Rethinking risk and rebalancing portfolios

Antonio Baldaque da Silva| Gabriella Barschdorff, CFA| Mike Pyle| Richard Flynn, CFA |May 11, 2020

Recent unprecedented market volatility has revealed unseen risks and left many portfolios out of balance.  To help investors get a better understanding of the risks that may be driving their performance, and to help guide rebalancing decisions going forward, we recently hosted a Market Pulse Call with Mike Pyle, Global Chief Investment Strategist for the BlackRock Investment Institute; Antonio Silva, Head of Analytics and Modeling and Chief Risk Strategist; Gabriella Barschdorff, Co-Head of the Americas Pensions Team; and Rick Flynn, Global Head of RQA Fixed Income and Multi-Asset Strategies. 

The group shared views on how risk models are performing in the current crisis, where they see opportunities for clients that are rebalancing, and how to integrate private markets assets into the total portfolio. It was a timely call, as the majority (56%) of attendees that responded to our polling questions are only somewhat comfortable with their ability to assess total portfolio risk, whereas less than one-fifth (18%) are very comfortable with their ability.  

Highlights of their discussion follow.

During the global financial crisis, investors sometimes criticized the performance of risk models. How have models performed during the current crisis?

It’s true that back in 2008 and 2009, we got a lot of questions about whether risk models were performing as they should be, but those questions are not coming up this time. Investors now have a much better understanding of what risk models are, and what they aren’t. 

Just as importantly, we now have a much better understanding of how monetary policy affects analytics and risk models. During the financial crisis, we were in uncharted waters when it came to Fed policy. But now those waters aren’t uncharted anymore.  We are seeing some new fiscal policies this time, but we’re learning rapidly from them. And the work that we’ve done in the recent past on incorporating scenario analysis, namely around geopolitical risks, into asset allocation and portfolio construction decisions has certainly helped.

As you use risk modeling to help clients construct optimized portfolios, what recent lessons are you applying?

The first one that comes to mind is the importance of scenario analysis. Many times, people try to define risk simply as expected volatility, but that concept doesn’t mean a lot to most institutional investors. We need to go deeper and give investors a way to see how market events may impact their specific portfolio objectives—and that’s the goal of scenario analysis. 

Earlier this year we created a Covid stress scenario that modeled very large drawdowns in equity markets—with some sectors being particularly hard hit—and a massive flight to quality.  And that’s pretty much what ended up happening when the coronavirus exploded. By walking through those types of scenarios and having conversations with our clients, we’re able to help them understand whether they’d be able to withstand a severe drawdown or whether they should be reducing their risk exposures.

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By using scenario analysis, we’re able to help clients understand whether they’d be able to withstand a severe drawdown.

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We also view the current situation as an opportunity to potentially re-underwrite the strategic asset allocations of our clients’ portfolios to try to ensure that they are aligned with their return objectives, their investment horizons, and their risk tolerance. And to see that they have the right measurement techniques to not only understand those risks but to explain them to other stakeholders.

Finally, we are spending a good deal of time evaluating how different instruments may be able to serve as equity hedges. We think long duration Treasuries still have a role to play in helping to mitigate equity market volatility, but given how low rates are, the amount of ballast they can provide is considerably less than it was at the start of the year. So, we’re actively looking at other options. 

For clients that are rebalancing, where do you see interesting opportunities?

In public markets, we think there are tactical opportunities for investors who can be nimble. There are myriad examples within fixed income, but two that stand out are distressed credit and securitized assets. The latter has become even more interesting with the recent expansion of the Fed’s Term Asset-Backed Securities Loan Facility (TALF). 

Within private markets, many assets are on sale right now. In a few years, when we look back at the 2020 vintage year for private equity (PE) strategies, we’d expect to see some strong results for those funds that were able to effectively capitalize on current dislocations.  So, for long-term investors who can afford to tie up some of their capital for some amount of time, we think PE—including secondaries—is certainly worth a look in the current environment.

When you’re adding private assets, how do approach the integration from a risk-management perspective?

To begin, you have to work to overcome the information asymmetry that accompanies private markets investing. At the individual transaction level, you need to perform fundamental analysis, verify disclosures, confirm representations and warranties, and much more before committing capital. 

When you start to aggregate individual transactions into portfolios, you introduce some degree of diversification, but you can also wind up with common exposures across those different transactions. For example, you could end up with concentrations in geography or industry exposure. Using statistical models and risk analysis can help integrate these common exposures across both the public and private assets in the total portfolio to better understand the whole portfolio. 

Finally, once you start to have multiple private investments in a portfolio, you’re now dealing with a tremendous amount of detail and data from the underlying companies. It becomes critical that everyone who needs to track and understand that information—from risk analysts to portfolio managers—is on the same page and can speak a common language of risk.

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It’s critical that everyone from risk analysts to portfolio managers can speak a common language of risk.

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Mike Pyle
Global Chief Investment Strategist for the BlackRock Investment Institute
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Antonio Silva
Head of Analytics and Modeling and Chief Risk Strategist
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Gabriella Barschdorff
Co-Head of the Americas Pensions Team
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Rick Flynn
Global Head of RQA Fixed Income and Multi-Asset Strategies
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