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“Risk” and Multi-Asset Portfolios: Volatility Is Just the Beginning

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“Risk” and Multi-Asset Portfolios: Volatility Is Just the Beginning FQ INSIGHT: Bond “Risk” and Multi-Asset Portfolios: Volatility is Just the Beginning May 2017 ED PETERS Partner, Investments better tied to inflation and monetary policy. Yet in a multi-asset portfolio (MAP), fundamental terms “DYING IS TOUGH, BUT NOT AS TOUGH are absent, particularly in multi-asset styles like AS COMEDY.” risk parity, where balancing statistical risk is - EDMUND KEAN the primary focus. In this paper, we address this disconnect and proffer a better way of looking at the role of bonds in a multi-asset context. These purported last words of the 19th To understand this, we discuss: century Shakespearean actor Edmund • Statistical risks for stocks vs. bonds in a Kean well describe a similar challenge MPT framework multi-asset managers face today. • Interest rate risk factors as defined in the bond risk literature, leading to the concept As we see it, “Defining equity risk of “utility” or “usefulness” as a measure is tough, but not as tough as defining of the risk/return tradeoff for bonds bond risk.” Many people see bonds as • The implications for MAPs, especially straightforward defensive assets used those that rely on volatility as a measure of downside risk for income and diversification – but, like comedy, defining bond risk is not Two Kinds of Risk: Statistical vs. as easy as you might think. Fundamental Modern Portfolio Theory (MPT) ties risk to Statistical Risks: The Multi-Asset Manager’s View statistics – that is, standard deviation, correlation Statistical measures of risk are now widely used in and tail risk. That may be fine for equities and portfolio management, with even managers who do most other “risk assets,” but it does not work not view themselves as “quants” using quantitative for bonds.¹ Instead, these statistical risks are, at techniques. Their use has been legislated, as in best, an incomplete view of bond risk. the European Union’s use of value at risk (VAR). Unlike stocks and other risk assets whose Our earlier research about risky assets (see text downside risk increases dramatically when their box on the next page) has shown that statistics volatility rises², bonds tend to experience higher are useful for suggesting the downside risk of FQ INSIGHT FQ average returns and less downside risk with an stocks and other traditional growth assets such 1 increase in bond standard deviation (volatility). as commodities and high yield bonds. In fact, bond managers rarely discuss statistical However, we have also shown that statistical risks when describing portfolio risk. Instead, measures of risk for bonds, unlike for “risky” discussions turn to fundamental risks, which are assets, tend to vary little over time.³ That’s a Past performance is no guarantee of future results. Potential for profit is accompanied by possibility of loss. FIRSTQUADRANT.COM FQ Insight: Bond “Risk” and Multi-Asset Portfolios: Volatility is Just the Beginning The behavior of risky assets in • Risk changes over the market different market states cycle, and periods of high and low Our earlier research has shown that markets uncertainty typically last for years. for risky assets have two states —high • “Tail risk,” the chance of extreme uncertainty and low uncertainty. The VIX, and events, happens much more frequently whether it’s above or below its long-term than a random process suggests. median, is the best-known indicator of which • “Tail events” tend to happen in state applies. However, other indicators, such the high-uncertainty state when as widening and narrowing credit spreads, can markets are fragile. also capture states of high or low uncertainty. • Diversification can fail just when History suggests the following lessons you need it the most. When tail about risky assets: events happen, correlations within • Increased volatility is accompanied asset classes like equities rise to by lower returns on average, while high levels, basically eliminating lower volatility typically means diversification benefits. higher returns on average. problem if you’re constructing multi-asset Let’s look at these four factors. portfolios using a covariance matrix that • Short-term interest rates are a measure combines standard deviation and correlations of current central bank policy. to measure diversification. Current methodology • Slope is the yield spread between short- defines risk for all assets in a multi-asset and long-term bonds, typically between portfolio in the same manner as equity risk. maturities of two and 10 years. Our previous studies have shown that bond • Curvature is typically defined as the risk and return, however, are only marginally difference between the 10-year yield affected by these same measures. Since we can and the average of the two- and 30-year be fairly certain that bonds do indeed have bull maturities. and bear markets, we need to look elsewhere • Term premium is the extra yield for an explanation. demanded by investors to hold longer- maturity bonds instead of rolling over Fundamental Risks: The Bond Manager’s View nearer-term debt. It is more difficult to In the last few years, there has been much digital measure than the other three factors ink spilled over risk factors. Interest rate risk discussed here. is one of the more prominent risk factors and These four factors share key characteristics is loosely described as an asset’s downside which we can examine for insights into changes sensitivity to rising interest rates. But what in the yield curve since they reflect inflation causes interest rates to rise? expectations and central bank policy. Interest rate risk for bonds can be examined Each measure reflects a different piece of FQ INSIGHT FQ by looking at short-term yields, the slope of the the yield curve. We have already investigated 2 yield curve, curvature and the term premium. the impact of changes in short-term interest rate These factors have been identified by Litterman targets set by the central banks in previous First and Scheinkman’s classic 1991 bond risk paper4 Quadrant work such as “Risk Cascades”, (2015)6. and Adrian et al.’s 2014 paper5. That research had already confirmed the effect of FIRSTQUADRANT.COM FQ Insight: Bond “Risk” and Multi-Asset Portfolios: Volatility is Just the Beginning short rates in a MAP framework, so we will focus investors may buy bonds individually for income, on the remaining factors. this is not true for buyers of multi-asset portfolios. By looking at the change in each factor, we can Saying that a MAP manager buys high-yielding see whether long-term inflation expectations are assets for income is disingenuous though current actually changing or whether it is instead near- yields are an important component of bond risk. term uncertainty tied to central bank activity or Given the three functions that bonds perform, political issues. When all factors point in one when are bonds useful? Or in quant-speak, when direction, risk is a long-term rather than near- do bonds have the highest utility? term phenomenon. And it is long-term risks that As shown in previous work, risky assets go cause bear markets. through periods of high and low uncertainty This view contrasts with the statistical view of as measured using the VIX or credit spreads. risk used by most MAP managers (see Table 01 for Because risky assets have growth as their a comparison). We believe that it would be useful primary function, we saw empirically that risky to combine the two perspectives. But first, we assets like stocks have high returns and low must understand the role that bonds play in MAPs. volatility during periods of low uncertainty – and low returns and high volatility in periods TABLE 01: BOND RISK: TRADITIONAL MAP of high uncertainty. It would follow that for a MANAGER VS. BOND MANAGER strategic asset allocation, stocks have more usefulness, or higher utility, in periods of lower Bond Risk MAP Bond Manager rather than higher uncertainty. That does not Source Volatility Inflation mean that you cannot have positive returns from equities in high uncertainty periods; however, Monetary Policy those positive returns are more tactical, or Measures Variance Interest Rate Levels short term, in nature than strategic or longer Correlation Slope term. Thus, defining utility for stocks is fairly straightforward: low uncertainty means high Tail Risk Curvature utility and vice versa for high uncertainty. Term Premium For bonds, however, defining utility is “tough.” “Risk Cascades”, (2015)7 showed that bond risk The Role of Bonds in MAPs and return do not appear to be tied to these statistical measures of uncertainty. Since a MAP Do Your Job: Usefulness and Utility does not invest in bonds for growth, but rather MAPs use multiple asset classes for a reason: for diversification, tail-risk hedging and deflation each asset has a job or function, such as growth, hedging, it might be more useful to examine how diversification or inflation/deflation protection. bonds do their job in these periods of high and In fact, most assets have multiple functions. low uncertainty than simplistically looking at Inflation-linked bonds, for instance, are tied to their volatility. both interest rate risk and hedging nominal bonds against inflation risk, as well as diversifying the Bond Utility in Two Market States growth assets. Looking at the different jobs First, we will examine the diversification and bonds have in the portfolio may help determine tail-risk hedging effectiveness in the two states. FQ INSIGHT FQ how we should measure risk. In Table 02, we used daily returns of the MSCI 3 Sovereign bonds serve three basic functions US equity price index and the return of the US in a MAP: (1) diversifying risk assets, (2) indirect 10-year T-Note from 1/1/88 to 12/31/16, and tail-risk hedging of risk assets, and (3) deflation disaggregated the returns of bonds into price hedging.
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