the-number-four

Complex dynamics drive asset returns, but it is useful to distill these dynamics down to four primary sources of risk. Two of these risks affect all assets in the same way, and are therefore undiversifiable. The other two impact different kinds of assets in different ways.

Since some assets respond positively to changes in these risks while others react negatively, these latter two risks can be diversified away. In other words, investors who take the right steps to diversify can effectively eliminate half of the sources of risk in their portfolio.

Before investigating the four sources of risk, it’s important to understand that asset prices do not change in response to favourable or unfavourable environments. Rather, asset prices change when there’s a shift in investors’ expectations about a favourable or unfavourable environment.

Asset class behaviours

Most important things that happen in markets are driven by what happens at the asset class level. Figure 1, describes the major asset classes that matter to this discussion. The asset classes in Figure 1 can be divided into three fundamental groups: stock-like assets, which include all global equity markets and real estate; bond-like assets, including inflation-protected securities; and assets with no cash flows, such as commodities and gold. The nature of an asset’s cash flows dictate how it reacts to different types of shocks.

Cash is always king

All things being equal, investors prefer cash to risky investments because the value of cash does not fluctuate, and it is always readily available to facilitate consumption. In order to entice an investor out of cash and into an investment, the investor must believe the investment’s future cash flows will be larger than what he would otherwise earn on his cash.


With that in mind, let’s turn our attention to how four risks impact the price of investments by shocking investors’ expectations about future cash flows from investments versus future returns on cash itself. For simplicity, we also discuss risks as primarily affecting certain asset classes. While the forces we describe are important drivers of asset returns, it is easier to understand the four risks in isolation. Then, we’ll describe their interactions.

Diversifiable risk #1: growth risk

The prices of stock-like investments are primarily influenced by investors’ expectations about the size and timing of future cash flows and corporate earnings. In aggregate, corporate revenues are ultimately driven by economic growth, so stock prices are thus sensitive to changes in growth expectations. For instance, where investors observe a series of underwhelming economic data, they will reduce their expectations about future cash flows, and price stocks lower.

Diversifiable risk #2: inflation risk

The prices of bond-like investments, and hard assets like commodities and gold, are primarily impacted by changes in inflation expectations.

Inflation affects the rate of return, or interest rate, that investors require to hold cash rather than consume. If investors believe that prices will be much higher in the future, they have high incentives to consume today. As a result, they require higher interest rates to offset their rational desire for current consumption. All things being equal, high inflation means high interest rates, and the opposite is also true.

Bonds and hard assets are expected to react in opposite ways to changes in inflation expectations. Bonds react positively to negative inflation shocks, but fall in periods of unexpectedly high inflation. Bonds with inflation protection, commodities and gold should do relatively well during periods of unexpectedly high inflation. For this reason, they act as ballast to falling bond prices in the event of upside
inflation shocks.

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Chart 2: Saudi Arabian oil reserves

Growth and inflation risks can be diversified away

Figure 1 shows us that stocks and bonds only do well in certain economic environments. Specifically, portfolios of stocks and bonds thrive when growth is stronger than expected, and changes in inflation expectations are benign or decelerating.

Unfortunately, most portfolios are composed almost entirely of these two asset classes. Since the global economy can spend decades experiencing negative growth shocks and large inflation shocks in either direction, these traditional portfolios can struggle for long stretches of time during unfavourable regimes.

Figure 2, describes how a typical U.S. balanced portfolio (green in the chart) consisting of 60% stocks and 40% intermediate Treasury bonds would have fared during major economic environments over the past half-century. In the 1970s, both stocks and bonds struggled under a stagflationary regime. And, during the brutal bear markets of 1974, 1987, 2000 and 2008, there were extended periods of 20% to 30% losses, in some cases lasting several years. These episodes are symptomatic of inadequate portfolio diversification.

Sadly, investors in traditional portfolios endure unnecessary financial risk because they think too narrowly about diversification. A truly diversified portfolio would hold assets that are designed to thrive in a wide variety of economic environments, such as the entire universe described in Figure 1.

To maximize the diversification properties of all the assets, they must all contribute an equal amount of risk to the portfolio. That means holding less capital in riskier assets like stocks, and holding more capital in less risky assets like bonds. This is the concept of risk parity.

Notice in Figure 2 how this diversified approach produces steady returns in virtually all market environments, with lower volatility and relatively minor peak-to-trough losses. Many large global institutions have embraced risk parity products in the past few years for this reason.

Undiversifiable risk #1: policy risk

Consider a stock market index that is trading at $1,000. Assume that, at this price, the market is expected to produce a compound return of 7% over the next few years. Meanwhile, central banks have been communicating their intent for cash interest rates to remain below 5% for the foreseeable future. The current market price of $1,000 is reflecting that, at equilibrium, investors are prepared to accept stock market risk for at least a 2% premium return over cash.


Now imagine the central bank signals it is going to move its target for cash rates from 5% to 7% over the next few years. Critically, this move was not anticipated by the market, and stock market investors are now faced with a very different economic equation. They can invest in risky stocks and expect to earn 7%, but with a chance of extreme losses in the short and intermediate term. Alternatively, they can invest in safe cash and expect to earn 7% with essentially no risk of loss.

Investors were previously willing to accept a 2% premium for investing in stocks over cash. Now they are faced with a 0% premium. As such, they will reprice the market lower so that, if they were to purchase the market at the new price, they can expect to earn the same 2% excess return. This might require that the market should be priced at $980, or $950, representing a 2% or 5% loss respectively to current holders of the market index.

All assets respond to this type of shock by falling, which means that this type of risk cannot be diversified away, and there is no costless way to hedge it.

Undiversifiable risk #2: sentiment risk

Markets are simply the collective expression of all investors’ fears and hopes at a particular time. Sometimes investors are optimistic in aggregate, while at other times they are pessimistic. For instance, an investor fearful about economic uncertainty will require a larger potential return to entice them into a risky investment. Greedy investors will be willing to accept a high degree of risk for the chance of a small return.

A meaningful portion of changes in investor risk appetite stems from changes in expectations about growth and inflation. As a result, it is challenging to observe this type of risk in isolation. Moreover, when changes in risk appetite manifest independently of genuine, fundamental shifts in expectations about economic conditions, markets tend to normalize quickly. As a result, while this risk is real and can’t effectively be diversified away, the practical effects of it are likely to be relatively small.

Implementation

The first step in developing a more diversified portfolio is to expand one’s investment horizon to include all liquid global assets. Fortunately, Canadian investors have access to ETFs that track the majority of global asset classes. Next, it’s critical to engineer an asset allocation that effectively balances each asset’s risk contribution to the entire portfolio, taking into account the fact that some assets are more volatile or more correlated than others. The portfolio in Figure 3 is one potential tracking portfolio using Canadian-listed ETFs. Alternatively, there are a small number of mutual funds and a Canadian-listed ETF that run global risk parity mandates.

Setting expectations

Volatility is derived from four fundamental sources, as illustrated in Figure 4.

What does this all mean for investors? First, investors in diversified portfolios should expect to be compensated for accepting the risk of unanticipated shifts in expectations. That’s because this risk affects all assets in the same direction and cannot be diversified away. Indeed, history has rewarded investors who accept this risk with superior returns above cash. Since 1927, a simple risk parity portfolio has produced about 4.3% per year in excess returns above cash.

Second, investors should not expect to be compensated for taking risks that can be easily neutralized through better diversification. For an investor with neutral views on the future, a globally diversified portfolio almost always has a higher expected risk-adjusted return, with less exposure to major economic risks, than any other more concentrated portfolio.


It’s important to realize that a risk parity portfolio will, by definition, underperform one or more asset classes at any given time. The period from 1995 to 2000 is an excellent example. The stock-heavy U.S. domestic 60/40 portfolio outperformed the more diversified risk parity portfolio by a wide margin. This was a period of persistent, large deflationary growth shocks, which were particularly favourable to U.S. stocks and bonds.

If we knew which assets would outperform ahead of time, there would be no need for diversification. As financial historian Peter Bernstein said, “Diversification is an explicit recognition of our ignorance” about the future. Investment strategists and portfolio managers have a poor track record of forecasting future investment regimes. The risk parity portfolio can work for investors who recognize that the future is cloudy, but want to ensure their wealth is protected against whatever the future might hold.

Adam Butler, CFA, CAIA, is chief executive officer of ReSolve Asset Management.


Originally published in Advisor's Edge Report

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