Managing risk within an investment portfolio is never straightforward but uncertain market conditions make the process all the more challenging. Brian Tora highlights key considerations to ensure that portfolios remain efficient as well as fit for purpose
These are difficult times for investors. Uncertainties abound. While the shakeout in share prices last year has left equity valuations looking less demanding, upsets from a number of different directions could yet see shares being dumped, while the ending of a decade or so of cheap money as central banks rein in their efforts to stave off the recessionary effects of the financial crisis could undermine bond values. Even so-called alternative investments have failed to shine. Portfolio construction has never seemed harder.
Risk On Or Risk Off?
You will often see the terms “risk on” or “risk off” used in reports on how the stock market is behaving. Essentially it is simply a description of the nature of activity amongst investors. A sharp rise in the share index may well encourage commentators to say that a risk on approach has returned, just as a slide in values could be termed as the return of risk off attitudes amongst investors. Risk is the operative word. In the end it is an investor’s appetite for risk that will govern the strategy adopted.
Managing risk is a core principle for investment fund and portfolio managers alike. While the tools available to limit or measure risk in a portfolio have increased exponentially over the years, in many ways the basic approach has remained much the same since investment developed as a professional skill back in the middle of the last century. Two words exist at the heart of risk management – time and diversification. Time, because the shorter the time horizon, the higher the risk profile. Diversification, because whether within an asset class or in a portfolio encompassing a multitude of assets, the wider the spread, the lower the risk.
Taking a single asset class such as equities, a concentrated portfolio might be said to deliver alpha in terms of potential return, but it will also contain a higher degree of risk. These days a passive approach could be said to deliver the ultimate opportunity to diversify, with most indices now having some form of tracking vehicle available. Moreover, these are usually the cheapest option and advisers and investors should never forget that costs are a tax on performance or that, on balance, more active funds underperform the index than beat it.
And in a portfolio it is possible to include a wide variety of asset classes that could well have differing dynamics in terms of what will drive performance. Once upon a time, cash, bonds and shares were the only options. Today property, infrastructure, private equity and commodities can be easily added to the mix, while the ability to subdivide broad asset classes, such as equities and bonds, into geographic, industrial and even financial strength categories allows a degree of diversification that would have been impossible when I started in the investment game. And many of these asset classes have passive options.
It happens that John Bogle, the architect of Vanguard, the world’s leading passive investment firm, died earlier this year. His remarks on investment in general are legend. In The Little Book of Common Sense Investing he wrote “Don’t look for the needle in the haystack, just buy the haystack”. Now that’s what I call diversification. He also once said that Index funds eliminate the risks of individual stocks, market sectors and manager selection. Only stock market risk remains. So how do you deal with market risk?
“Don’t look for the needle in the haystack, just buy the haystack” – John Bogle
Managing Market Risk
This is where time comes in. Several investment gurus have made the point that it is time spent invested in the stock market, rather than timing your entry or exit from this asset class that pays dividends in the long run. Indeed, John Bogle also stated that owning the stock market over the longer term is a winner’s game, but attempting to beat the market is a loser’s game. I am not advocating taking the passive approach for risk management, but the time issue is most important when it comes to risk management.
Some years ago I read a fascinating novel by Robert Harris. Called The Fear Index, it related the story of an academic who had turned hedge fund manager, using his skills to develop computer algorithms to manage money. I recommend it to those who are not nervous regarding the advance of Artificial Intelligence. The Fear Index really does exist. Officially called the CBoE Volatility Index, it is better known by its ticker – VIX.
The Vix Volatility Index
Visiting the website for CBoE you will find VIX promoted as a tool for managing risk, creating diversification and even generating income. Presently standing around 18, for much of the time it has existed its value has hovered around an average in the mid-teens, though in 2008 it spiked at nearly 33, only dropping marginally the following year and staying relatively high until 2013. It ended last year at an average of 16.7.
VIX can be a risk management tool, but for me it is more useful as an indicator on how risk on or risk off investors are behaving. When we are in a period of such uncertainty – Brexit, China/US trade wars, global economic slowing, the rise of populism, geopolitical stress points – managing risk becomes a common sense issue. Taking the long view and ensuring that portfolios are properly diversified makes good sense. We’ll emerge at the other end of this tunnel at some stage. We always have.
Brian Tora is a consultant to investment managers, JM Finn.