Risk versus performance... The risk of a portfolio or investment is often contrasted with its performance. Either you have low risk and low performance, or you accept higher risk in the hope of higher performance. For most managers, risk is a constraint that limits portfolio performance. But this is not necessarily the case.
The importance of risk management
Risk management is an essential component of portfolio management, the aim of which is to optimize the risk/return trade-off and preserve capital in real terms (above inflation). To make money, you have to avoid losing money in the first place. To recoup a 50% decline, you need to grow by 100%, for example...
Many investors and managers talk about the performance they've achieved (especially when it's good), but very few communicate about the risk taken to achieve it. What's more, the performance and risk levels of profiled portfolios are highly volatile. Yet neither portfolio risk nor performance should be so dependent on the market environment.
But we can go further: risk management should become a source of performance rather than a hindrance. When you invest, you can't control the performance you're going to get, but you can control the risk and your behavioral biases.
Limiting emotional biases
According to Benjamin Graham, "the investor's main problem and even his worst enemy is probably himself". This is absolutely the case. We must therefore keep our emotions to a minimum when managing our portfolios, focusing on the objective of optimizing the risk/return trade-off and seeking to maximize performance within a defined risk constraint.
We need to think outside the box, broaden our investment universe, have no other constraints than risk management, and be totally pragmatic.
Developing quantitative models
Quantitative models undoubtedly reduce emotional bias. They can be used for fund analysis and selection, for portfolio construction and fund combination (with constrained optimizations), or for determining exposure to a risky asset.
To limit emotional bias, we can, for example, follow trend-following models based either on indicators or on negative deviation (the standard deviation of negative performance).
This distinguishes between positive and negative trend phases. If you invest only when the trend is positive, you reduce risk while increasing performance; the risk/return ratio is truly improved.
This approach works particularly well on credit, and High Yield bonds in particular.
Simulation of the strategy on the Bloomberg Pan-European High Yield in EUR index (investment in this index only when the Negative Deviation is less than 1%) shows a performance of 6.3% per annum since 2000, with a Max Drawdown of -2.5% and volatility of less than 2%. Over the same period, the Bloomberg Pan-European High Yield index has delivered an annual performance of 5.6%, but with a Max Drawdown of -40.1% and a volatility of 5.9%.
Here, too, we succeeded in significantly reducing risk but also increasing performance, thus improving the risk/return trade-off.
Of course, this model works even better when we add the Alpha of the managers by selecting and combining very good High Yield funds. Performance can increase significantly, while risk remains very low.
Qualitative diversification and alternative management
Diversification is a good way of reducing portfolio risk, provided that the underlying assets are not highly correlated, even during periods of market stress. However, all risky asset classes are fairly correlated on average, and their correlation increases during phases of sharp equity correction. Since last year, we have seen a re-correlation of equities and bonds.
To achieve good qualitative diversification and reduce portfolio risk without reducing expected returns, absolute return strategies should be favoured, including the flexible credit strategy described above.
For example, with a portfolio composed of 20 funds with an average correlation of 0.05, we can eliminate more than 2/3 of the risk thanks to this qualitative diversification. Of course, the performance of the selection will be the weighted performance of the 20 strategies.
Hedging to reduce uncertainty
Derivatives are generally considered risky, and they can be, not least because of their leverage. However, using derivatives for hedging purposes can be a good way of managing portfolio risk and limiting its downside. For example, to hedge equity risk, you can buy put options on the S&P 500 index (the leading market, highly liquid and one of the most expensive) or on another index.
Today, these insurance premiums are relatively inexpensive, thanks to low volatility and relatively high interest rates.
Conclusion
It is extremely difficult to make forecasts on the macro, on the performance of equities and other asset classes, on the level of interest rates, currencies and commodities. Feeling" management has its limits, and traditional profiled management has shown its weaknesses in 2022.
It's better to concentrate on what we can and must master: risk management, in particular through quantitative strategies that eliminate emotional bias. This can be a very good source of performance, optimizing the risk/return trade-off and ensuring a relatively stable level of risk and performance for everyone's peace of mind.
