Given that we know what kinds of portfolio risks to be aware of and a way to quantify them here, we will proceed to the final piece of the risk management process, namely how to manage or mitigate some of these risks. It is important to appreciate that once a portfolio is created, risk can thereafter only be transformed into a different form (if we do not want to affect the return or liquidity profile)- which implies that portfolio risk reduction would almost always involve a compromise on some other metric, generally return or liquidity. For this note, we shall look at risk mitigation techniques used by portfolio managers, which will be more relevant to individual products or strategies. For an investor, however, the best form of risk mitigation would generally be diversification – across asset classes, products, and investment styles.
Some forms of risk management are built into the strategy or the investment process while for some others, this would be an overlay on top of the investment strategy. A portfolio manager would have to evaluate their risk management decisions using a broad framework:
- What risks do they control or exclude as part of the investment process
- What risks are they comfortable with and to what extent
- When portfolio risks go beyond allowable limits, what action needs to be taken
- When hedging, what is the most effective way of doing it
Market risk: Whether a portfolio is made of entirely equities, debt or real assets, all portfolios have some element of market risk to a large extent. In general, the best way to manage market risk is by the use of derivatives- the most commonly used ones being futures, options or swaps. For example, a portfolio of long equities can be hedged by selling futures for a broad market index or by purchasing puts on the index. Futures, being linear instruments, would reduce risk and return in an almost equal proportion, however, options being non-linear, have the potential to greatly reduce risk while not penalising returns proportionately. Similarly, a portfolio of longer-maturity debt securities could be hedged using an interest rate future while a portfolio of high-yield bonds could be hedged using a credit default swap. The market risk could also be mitigated by adding certain alternative strategies, if the mandate permits, such as trend following which could benefit from falling markets.
Liquidity risk: Depending on the nature and tenure of the investment product, managing the liquidity profile of investments is a key concern for portfolio managers. This is more relevant for open-ended structures as they need to account for flows regularly, while it is greatly reduced for closed-ended ones. Portfolio managers, therefore tend to align the liquidity profile of their underlying investments with the expected profile of the product/ investors. Liquidity risk is generally amplified during market crashes as buyers are scarce and there is a rush to sell, leaving portfolio managers with the unenviable choice of selling what they can, rather than what they want to. Managers would, therefore, also make a conscious choice of creating a liquidity buffer or a liquidity profile across their investments, such that at least some portion of the portfolio can be quickly exited to manage such extremes.
Currency risk: Whenever there are investments across various geographies, it becomes imperative for the manager to be cognizant of the impact of any currency movement concerning the target currency of returns. Generally, a manager might hedge any realised cross-currency gains periodically (monthly or quarterly) while unrealised gains could be hedged using a currency derivative. In certain cases, currency risks can also be hedged using sovereign credit default swaps, if available.
Concentration risk: This is generally imposed as a constraint on the investment process or sometimes added on top of the investment process. Concentration could be at the security, issuer, style, asset class or country level and depending on the original mandate, some of these might have to be constrained. E.g., in a multi-asset portfolio, the maximum weight for a risk asset such as emerging market equities or high-yield debt might be pre-defined and this serves as a risk control measure in cases of unforeseen scenarios. Similarly in a broad market equity portfolio, the manager might want to limit the extent of overweight/underweight to individual sectors compared to those in the benchmark and also limit the maximum allocation to any single security.
Style risk: For portfolios where this is no defined mandate to adhere to a particular style or philosophy, the most common way to achieve this is to diversify across investment styles and philosophies. E.g., in a market-neutral fund the manager might run versions of various known risk factors such as quality, value, momentum etc and also add on a few other localised or asset-class specific factors to design a portfolio which is not dependent on one particular style outperforming the market.
Shock risk: Possibly one of the only ways to mitigate this is by buying out-of-the-money options on the underlying instruments or a broad market index. Since this is a risk with almost all listed assets, it can never be eliminated. However, as mentioned in our earlier note, certain strategies like options writing or short volatility are extremely sensitive to this, and therefore extreme risk protection (buying out of the money wings) is almost always built into the strategy process itself. Depending on the underlying strategy, buying only puts, calls, or both might be prudent.
An effective risk management process also needs constant monitoring of portfolio risks using multiple dashboards and screeners as well as a continuous evaluation of unknown scenarios and trying to model these in the best way possible. Risk management is best achieved with a healthy mix of hindsight and foresight, and it is one of the most essential parts of any investment process.