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Building More Robust Portfolios

The dangers of backward-looking and parametric risk models

On first glance, most institutional portfolios appear to be well diversified, accessing a range of different and uncorrelated asset classes and strategies. However, this diversification often falls apart when markets exhibit more extreme conditions – events that happen much more frequently than traditional risk measures would suggest. In this paper we discuss a methodology to build more robust portfolios that are less fragile and have a better chance of holding up in tough times.

Fig.1 Example of a factor-based implied risk profile (bars), overlaid with the corresponding distribution obtained by fitting historic data with a normal distribution
Source: bfinance

The problem

Most portfolios are constructed to be well diversified by combining uncorrelated investments, however, history has shown that in many extreme market moves, the uncorrelated becomes correlated and the diversified becomes undiversified. Furthermore, different asset classes and strategies that are assumed to be totally different from each other often exhibit periods of high overlap and/or high correlation (especially as experienced in ‘risk on/ risk off’ environments and sharp market sell-offs). This effect has become more prominent as portfolios have become more complex, utilizing strategies that are less constrained in the range of exposures they can take, strategies that invest across a range of markets, and less liquid strategies where risk is not represented by volatility of track record e.g., diversified growth and alternative/structured/asset backed credit.

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