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Managing portfolio risk

Risk factors

Many traditional asset allocation strategies seek to manage the overall portfolio volatility by investing in various asset classes. These asset classes have low dependency on one another and tend not to move in the same direction at the same time. However, the correlations between different asset classes are actually less stable than many investors realise.

Long-term trends, such as globalisation, are driving the correlation as the inter-dependency of the global economy grows. This was illustrated in the midst of the 2008-2009 financial crisis where seemingly disparate asset classes were moving in tandem. These high level correlations have led many investors to question traditional models.

As investors search for higher returns in the current low yield environment, they need to understand the specific factors that can influence the value of their portfolios and how these factors can be managed to optimise their investment’s risk and return profile.

These factors refer to the components with independent risks that are individually rewarded by the market for their level of risk. These could be risks such as inflation, GDP growth, currency or liquidity. All asset classes can be broken down into these building blocks.

Types of risk

Risk factors that influence the performance of an asset class can be categorised into four major categories:

  • Country risk
  • Sectors risk
  • Style risk
  • Idiosyncratic risk.

Take the US equity market for example: its performance is influenced by the macroeconomic environment in the US and perhaps across the globe. Changes in factors such as GDP growth expectations, productivities or the regulatory framework would have an impact on the stocks’ performance. These are known as the “country risks” of investing in the US market.

Share prices are also likely to be subject to changes in broad sector sentiment. Factors such as the size, valuation and trend of the stock would determine which investment styles would be associated with the stocks which typically lead to different pattern of returns. These are known as style risk.

There are also risk elements which are specific for individual companies, such as management experience or corporate events. These risk factors are known as idiosyncratic risk which are typically difficult to manage at the portfolio level.

Investing in fixed income assets would leave you exposed to other risk factors, such credit risk and interest rate risk. Credit risk refers to the possibility of the bond issuer (borrower of the money) to default on its promise to pay. Interest rate risk refers to changes in the bond’s value due to the changes in the base interest rate, this is used to price all the bonds (government and corporate) in the reference currency. You get extra returns from corporate bonds due to extra yield compared to government bond yields, more yield means more credit risk.


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Another significant source of risk to any multi-asset portfolio would be currency risk. If an investor has a portfolio of assets with large non-home based currency exposure, large fluctuations in the home currency’s exchange rates versus other currencies can significantly impact the performance of the overall portfolio. In fact, for most of the bond portfolios that are not currency-hedged, a large part of their performances are attributable to the currency performance rather than the underlying bond performance.

Building a risk appropriate investment portfolio

Breaking down portfolio risk into small, independent risk factors gives greater insight on how changes in the markets and macroeconomic conditions can contribute to the performance of the portfolio. It also shows investors how each risk can be managed efficiently to optimise the risk and return profile of their investments.

Thanks to financial product innovation and advanced risk management strategies, there are many ways for investors to “cherry pick” the risk factors that they believe would add value to their investment. In this way, investment strategies can become more targeted and express specific views of the investors on each risk factors, compared to what a basic equites and bond mix would offer.

At Moneyfarm we prefer to buy simple liquid products. We drill down to understand which “atoms” we are buying.

When we buy an ETF linked to an asset class, such as the MSCI World index (a global equity index), we look at the geographical exposure: here we have roughly 60% US, 8% Japan, 6% UK. In this instance we are skewing our equity mix towards the US. This also applies to currency risk.

Most of our sector allocation goes to cyclical sectors like financials (19%, the highest), information technology, consumer discretionary, with utility only 3% approximately. We are buying an equity product that is more sensitive to economic conditions than a product with equal weights among sectors.

Buying a diversified product like MSCI World index means we reduce idiosyncratic risks like corporate events.

Putting all these features together we can see in which scenarios buying a MSCI World makes sense. Currently, many investors are worried about a sudden rate hike in the US, but studying the atoms an increase of 0.50% in 1 year in Federal Reserve interest rates would generate an expected loss below 2%, this is very small compared to the current concerns.

Buying simple products, understanding the make-up of risk, diversification and long-term macroeconomic trends is the recipe we follow at Moneyfarm. Trying to outsmart the market in the short term is unlikely to deliver consistent returns. It’s like being in a casino placing all your chips on red, in the long run you will lose your money because the probability of getting zero is not zero, that’s why the casino always wins.

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As with all investing, your capital is at risk. The value of your portfolio with Moneyfarm can go down as well as up and you may get back less than you invest.