Fitch Ratings’ Aymeric Poizot and Richard Woodrow review challenges to risk budgets in multi-asset funds
Aymeric Poizot and Richard Woodrow at Fitch Ratings have analysed the performance of multi-asset funds relying on new risk budgeting techniques.
In recent years, and after the experiences of 2008, fund managers have implemented new techniques in multi-asset funds with the aim of minimizing drawdowns and maximising diversification. The most popular techniques are dynamic risk budgeting and risk parity.
They were challenged in 2013, as Fitch Ratings shows in its recent update on multi-asset funds. By contrast, funds that had more static asset allocations, with low exposure to duration and high exposure to equity and high yield, performed better. Whilst alternative allocation techniques continue to make a lot of sense (see Fitch’s special report “Rethinking Asset Allocation and Market Timing in Volatile Times”, October 2012 https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=693230), their calibration (eg. triggers or factors) remains a work in progress.
Dynamic risk budgeting involves adjusting the overall risk budget of a portfolio in a systematic manner. Typically, the adjustment is a function of the prevailing market risk, the fund’s cumulated performance and investors’ tolerance to volatility or drawdowns.
The chart below shows the recent performance of a sample of funds in Fitch’s peer group that employ dynamic risk budgeting techniques, and illustrates the difficulties faced in the second half of 2013. Funds A and B were not able to effectively de-risk and have not participated in the recovery either. Fund C was able to de-risk but performance lagged during the first part of the rebound. Fund D was the most effective at de-risking. The timing and magnitude of the risk reduction and re-risking has materially affected cumulative performance.
Risk parity is a type of risk budgeting technique used by funds, where each asset class is assigned an equal risk contribution within a portfolio. Funds managed in this way also suffered a poor 2013 – the average 2013 fund return in Fitch’s risk parity peer group was – 0.1%, compared with 5.1% for global flexible funds (where asset allocation is at the discretion of the manager.) The risk parity approach has suffered from rising rates but overall from increased asset class correlation. Incorporating the new correlation paradigm induced by central banks’ interventionism will be an important task for risk parity managers.
Many risk-based allocation models rely on market risk indicators, such as the VIX index. Yet, the magnitude of volatility shocks and the relationship between the VIX and risky asset classes has become less stable over time. The metrics that funds use to assess market risk need to be carefully calibrated with a range of indicators beyond implicit volatility, including long term asset valuation, asset correlation, investor flows and/or realised volatility.
European multi-asset funds continued to increase in popularity in 2013, remaining the vehicle of choice for non-institutional investors in many jurisdictions. Inflows to these funds totalled EUR36.6bn in the first 11 months of the year. Multi-asset funds performed well in 2H13, with variance in fund performance mostly due to the level of allocation to risky assets. Challenges for the new allocation models are likely to continue in markets characterised by low volatility, high asset correlation and upside pressure on interest rates.
Richard Woodrow, Fitch Ratings