Deepening the Understanding of Intelligent Investment Risk
Managing investment risk can be much more complex than people realize. While most investors prefer to avoid as much risk as possible, some risk is needed to achieve higher returns. Many professional investment advisers now use highly sophisticated techniques to monitor and manage investment-related risks. While those techniques go well beyond what is available to most investors, the approach itself offers implications for everyone.
Understanding Risk and the Role of Benchmarks
Investment risk can be broadly defined as the potential to fall short of financial goals. For example, shorter-term fear of losing money drives many investment decisions, and over the long-term, no one wants to outlive their assets.
Targeting known universes of equities, bonds, or other investments offers several advantages for gauging risk. First, we know how universes of assets like the S&P 500 Index have behaved historically, which helps define expectations for the future. Although historical experience must be updated for changing conditions, realistic expectations are an essential first step in forming achievable financial goals.
Tracking a universe also helps ensure that underperforming investments do not derail otherwise solid plans. While it is becoming more common to invest some money in index funds or exchange-traded funds (ETFs) that “passively” replicate benchmarks, most investors still rely heavily on strategies that “actively” differ from their benchmark indices. Since all active strategies underperform at times, regular evaluation of performance helps identify problematic strategies before they undermine long-term goals.
If passive investments can guarantee performance that will closely mimic relevant benchmarks, then why risk any active exposures? Because we know that actively managed strategies can deliver better returns than the index or decline less during market downturns. Historic experience tells us that the rewards of effective active strategies can be well worth the risk of periodic underperformance.
Risk-Reward with Factor Exposures
Investors have long used sector and industry exposures to assess investment fund strategy for outperforming a benchmark. Sophisticated quantitative techniques now allow an even deeper evaluation of a strategy’s targeted exposures, by assessing how particular strategies reflect the economic (e.g., interest rates and inflation) and market (e.g., company quality or valuation) “factors” that have been found to drive market prices.
Knowing an investment’s factor exposures can help more precisely define the investment strategy that guides it. When a strategy underperforms its benchmark, that can help differentiate whether the disappointing performance stems from a sound strategy that is simply out of favor or from poor execution.
Unfortunately, factor evaluation of portfolios requires expensive software, which limits its use primarily to professional investment firms. The theory and application of those techniques, however, have implications for all investors.
First, even without sophisticated quantitative analysis, investors can explore how economic and market factors have historically affected specific strategies.
Do certain strategies underperform when interest rates rise or when inflation accelerates? Do they perform well when high-quality or low-valuation equities outperform? Certainly, such evaluations cannot be as precise as more-sophisticated techniques allow, but an improved understanding of a strategy’s risk exposures certainly helps to define both its potential and its role within a well-diversified portfolio.
Second, when an investment’s specific risk exposures can be identified, investors may be able to improve the balance of exposures.
As a simple example, suppose one manager targets deep-value, out-of-favor equities that perform well in the early stages of economic cycles, but typically lag toward the end of those cycles. That fund’s economic exposures might be balanced with a growth-oriented manager that typically performs well late in cycles. As long as each manager outperforms over the longer term, their combination should balance risks of economic and market cycles while still allowing a performance advantage for the overall portfolio. In addition to using complementary active strategies, factor-specific ETFs (e.g., MSCI Quality Factor ETF) and other targeted ETFs can also be considered for improving risk balance.
Finally, active management does not need to be an all-or-none decision. Professional fund managers often employ “risk budgets” that allow them to take attractive risks while still controlling total risk exposure. In a similar way, investing some money passively can control total risk but still allow the use of promising active strategies.
Some risks are unavoidable. The awareness of factor exposures, however, allows for an enhanced approach to risk management. By being more disciplined about short-term risk factors, the odds of achieving longer-term goals should be significantly improved.
About Bruce McCain, Ph.D., CFA®
Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com.