The explosive growth in investable indexes and ETF issuance allows for a truly diversified global portfolio, but the question remains, how does one create and maintain a disciplined investment strategy.
Passive versus Active. Passive strategies require an initial construction of an index and are therefore not truly passive. Are you going to weigh by market capitalization, economic growth, alternatives, and low volatility? How often are you going to rebalance back to your initial exposure? More importantly, are you comfortable with portfolio drawdowns when it can take many years to recover the capital value?
It is a strategic imperative that investors establish a risk management overlay that addresses portfolio risk. There are many definitions of risk; terminal risk (the risk of not having the capital at the time you need it) to volatility risk (can you comfortably maintain your portfolio allocation in times of severe market stress), being two key measures.
In addressing the control of risk, one’s portfolio management structure can focus on seven key issues as highlighted on the following risk management chart (for this example, an ETF-focused portfolio is highlighted).
Defined risk on each security. Think in terms of a trigger review price point on each security. Whether your investment style is fundamentally based or more quantitative, it can make sense to reduce or eliminate positions based on negative price action. In addition, this safety measure can be particularly useful when one wants to lock in profits for a security that has performed well and where you may have an emotional connection that is difficult to override.
Strategic Rebalance. For several years, technology-focused ETFs was a top-performing asset. Is this a position that you want to continue to hold or are there better opportunities? Designing a process that stress tests your view against either the economic outlook or a price-performance metric, strengthens your strategy. A periodic, disciplined, repeatable process can make a world of difference.
Currency Exposure. Investors can take a passive or active stance on currency exposure. Perhaps one wants Asian currency exposure but not U.S. dollar exposure? Over the past few years, more ETF issuers are addressing this question and offering either currency hedged or un-hedged ETFs. We expect to see more hedged ETFs in the future, allowing for comprehensive currency positioning.
Portfolio Risk Budget. What is your comfort level when experiencing portfolio drawdown? A risk budget attempts to quantify the amount of loss that you are prepared to accept within this comfort zone. For example, within a widely diversified portfolio, one might forecast potential losses of 12% on a twelve-month forward basis. Based on historical volatility and asset correlation one can map out a range of possible negative outcomes. Portfolios’ can be rebalanced when your analysis indicates a higher than anticipated level of risk
Look-Through Analysis. ETFs provide substantial transparency, less so for external active managers. Importantly, are you aware of intentional or unintentional sector weightings across your broad portfolio? For example, many large capitalization global indexes are heavily weighted in technology and you may be duplicating technology in other areas of your portfolio. As you fill in the overall portfolio with sector positions, be aware of the sector composition of your portfolio. A careful look-through of sector weightings is enormously beneficial.
Black Swan. Conceptually it is comfortable to contemplate adding securities to the portfolio that will reduce losses, in the event of a sudden, unexpected market drop. The difficulty comes in selecting portfolio additions that can be counted on to assist in a market correction (i.e., out-of-the-money put options) and that are not prohibitively expensive to hold in the portfolio on an ongoing basis. The evidence that products exist that can successfully hedge against Black Swan events, is mixed. Stay tuned.
Risk Parity. Volatility levels vary from one strategy to another. Small-capitalization / emerging market positions can experience greater volatility than large-capitalization securities. It is important to weigh each holding (or strategy) according to the dollar risk that you are prepared to take. In my experience, measuring historical volatility can act as a guide in the percentage allocation to each security. If desired, each holding can be weighted to expose one’s portfolio to a similar degree of dollar risk per asset class, thereby attaining forecasted Risk Parity.
The application of a rules-based strategy should allow for greater comfort in designing and implementing your portfolio.
Tim Morton
Tim Morton, CFA is a recently retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com
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