Many investors became accustomed to earning attractive returns with hardly any risk from investing in money markets, but with interest rates now lingering near all-time lows, they have little choice but to take more risk to earn anything like an appealing yield. Diversified multi-asset portfolios can be interesting for such investors, but their strong aversion to losses may keep them from actually investing. Portfolio insurance strategies such as risk overlays can be used to successfully manage risk and limit losses, making them an attractive addition to multi-asset portfolios.
Interest rates in many developed countries are at all-time lows, leaving those investors who have been accustomed to parking their cash in money market instruments with a diet of meagre returns. These days, if investors still want to target returns comparable to those they earned in the past from money markets, they have little choice but to take more risk. Unfortunately, with risk comes not only the possibility of earning higher returns, but also of losing money, in particular in the short term.
It is not surprising that such investors would seek ways of taking risk with as much diversification as they can find in an attempt to maximise the returns they can earn from the smallest possible amount of (additional) risk. Accordingly, multi-asset funds are in demand. But diversification alone can hardly prevent investors from losing money in the short term. The 2008 crisis is a good example of multi-asset diversification breaking down and losses from riskier asset classes amplifying each other.
Next to diversification, investors should be open to the idea of adding a layer of risk control, or risk overlays. Risk overlays exist in many forms. Typically, their goal is to curb the portfolio’s total risk when this rises to above a pre-defined level and thus limit short-term losses, adding a level of portfolio insurance.
There is a downside: reducing portfolio risk can be expected to cap the long-term return in exchange for accepting smaller short-term losses. That would be the price to pay for short-term risk aversion.
In a recent paper, we showed that this need not be the case. Carefully crafted risk overlay strategies can successfully control risk and limit portfolio losses in the short term without sacrificing long-term returns. Better still, risk overlays should be able to increase long-term risk-adjusted returns when properly designed.
Risk overlay strategies should be designed to take advantage of the properties of returns and volatility of asset classes, namely that volatility is not constant, but actually moves in predictable patterns; that return distributions tend to include fat tails, i.e. more extreme events than what might be expected; and finally, that returns and volatility are often negatively correlated.
For equities, in particular, it has been known for long that volatility forms clusters, i.e. when volatility is low, it tends to stay low and when volatility is high, it tends to stay high. This makes volatility reasonably predictable and can help explain the success of risk forecasting. Equity volatility can be kept constant in a portfolio by increasing the weight of equities when volatility decreases and decreasing the allocation to equities when volatility increases. There is another benefit: equity returns and volatility tend to be negatively correlated. Thus, managing volatility leads to a higher exposure to equities when they offer the highest risk-adjusted returns, in low-volatility regimes, and a lower exposure when they offer the lowest risk-adjusted returns, in high-volatility regimes.
The impact of extreme events, which is typically larger in high-volatility regimes, can also be smoothed by adjusting the exposure to equities in this way. As shown in the paper, the rebalancing of the equity exposure can pay off when done sporadically, i.e. only when volatility increases or decreases significantly. This is typically how risk overlays operate.
Looking at the distribution of the returns of other asset classes, we have found that higher levels of volatility clustering, fatter tails and a negative correlation between returns and volatility are features of riskier asset classes such as high-yield bonds or commodities. They are not prevalent in lower risk asset classes such as corporate investment-grade bonds and government bonds.
That means that risk overlays are likely to be more successful when they control for risk via leveraging and deleveraging riskier asset classes than for government bonds or investment-grade corporate bonds. Implementing risk overlays via trading in riskier asset classes will involve lower turnover to reach the risk control targets, and is thus also more efficient from an operational point of view.
In this world of low returns, investing in multi-asset funds with properly managed risk, using well-designed risk overlays, is in our view one of the best propositions for investors to consider as an alternative to money markets.[starbox id=raul.leotedecarvalho][starbox id=anton.wouters]