Index and Global Equities is represented by MSCI World Index. The illustration is hypothetical and being shown for illustrative purposes only. Although these asset classes have displayed these characteristics historically, there is no guarantee that they will continue to in the future.

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Precious Metals


Hedge Funds

Managed Futures

Risk Budget



Risk/return balance of risk-budgeted portfolio8% risk budget allocated among risk reducers and return enhancers cognizant of the total allotment and the trade-offs equals about 8% annualized return

For a complete list of indices represented and their allocation in the represented portfolio see handout or slide 32 & 34.

The graphic above reflects the historical performance of a risk-budgeted portfolio with an 8% risk budget from 1/1/1997 to 12/31/11. The illustration is hypothetical and being shown for illustrative purposes only. Although these asset classes have displayed these characteristics historically, there is no guarantee that they will continue to in the future.

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Precious Metals


Hedge Funds

Managed Futures

Risk Budget


Risk/return balance of risk-budgeted portfolio8% risk budget allocated among risk reducers and return enhancers cognizant of the total allotment and the trade-offs equals 8% annualized return


The graphic above reflects the historical performance of a risk-budgeted portfolio with an 8% risk budget from 1/1/1997 to12/31/11. The illustration is hypothetical and being shown for illustrative purposes only. Although these asset classes have displayed these characteristics historically, there is no guarantee that they will continue to in the future.

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Precious Metals


Hedge Funds

Managed Futures

Global Small Cap Equities

Emerging Markets Equities

Global Real Estate

Emerging Markets Debt

Risk Budget





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Precious Metals Global Small Cap Equities

Emerging Markets EquitiesGlobal Gov’t/Credit

Hedge FundsGlobal Real Estate

Managed Futures

Emerging Markets Debt

Risk Budget





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Risk Budget







Risk-budgeted portfolio in actionHypothetical comparison of active risk-managed portfolio vs. traditional portfolio

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

$400,000

01/97 01/98 01/99 01/00 01/01 01/02 01/03 01/04 01/05 01/06 01/07 01/08 01/09 01/10 01/11

60/40 equities/fixed-income8% volatility target portfolio

The above chart reflects the historical performance from 1/1/1997 to 12/31/11 of a risk-budgeted portfolio which has been optimized to achieve an 8% risk budget versus a traditional portfolio of equities and fixed-income where equities are represented by MSCI World Index and fixed-income is represented by Barclays Global Aggregate Bond Index. The 2007 callout is intended to provide an extreme example of how allocations can change when managing actively to a specific target. The illustration is hypothetical and being shown for illustrative purposes only. Although these asset classes have displayed these characteristics historically, there is no guarantee that they will continue to in the future.For a complete list of indices represented and their allocation in the represented portfolio see handout or slide 32.



0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

$400,000

01/97 01/98 01/99 01/00 01/01 01/02 01/03 01/04 01/05 01/06 01/07 01/08 01/09 01/10 01/11

60/40 equities/fixed-income8% volatility target portfolio: active rebalance

2/1/07

The above chart reflects the historical performance from 1/1/1997 to 12/31/11 of a risk-budgeted portfolio which has been optimized to achieve an 8% risk budget versus a traditional portfolio of equities and fixed-income where equities are represented by MSCI World and fixed-income is represented by Barclays Global Aggregate Bond Index. The 2007 callout is intended to provide an extreme example of how allocations can change when managing actively to a specific target. The illustration is hypothetical and being shown for illustrative purposes only. Although these asset classes have displayed these characteristics historically, there is no guarantee that they will continue to in the future.For a complete list of indices represented and their allocation in the represented portfolio see handout or slide 32.



0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

01/97 01/98 01/99 01/00 01/01 01/02 01/03 01/04 01/05 01/06 01/07 01/08 01/09 01/10 01/11

60/40 equities/fixed-income8% volatility target portfolio: active rebalance

12/3/07

2/1/07

The above chart reflects the historical performance from 1/1/1997 to 12/31/11 of a risk-budgeted portfolio which has been optimized to achieve an 8% risk budget versus a traditional portfolio of equities and fixed-income where equities are represented by MSCI World and fixed-income is represented by Barclays Global Aggregate Bond Index. The 2007 callout is intended to provide an extreme example of how allocations can change when managing actively to a specific target. The illustration is hypothetical and being shown for illustrative purposes only. Although these asset classes have displayed these characteristics historically, there is no guarantee that they will continue to in the future.For a complete list of indices represented and their allocation in the represented portfolio see handout or slide 32.

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Comparison with traditional portfolio

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For illustrative purposes only. Risk and return levels will vary significantly depending on asset allocation mix. Please see appendix for portfolio methodologies. Past performance is no guarantee of future results. Performance reflects the reinvestment of capital gains and dividends, if any. Indices are unmanaged and do not incur fees. It is not possible to invest in an index.


January 1997 – December 2011

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6

8

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Performance vs. Risk

4 5 6 7 8 11 12

Total annualized standard deviation, %

Tota

l ann

ualiz

ed r

etur

n, %

7

3

4

9 10

8% Budget Portfolio

60/40 MSCI World/Global Agg.

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Comparison with traditional portfolio

• 60% stocks/40% bonds portfolio 15-year averages:– Average annual standard deviation: 11% - volatility range for this portfolio

has been 3% - 24%– Average annual return: 5%

• 8% portfolio targeted and managed: Matches standard deviation but achieves far more efficiency– Average annual standard deviation: 8% – Average annual return: 8%– Volatility range is 3% – 13%


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Summary


• Start with risk: Specify how much and what variety‒ A far more stable and predictable input

‒ A key determinant of investment returns

‒ The variable investors are most sensitive to

• Make your allocation decisions on the basis of the whole rather than the parts‒ Diversification benefit ought to be maximized

‒ Correlation between assets alters their risk profile in portfolio terms

‒ Think function not form when considering assets for the portfolio

• Manage Risk: Take corrective action when the situation changes‒ Steady the part of the formula that elicits the greatest emotion

‒ How long will it take before the market (your portfolio) reverts to the norm

‒ Do clients have the staying power as they await mean reversion

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Appendix – Static 8% Risk Budget Portfolio

Asset Class Represented Index Allocation

Managed Futures DJ Credit Suisse Managed Futures USD 8.40%

Hedge Funds HFRI Fund of Funds Composite 8.4080% CBOE S&P 500 BuyWrite / 20% "Inverse" CBOE S&P 500 PutWrite 8.40

Precious Metal S&P GSCI Precious Metal TR 8.40

Global Gov't/Credit Citi WGBI NonUSD USD 8.40Barclays Global High Yield TR USD 8.40Barclays Global Aggregate TR USD 8.40

Emerging Markets Debt BofA ML USD Emerging Markets Sovereign Plus 10.30

Global Real Estate S&P Global REIT TR USD 10.30

Global Small Cap Equities MSCI World SMID NR USD 10.30

Emerging Markets Equities MSCI EM USD 10.30

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Appendix – Active 8% Risk Budget Portfolio

Asset Class Represented Index

Managed Futures DJ Credit Suisse Managed Futures USD

Hedge Funds HFRI Fund of Funds CompositeCBOE S&P 500 BuyWrite "Inverse" CBOE S&P 500 PutWrite

Commodities S&P GSCI Precious Metal TRS&P GSCI Energy TR

Global Gov't/Credit Barclays Global Aggregate TR USDCiti WGBI NonUSD USD

Emerging Markets Debt BofA ML USD Emerging Markets Sovereign Plus

Global Real Estate S&P Global REIT TR USD

Emerging Markets Equities MSCI EM USD

Equities MSCI World ex USAS&P 500 TR USDMSCI World SMID NR USD

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Appendix – Index performance

Annualized PerformanceAs of Quarter End December 31, 2011 (Ann. Return, %)

QTD YTD 1 Year 3 Year 5 Year 10 Year 15 Year Since Incep Time PeriodMSCI World NR USD 7.59 -5.54 -5.54 11.13 -2.37 3.62 4.2 8.39 1/70 - 12/11MSCI World SMID NR USD 7.52 -8.4 -8.4 16.63 -1.16 7.35 6.18 6.44 6/94 - 12/11Developed ex-US Eqty 3.57 -11.78 -11.78 9.06 -3.62 5.6 4.19 9.64 1/70 - 12/11MSCI EM USD 4.45 -18.17 -18.17 20.42 2.7 14.2 7.13 12.5 1/88 - 12/11S&P GSCI Energy TR 13.37 4.86 4.86 5.92 -4.29 6.21 3.19 8.57 1/83 - 12/11S&P Global REIT TR USD 9.57 1.7 1.7 18.84 -3.9 9.68 8.52 9.94 1/95 - 12/11BofA ML USD Emerging Markets Sovereign Plus 4.79 8.15 8.15 15.68 8.14 11.5 10.21 11.97 1/92 - 12/1180% CBOE S&P 500 BuyWrite / 20% "Inverse" CBOE S&P 500 PutWrite 9.61 3.53 3.53 6.78 0.57 2.31 3.81 5.32 7/86 - 12/11S&P GSCI Precious Metal TR -4.06 6.63 6.63 21.49 18.18 18.11 10.79 8.04 1/73 - 12/11Barclays Global Aggregate TR USD 0.23 5.64 5.64 6.04 6.46 7.16 5.83 7.14 2/90 - 12/11Citi WGBI NonUSD USD -0.48 5.17 5.17 4.92 7.23 8.36 5.54 9.41 1/85 - 12/11HFRI Fund of Funds Composite -0.47 -5.72 -5.72 3.56 -0.76 3.25 4.91 7.4 1/90 - 12/11Barclays Global High Yield TR USD 0.23 5.64 5.64 6.04 6.46 7.16 5.83 7.14 2/90 - 12/11DJ Credit Suisse Mnaged Futures USD -4.14 -4.19 -4.19 0.15 4.73 6.89 6.16 6.02 2/94 - 12/11S&P 500 TR USD 11.82 2.11 2.11 14.11 -0.25 2.92 5.45 10.02 2/70 - 12/11

Annualized PerformanceAs of Quarter End March 30, 2012 (Ann. Return, %)

QTD YTD 1 Year 3 Year 5 Year 10 Year 15 Year Since Incep Time PeriodMSCI World NR USD 11.56 11.56 0.56 20.24 -0.7 4.72 4.94 8.62 1/70 - 3/12MSCI World SMID NR USD 12.9 12.9 -2.41 26.04 0.25 8.24 7.32 7.07 6/94 - 3/12Developed ex-US Eqty 10.5 10.5 -6.19 18.13 -2.46 6.6 4.99 9.84 1/70 - 3/12MSCI EM USD 14.14 14.14 -8.52 25.42 4.97 14.47 7.5 12.98 1/88 - 3/12S&P GSCI Energy TR 7.32 7.32 -2.47 14.35 -4.3 4.59 5.02 8.76 1/83 - 3/12S&P Global REIT TR USD 10.99 10.99 6.93 35.58 -2.98 10 9.24 10.46 1/95 - 3/12BofA ML USD Emerging Markets Sovereign Plus 4.55 4.55 12.1 16.15 8.57 11.39 10.44 12.06 1/92 - 3/1280% CBOE S&P 500 BuyWrite / 20% "Inverse" CBOE S&P 500 PutWrite 2.91 2.91 5.71 8.58 1.05 2.41 3.85 5.38 7/86 - 3/12S&P GSCI Precious Metal TR 7.67 7.67 10 22.45 18.96 18.07 11.55 8.19 1/73 - 3/12Barclays Global Aggregate TR USD 0.87 0.87 5.26 7.52 6.38 7.34 6.11 7.09 2/90 - 3/12Citi WGBI NonUSD USD -0.22 -0.22 3.93 6.93 6.95 8.54 5.94 9.31 1/85 - 3/12HFRI Fund of Funds Composite 3.38 3.38 -3.39 4.59 -0.71 3.49 4.84 7.48 1/90 - 3/12Barclays Global High Yield TR USD 0.87 0.87 5.26 7.52 6.38 7.34 6.11 7.09 2/90 - 3/12DJ Credit Suisse Mnaged Futures USD -0.67 -0.67 -3.82 0.9 5.6 7.31 5.87 5.89 2/94 - 3/12S&P 500 TR USD 12.59 12.59 8.54 23.42 2.01 4.12 6.1 10.27 2/70 - 3/12

Questions & answers

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All investment strategies involve risk including loss of principal. This presentation is not meant as investment advice. Reference to specific securities or industries should not be considered recommendations or advice for individual investors. There is no assurance that any predictions or projections will occur. This material is dated as indicated, and opinions and viewpoints may change as economic conditions change.

This material should not be considered a solicitation to buy or an offer to sell any product or service to any person in any jurisdiction where such activity would be unlawful.

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putting risk to work - amazon web services · 2017-03-13 · liquidity risk geopolitical/currency...

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