Make a portfolio with desired risk exposure

Investors holding portfolio containing traditional assets such as stocks and bonds typically find it difficult to contain losses during sharp asset price declines. One reason is that the asset allocation strategy does not explicitly consider risk contributed by each asset class to the total portfolio.

The question: Can investors consider an alternative allocation process to manage portfolio risk better?

This article explains the issues concerning traditional asset allocation. It then shows how risk allocation addresses these concerns and briefly discusses how to create portfolios based on desired risk exposure.

Asset allocation is the process of allocating money across various asset classes based on the investor's return objectives. A typical portfolio has 60 per cent allocation to stocks and 40 per cent allocation to bonds with a range of 10 percentage points. The advantage of having stocks and bonds inside one portfolio is that bonds are less volatile and reduce portfolio volatility.

A well-crafted asset allocation strategy should increase the likelihood of the investor reaching her desired investment objective at the target date.

There are, however, several issues with traditional asset allocation. For one, an equity exposure of 60 per cent in a stock-bond portfolio will most likely contribute to 80 per cent of the portfolio risk. The asset class exposure does not explicitly consider asset risk exposure.

Besides, the asset allocation process only implicitly considers the correlation of returns between asset classes — the relationship that the equity index has with the bond index, for instance. And such correlation structures breakdown during global meltdown such as the sub-prime crisis. The asset class relationships that are weaker during “normal market” conditions tend to become stronger during global crisis.

Referred to as correlation asymmetry, this change in correlation structure sometimes defeats the purpose of asset allocation. Investors concerned with issues surrounding traditional asset allocation can consider an alternative process called risk allocation. The risk allocation process is based on the risk contribution of each asset class to the total portfolio risk.

Asset class risk can be decomposed into systematic risk and active risk. Systematic risk is the result of passive portfolio exposure while active risk comes from active exposure. In a core-satellite portfolio framework, an investor takes passive exposure inside the core portfolio and active exposure inside the satellite portfolios.

Systematic risk comprises of broad equity market exposure and interest rate exposure. The former can be measured by the downside deviation in a broad equity index such as the S&P CNX 500 Index and the latter, the downside deviation in a government bond index such as the NSE Government Securities Index.

Suppose the investor requires 15 per cent return, only index returns below 15 per cent will be considered for measuring the downside deviation. The argument is that the investor faces risk only if actual return is below the required return.

Likewise, active risk is captured by the downside tracking error. This measures excess returns (actual returns less benchmark returns) below the required excess returns. Suppose an investor wants an excess return of 2 per cent, the actual excess return below 2 per cent will be considered for measuring downside tracking error.

The asset allocation is achieved using an optimisation function with inputs such as investor's desired total risk exposure, downside deviation of equity and bond indices and the downside tracking error.

More sophisticated allocation process uses copulas to moderate correlation asymmetry. The allocation process is sensitive to the risk contribution of the asset classes to the total portfolio risk.

Traditional asset allocation is based primarily on expected return. Risk allocation, on the other hand, is based on the investor's desired risk exposure. Importantly, rebalancing is based on the changes in correlation structure and volatility among asset classes. The emphasis is, hence, on risk and the need to optimise returns for the desired level of portfolio risk.

A popular application of risk allocation strategy is the risk parity portfolio — the portfolio carries equal risk exposure to stocks and bonds.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at >enhancek@gmail.com )

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