Beware: Portfolio Risk Has Dropped

September 26, 2017

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Rusty Vanneman, chief investment officer of Omaha, Nebraska-based CLS Investments.

While market prices are steadily moving higher this year, risk (defined as price volatility) has declined for many multi-asset ETF portfolios. In turn, returns are steady and providing a smooth ride for investors. No wonder so many surveys lately show investors are feeling comfortable. But will this trend continue?

Risk is decreasing for two reasons. First, in absolute risk terms (as defined by price volatility), overall market volatility is dropping. By some measures, it recently reached its lowest levels since the 1960s. 

That alone explains why investment firms are seeing inflows and higher asset-retention rates. Volatility is destabilizing for investors and often a catalyst for emotional decision-making. That is the case whether prices are falling (investors are nervous of losing money), or rising (investors fear missing out on gains).

The second reason is correlations between asset classes are also dropping. Correlations between asset class segments and strategies have dropped significantly—in other words, the diversification benefit is as strong as it has been in years, making portfolio risk measures drop for many globally balanced portfolios, such as those managed by CLS.

For example, the chart below, prepared by Jackson Lee, CFA, quantitative investment research analyst at CLS, shows that correlations are decreasing among mutual fund categories versus a global equity benchmark. All else being equal, this trend lowers portfolio risk.



Looking At Risk Targets

At CLS, we strategically manage balanced portfolios to relative risk targets (unlike other strategic managers who manage to target asset allocations). This decline in correlations has lowered our actual portfolio risk levels. While risk levels remain within our Risk Budget bands, they are definitely on the lower edges. This is not because we are becoming more cautious; it is simply due to the current market dynamics.

When correlations start to move higher again, as they eventually will do, portfolio risk numbers will rise—not necessarily because we’re becoming more bullish (though we could be if the market offers investments on sale), but because market internals are changing.

It should be noted, however, that not all balanced portfolios in the industry are showing reductions in portfolio risk. I believe that is because many balanced funds do not include much exposure to international markets or real assets, such as commodities and natural resources.

In addition, many balanced funds are crowding into popular sectors, such as consumer discretionary stocks. At CLS, our decisions are driven by relative valuations and a contrarian bent, so we tend to have less exposure to the popular sectors and more exposure to the undervalued and unloved.


The chart below, created by CLS Portfolio Manager Grant Engelbart, CFA, illustrates how risk has changed for many ETFs. It shows year-over-year changes in relative risk (as defined by dividing the standard deviation of the ETF by the standard deviation of a global equity benchmark) and in portfolio beta.



It’s All Cyclical

Some conclusions:

  • Relative risk increased in every broad asset class, except the iShares MSCI EAFE Value ETF (EFV) (developed international value stocks), in the two one-year periods shown, but there were a lot of divergences in betas.
  • Energy and natural resources saw large risk reductions from a beta standpoint.
  • Emerging market risk has also dropped significantly.
  • Many funds are overweight to the consumer discretionary sector (Amazon dominates this sector, but it also includes investor darlings, such as Netflix and Tesla, along with powerhouse names like Home Depot and McDonald’s), which has actually increased in beta by 25%.

In summary, portfolio risk—whether measured in absolute or relative terms, or both—has been dropping this year. I would suggest caution and warn that these numbers won’t always look like this. Absolute volatility is cyclical and will rise. Correlations are also cyclical, and they will also rise. 

For many ETF investors, I have two recommendations. First, simply be aware of how exceptional the current environment is and anticipate that portfolio risk will rise again. Second, it might be a good time to consider broader diversification, whether that means becoming more global, adding more real assets or even diversifying further into value-oriented sectors, such as financials and energy.

Doing so should help manage overall portfolio volatility, especially once overall stock market volatility starts to pick up again.

At the time of this writing, CLS Investments invests in all of the securities mentioned above for its clients. CLS Investments is a third-party investment manager and ETF strategist. It began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds. Contact CLS’ Chief Investment Officer, Rusty Vanneman at 402-896-7641 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.



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