Getting to all layers of risk

Risk exposures may dramatically vary among investments, even if those assets have the same overall volatility. That means two funds with the same overall risk could react differently to market movements depending on their risk decomposition. Analyzing the underlying risk factors can increase your understanding of what’s really going on inside a portfolio.

Risk can be complicated to explain to clients. The ability to decompose top line risk into various factors, such as equity beta, sector, interest rates and FX, can help advisors articulate the sources of risk in their portfolios.

We frequently hear about interest in risk factors. Our asset allocation article answered why it’s important to look at risk exposures.

Here, we’ll discuss how to look at those risk exposures. We believe viewing the factors that drive risk can more properly inform advisors when they make portfolio allocations according to a client’s risk/return goals.

Let’s say 10 students all have the same grade point average. Though it tells you how they did in school overall, it doesn’t reveal much about their core strengths or what career paths suit them well. It’s their classes, and their performance within them, that can better depict their strengths and eventual career outcomes.

So, how can advisors help clients make more informed portfolio decisions by understanding the risk decomposition of investments?

The view across seven funds

Imagine you are constructing a portfolio for a client and considering allocating some of the client’s capital across a combination of seven types of funds, shown below. All of them have an overall risk of about 12%.

Below is the perspective on risk based on this understanding.

Similar risk across seven fund types?

Chart image

Source: For illustrative purposes only. BlackRock Aladdin, 2021.

The chart shows that these seven funds have similar risks, but beyond that, it doesn’t tell us much else. We may know that a large value stocks fund is different than a commodities fund, but we can’t see from this picture what specific risks each fund is exposed to. We don’t know what risk factors matter.

That means we don’t know how they could react to swings in the markets. So, we don’t know how the funds interact with one another or with other funds already in the portfolio.

While helpful from one view, this chart provides a surface-level analysis. It may not provide enough information to help you make allocations that match a client’s target risk/return. Let’s see how looking at the risk decomposition can paint a different picture.

Painting the risk picture more clearly

Let’s assess specific and quantifiable attributes of individual securities in the funds for a bottoms-up approach to decomposing risk. It can reveal the factors that contribute to the funds’ risks, and to what degree.

We analyzed the funds across market, country, sector, style, specific, rates, spreads, alternative, FX and other risk factors, seen in the chart below.

Risk factors reveal underlying risk drivers

Chart image

Source: For illustrative purposes only. BlackRock Aladdin, 2021.

How does this picture give you a better understanding of the risk within these funds? In comparison to the previous graph, investing in large value stocks looks like it could produce a different risk/return outcome than commodities.

Diversification strategies could also be enhanced with the insights gained from this picture. If your client has already taken on significant market risk, for instance, it could help to diversify the risk among other risk factors.

Much of what we didn’t know based on the first chart could be answered by this one.

With insight into the risk sources, and their degree of contribution, you can make more informed choices on the risk/return tradeoffs among different investments and communicate that more clearly with clients.

Applying clarity on risk to asset allocation 

In addition, advisors can make the connection between risk factors and what’s evolving in the financial markets when they use this information in stress tests. To learn more about stress testing, read about the power of it here.

By understanding an asset’s risk decomposition, you can enhance client conversations on risk and build portfolios that better match their target outcomes.

Enhance your portfolio construction with Aladdin Wealth™

Only looking at topline risk may limit your view when constructing portfolios. It helps to see the risk decomposition in the context of a whole portfolio.

Advisors can use the Aladdin Wealth™ platform’s proprietary portfolio analysis and construction tools to gain transparency into what’s driving the risk of clients’ investments. With the platform’s built-in whole portfolio approach, advisors can enhance the value they bring to clients with a more informed understanding of risk.