Thierry Crovetto is a financial analyst and advisor, founder of the management company TC Stratégie Financière, a key partner of asset managers and family offices. Wishing to establish a link between Finance and Research, for an academic validation of the proposed analysis models, he focuses on performance optimisation with risk reduction.
You put a lot of emphasis on the notion of risk. Do Asset Managers take it into account?
Investors and portfolio managers often talk about their performance but not much about their level of risk. However, the main objective of portfolio management is to optimise the risk/return trade-off. We cannot judge performance if we do not know the level of risk that has been taken to achieve it...
The real risk for an investor is losing money...
This is why the most relevant and comprehensible risk measure is the Maximum Drawdown! Risk management should be the priority of investors. Diversification is an important but not sufficient step in optimizing the risk/return trade-off. It is necessary to assemble attractive investments with low correlation. Absolute return strategies can form the core of portfolios; the more defensive strategies can replace some of the bonds while more dynamic ones can replace part of the equities. Hedging strategies must also have a place to protect against sharp declines and function as insurance.
Unrealized risks are hard to imagine?
While performance is easy to calculate and understand, there are different notions of risk, more or less concrete. Very often, it is wrongly assumed that only equities are risky and that risk is determined by the percentage of equities in the portfolio. The measure of market risk can be broadened by calculating Beta (sensitivity to movements in a stock index for example). The latter is defined as the ratio of the covariance of the return on assets to that of the market to the variance of the return on the market. In concrete terms, let us take the example of a portfolio with a Beta of 0.8 relative to the CAC 40. This means that if the CAC 40 index varies by 10%, the portfolio should theoretically vary by 8%. This is only an average though, and the participation to the upward movement can be different from the participation to the downward movement of the index, which is called convexity.
Does measuring volatility help control risk?
Considered in finance as the basis for measuring risk, volatility is by definition a measure of the magnitudes of variations of the price of a financial asset. Thus, the higher the volatility of an asset, the riskier the investment in that asset will be considered and therefore the greater the expected gain (or risk of loss). The standard deviation is relatively simple to understand and apply. It is obtained by calculating the square root of the variance. The variance is calculated by averaging the deviations from the mean, squared. Since volatility does not differentiate between upward and downward deviations, it is rather an indicator of uncertainty. To focus on the real risk, negative volatility can be calculated, which will only consider negative deviations from the mean. In any case, these indicators are not stable over time since they tend to increase when markets fall and decrease when markets rise.
Vol Target strategies consist in determining a target volatility level for the portfolio and varying the weighting of risky assets according to their volatility. Thus, one will reduce their exposure when their volatility is higher than the target volatility by increasing the share of risk-free assets and, conversely, by increasing their weight (possibly using leverage) when their volatility is lower than the target volatility. This works like a trend monitoring strategy.
In classical financial theory, asset volatility is assumed to be constant, but in reality it changes over time. It can be shown that the "Vol Target" strategy generates higher returns for each unit of risk. In particular, it reduces the maximum portfolio declines that usually occur in a context of high volatility. Investors should reason in terms of risk budget rather than in terms of weighting within their asset allocation.
Let's take the example of a government bond fund that has performed very well over several years, what risk can be associated with it?
The bond fund is unlikely to replicate the same performance in the future and its risk is probably higher than it has been in the past.
In addition to quantitative risks, which can be calculated on the basis of historical data, qualitative risks such as liquidity, valuation, the risk of non-replicability of performance and "Black Swans" such as the Covid-19 pandemic that we are currently facing must be assessed.
