Rewarding risk

By Ioulia Tretiakova | December 22, 2008 | Last updated on December 22, 2008
5 min read

Portfolio and fund managers have short time horizons when investing. Their compensation promotes asset gathering and short-term performance. That means managers are paid for hot annual numbers, trade more frequently than is sometimes prudent, and subject clients to unnecessary costs. Managers will deny it, but they all try to “time markets,” a notoriously difficult and expensive pastime frowned upon by academics and knowledgeable investors.

These behaviours lead to three distinct problems.

Firstly, even as these managers move into and out of asset classes, global regions, market sectors, and industries to gain a short-term advantage over their competitors, they espouse long-term investing for advisors and unit holders.

Secondly, while clearly involved in market timing, they have shown little success at beating their benchmark indices in the short term and even less over the long term (

Finally, even those managers who do focus on the longer term tend to expose their clients to periods of high risk by rebalancing to a fixed asset mix.

While all three problems pose serious threats to a client’s portfolio, it is this third problem that we examine here since it is one variable an advisor can alter in order to improve portfolio results.

BEST ASSET ALLOCATION OFFERS DIVERSIFICATION Everybody knows the importance of asset allocation. Clearly, the best asset allocation is the one that provides the highest return, but that’s next to impossible to do consistently.

What can be done, however, is to hold a little bit of everything – diversify. This is strategic asset allocation and its main goal is to control risk rather than chase returns (a notoriously fruitless exercise).

Even with a solid approach towards strategic asset allocation, portfolio managers can put their clients at jeopardy. For example, an investor must decide between a 60/40 and a 70/30 equity to bond asset mix. Knowing that equities are more risky than bonds they will conclude that the 60/40 mix is more conservative. Investors try to target a particular risk level and assign weights to more aggressive asset classes correspondingly. But here comes the problem: the risk of asset classes themselves changes.

This is best seen through historical examples. For instance, at the beginning of the 1990s, an advisor could decide that a 60/40 of S&P 500 to bonds asset mix was right for their client (by running asset allocation software, going with a gut feeling or looking at a crystal ball, the method doesn’t matter). Knowing the benefits of rebalancing, the advisor would religiously rebalance to this fixed mix to ensure the portfolio matches the strategic asset mix. Eight years later the client would end up with a perfectly rebalanced portfolio of 60% equities to 40% bonds. The assumption is that the portfolio still has the same amount of risk as it had in the beginning of the 1990s – but it doesn’t.

In the sector composition chart of the S&P 500 Index (see Figure 1), the Technology Sector weight was 8.9% as of December 31, 1990. Eight years later, the technology weight was a whopping 28.2%. Given how risky the sector is, we intuitively feel that this increase in tech holdings would increase the overall risk level of S&P significantly. In other words, despite all the rebalancing, we have a significantly riskier portfolio than what we started with in the early 1990s.

This increase in risk is con- firmed by calculating the actual risk of the S&P 500 as measured by 252-day rolling standard deviation. At the beginning of 1990 the volatility was around 15%. As the technology weight ballooned, the overall S&P 500 volatility increased to 20%. Given the historical evidence, this example clearly illustrates one important fact – risk changes over time.

In order to control the downside, an advisor needs to control the asset mix over time. We are not suggesting chasing performance or timing the price changes of markets. But we do recommend adjusting the proportion of asset classes as they become more volatile whether in bull or bear markets. In other words, we advocate timing risk, rather than return.

One can do this because while risk changes over time, it is persistent. This means that if the markets were volatile in the previous month, they will likely be volatile in the following month and vice versa. One measure of persistence is autocorrelation. The autocorrelation for monthly volatility of the S&P 500 is around 60%; the autocorrelation for monthly returns is close to 0%. In other words, risk is persistent, return is not. The persistence of volatility is the raison d’être for the whole risk modelling industry.

USING RISK MODELS FOR ASSET ALLOCATION In practice, one should ideally employ asset allocation with the help of a regularly updated risk model, putting the overall portfolio risk in the context of each individual investor’s risk tolerance. Access to risk models is often not an option for many advisors. Alternatively, as a rule of thumb, one could look to the Chicago Board of Options Exchange Volatility Index (VIX®) which measures the implied volatility of S&P 500 index options. Persistently higher levels for this index may indicate rebalancing to a more conservative asset mix (perhaps a 5% equity weight reduction). Conversely, persistently lower levels may indicate a higher equity weight.

If, in the long term, risk equals return, then focusing on risk management today will pay off in robust returns in the future. More importantly, keeping the risk of a client’s portfolio consistent with their goals through good and bad markets just makes sense. The corollary benefit is that a constant risk portfolio will avoid the big swings in volatility that make clients crazy and prone to do things that you and they will regret later, like find a new advisor.





Ioulia Tretiakova is vice president, portfolio manager and director of Quantitative Strategies for PUR Investing Inc., an investment counselling firm specializing in ETF portfolio construction for advisors and their clients. She may be reached at

Ioulia Tretiakova