Franck Nicolas, Head of Investment & Client Solutions at Natixis Asset Management, and Marina Gross, SVP, Portfolio Research & Consulting Group at Natixis Global Asset Management, discuss targeting risk versus returns within the asset allocation process, budgeting for risk, and tips for dealing with market volatility.

Part One: Using Risk to Your Advantage

Why should investors focus on risk when determining asset allocations?

Marina Gross: Now that the markets are less predictable and more demanding, it’s important to look past the surface and figure out what risks you are really exposed to. Considering risk first leads to a set of binary decisions. On the one hand, you want to cap and control certain risks because the payoff is not attractive. On the other, there are risks you want to exploit because they have the greatest likelihood of a good payoff. Currently in the U.S., interest rate risk is being suppressed in many portfolios while illiquidity or emerging markets risks hold out greater potential for returns.

Franck Nicolas: We believe investors should always make risk their number one priority. This means targeting a consistent range of risk, rather than a potential range of returns. Many investors have started to do this but need to be much more precise about how they implement it.

Are the risks the same for all investors?

Marina Gross: I work with retail platform providers and advisors, and it’s clear that many retail investors struggle with the concept of risk. We help them to understand what forms risk can take, how they can measure it and the shortcomings of each of those measures. We often apply this to model portfolios and report back on issues such as risk concentration, and whether the composition of a portfolio is consistent with an investor’s expectations and intentions.

Franck Nicolas: For institutions such as pension funds, the asset-liability spread is a significant risk. If liabilities are believed to inflate over time, then you have a big inflation risk and your investment strategy should reflect that with an allocation to index-linked bonds and so on. If, on the other hand, your liabilities are in a number of different currencies, then the foreign exchange risk needs to be identified. Conversely, if your liabilities are purely domestic, you need to be very careful not to introduce too much currency risk into the portfolio. The strategy we advise is to design a bucket of risk with the best mix of asset classes that can close the gap between assets and liabilities in the long run.

Part Two: Understanding Risk Budgeting

What is risk budgeting and can it boost returns?

Franck Nicolas: Investors need to understand what can happen to their portfolios in both good times and bad times. In this way institutions will not be too surprised about the effects on their investments when markets fall and panic them into bad decisions. Obviously it is important to do this proactively, because having to react to a difficult landscape leaves you with fewer options.

Marina Gross: Risk budgeting essentially recognizes that investors have a finite tolerance for risk. When you quantify your risk tolerance, you can go into the marketplace and spend your risk budget to get the most yield or output per expenditure. Every decision becomes a trade-off: if you are conservative here, then you can be more aggressive there. If you spend more of your risk budget on small-caps because you believe you can capture higher returns, it needs to be balanced with something more conservative. You end up with two buckets: one return-seeking and the other risk-reducing, each weighted according to your risk budget, or your risk tolerance.

How can investors measure their risk tolerance to arrive at a risk budget?

Franck Nicolas: Institutions with defined liabilities need to establish their cash flow needs over time and then examine how these could be modified by changes in longevity, inflation, market movements and so on. Investment policies will reflect these factors and will need to be monitored dynamically to foresee potential deviations between assets and liabilities. It is not the kind of exercise that is carried out once; it’s ongoing.

Marina Gross: We counsel many of our clients to use a volatility range, as measured by standard deviation,* to define their risk tolerance. Standard deviation is readily available, standardized and understood by advisors. To ascertain the efficiency of each asset class we would typically use the Sharpe Ratio [a statistical measure which measures the return premium per unit of volatility]. When faced with a decision to take risk out of the portfolio when risk parameters have been violated, we would recommend, for instance, taking assets with declining Sharpe Ratios out of the return-seeking bucket.

Are there traps to avoid in setting risk budgets?

Franck Nicolas: Investors commonly make two mistakes in their risk budgeting processes. The first is to overlap two categories with similar risk profiles, such as overweighting emerging markets and commodities. The second mistake is to size all their risk buckets equally. Investors may be bullish on inflation, the U.S. dollar and Chinese equities, but the volatility of each is very different. Risk budgeting can help you to size each bucket more effectively.

*Standard deviation measures the risk of a portfolio or market. Standard deviation is a statistical measure of historical volatility.

Part Three: Dealing with Investment Loss and Volatility

Many investors view permanent loss as the biggest risk. What tips do you have to deal with that?

Marina Gross: One way of measuring and controlling this risk is by using Value at Risk techniques. These techniques are well known in institutional investment circles, but for a retail audience it is a relatively sophisticated concept. Value at Risk considers the likelihood of rare events that could negatively impact a portfolio. (Analysts call this “left tail risk.”) Once you know the value that is at risk, there are many different ways of dealing with it in the portfolio.

Franck Nicolas: There are a number of ways volatility can be managed so it doesn’t produce bad decision-making and lead to the worst-case scenario for investors – permanent capital loss. A technique known as risk parity is fashionable at the moment. This entails giving an equivalent risk budget to every asset class in the portfolio. This fits with our preference of allocating capital according to risk allocation techniques.

Are there other ways to reduce volatility?

Marina Gross: In many cases, attempts to diversify portfolios to reduce volatility are flawed. Diversifying your equity allocation by geography, size or sector – in other words, by investment style – does not necessarily lead to a less correlated portfolio. We believe in diversification by factors, such as equity risk, foreign currency risk, credit spread risk and interest rate risk.

Franck Nicolas: Diversification is important in creating durable portfolios, but it’s not sufficient in itself. We would typically use derivatives in portfolio construction, which are a more direct hedge.

Durable Portfolio Construction® does not guarantee a profit or protect against a loss.

Investing involves risk including the risk of loss. Investment risks exist with equity, fixed-income, and alternative investments. Sophisticated and aggressive investment techniques such as leverage, derivatives, and short-selling can magnify a gain or loss.

This article is for informational purposes only and should not be construed as investment advice. The analyses and opinions referenced herein represent the subjective views of Marina Gross and Franck Nicolas as of September 2012. They are subject to change at any time based on market and other conditions.