The Curious Case of Risk Exposures in Diversified Portfolios

October 30, 2015 |
4 minute read
|

Our research at Commonfund has found that a 70/30 stock/bond portfolio  has north of 99 percent of its risk, as measured by standard deviation, allocated to equities. Thus, portfolio risk typically is not broadly diversified across equities and fixed income, but rather, highly concentrated in one exposure: equities.

Does a more diversified portfolio, such as a typical endowment portfolio, do a better job of balancing risk?

For our representative diversified portfolio, we use the 2014 NACUBO-Commonfund Study of Endowments (NCSE) portfolio. This study includes 832 U.S. educational institutions (public and private), representing $516 billion in assets, making it broadly representative of the endowment universe. This diversified NCSE portfolio adds real assets and hedge funds to the traditional, domestic focused 70/30 portfolio. The proportions are 51% global equity, 13% fixed income, 13% real assets and 23% hedge funds. 
Allocation ≠ Risk Contribution

QC-CH1-RiskExposures
Exhibit 1 (above) shows the return and risk statistics for the asset class constituents of the NCSE portfolio. Also illustrated are the correlations of each asset class with the NCSE portfolio. Statistics of the traditional 70/30 portfolio are provided alongside for reference.
For the diversified NCSE portfolio, the dollar allocation to asset classes misrepresents the risk allocation in the portfolio. Relatively similar percentage dollar allocations to Fixed Income (13%) and Real Assets (13%) translate into considerably different percentage risk contributions: less than 1 percent from fixed income and over 18 percent from real assets. Percentage contributions to portfolio risk by asset class can be calculated using the x-sigma-rho framework coined by Jose Menchero and Ben Davis.   The drivers of this mismatch are the asset classes’ differences in volatility and correlation with the total portfolio. Fixed income and hedge funds have low levels of volatility (3- 7%) compared to equities and real assets (16-18%). Also, fixed income has a low correlation with the total portfolio (less than 10%) when compared to equity, real assets and hedge funds (80-100%).

Compared to the 70/30 portfolio that has more than 99 percent of portfolio risk coming from equities, the NCSE portfolio looks better diversified since the contribution from equities is only about 70 percent. However, we show below that due to the high correlation among three of the constituent asset classes, the NCSE portfolio has equity “factor” risk well north of 70 percent.

A Factor Model – from Asset Classes to Factors

The relatively high correlation of equity, real assets and hedge funds to one another suggests the presence of one or more common underlying “factor” exposures. Perhaps unsurprisingly, the primary common exposure is equity itself but there are other shared exposures. We use a market factor model to identify the key drivers of risk for long term investors from amongst equity, duration (interest rate), credit, and commodity price risk.  This parsimonious set of factors captures most of the market risk embedded in typical diversified multi-asset class portfolios. Currency was evaluated as a factor, but it did not have statistical significance.

QC-CH2-RiskExposures
Exhibit 2 (above) shows the factor exposures in the NCSE portfolio from the perspective of contributions to risk. The contributions to risk in each row sum to 100 percent. This is as it should be: we are explaining all of the risk in each of the portfolios. Or are we? The second to last column in Exhibit 2 presents the idiosyncratic contribution to risk – the component of risk that is not explained by the factors we examined. Note that some of the individual asset class idiosyncratic risks look substantial, especially real assets and hedge funds. However, the asset class idiosyncratic risks diversify one another away. Thus, at the portfolio level, idiosyncratic risks are small (less than 10%) showing that this four factor model explains most of the factor risk.

Returning to the systematic factor exposures, there are a few additional key observations worth making. First, equity is evidently a broadly shared risk across asset classes. Equities, real assets and hedge funds all exhibit non-negligible contributions from equity risk. Second, real assets and hedge funds have the best diversified risk of the four asset classes with multiple factors contributing at least 10 percent.

Finally, based on the data, the NCSE portfolio exhibits better risk balance than the traditional 70/30 portfolio. The addition of hedge funds and real assets to the traditional 70/30 portfolio does improve diversification and reduce risk concentration. Yet the commonality of equity risk across asset classes means that equities still account for more than 85 percent of portfolio risk.

What is an Institutional Investor to do?

Our analysis finds that historically, diversified multi-asset class portfolios diversify risk better than traditional portfolios but still leave the portfolio with about 87 percent of its risk exposure in equities. Adding real assets and hedge funds to a traditional 70/30 portfolio reduces equity’s contribution to risk by about 12 percent. This is a valuable step in the right direction even if, from a factor exposure perspective, these portfolios still remain less diversified than we might wish.

Yet hope remains because investors have more levers to pull. They may achieve greater strategic diversification by increasing the role of active management, adding additional asset classes, directly sourcing factor exposures like carry or low volatility and by judiciously employing risk parity-style strategies.  In addition, investors may pursue tactical diversification by rebalancing risk exposures over time. This form of dynamic asset allocation involves reducing exposures to asset classes with rising volatility and increasing exposure to asset classes with falling volatility.

Readers interested in further details on this topic will find more information in our whitepaper “The Curious Case of Risk Exposures in Portfolios – A Deep Dive“.

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  1. 70% S&P 500, 30% Barclays US Aggregate
  2. The average NCSE portfolio allocations across all responding institutions are as follows: Equities 51% (15.7% U.S. Large Cap, 1.3% U.S. Small Cap, 12.2% Developed International, 6.8% Emerging markets, 11% Private Equity, 4% Venture Capital); Fixed Income 13% (6.7% Core Bonds, 2.3% Global Bonds, 4% short-term securities); Real Assets 13% (6% Private Real Estate, 6% Private Natural Resources, 1% Commodities); Hedge Funds 23% (12.6% Directional Hedge, 8.4% Relative Value, 2% Distressed Debt).
  3. Jose Menchero, Ben Davis (2011). Risk Contribution is Exposure Time Volatility Times Correlation: Decomposing Risk Using the X-Sigma-Rho Formula. The Journal of Portfolio Management, Vol. 37, No.2: pp. 97-106. Equity risk is represented by the MSCI ACWI equity total return index net of 3 month U.S. Treasury
  4. Equity risk is represented by the MSCI ACWI equity total return index net of 3 month U.S. Treasury bills, duration risk by the Bank of America Merrill Lynch US 7-10 yr Treasury note total return index net of 3 month U.S. Treasury bills, credit risk by the Barclays U.S. Aggregate Bond excluding U.S. Treasuries excess return index, and commodity risk by the S&P GSCI Spot Commodities index net of 3 month U.S. Treasury bills

 

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