Morgan Stanley: Risk as a starting point — not an afterthought

But seldom do we read stories about resilient strategies that have excelled in managing volatility while delivering, competitive returns. Yet managing volatility is one of the keys to surviving a sharp market downturn.

Most investment managers designate a benchmark to evaluate returns. Far fewer designate a benchmark focused on volatility.  We are one of the few who do. Our investment process begins with risk.  Depending on client preferences, we specify a target range of volatility, e.g., 4-10%, within which we aim to maintain the strategy’s volatility¹.

A link between volatility targeting and higher Sharpe ratios

Studies show that volatility is negatively correlated to equity returns. As such, it makes sense to allocate to lower-risk assets when volatility is high or rising and to riskier assets when volatility is low or falling². In fact, data supports that managers who do so have often delivered a superior Sharpe ratio³, which measures the amount of return generated given the amount of risk taken.⁴

Our multi-asset portfolios hold a mix of equities, fixed income, commodity-linked notes and cash. This flexibility to diversify across asset classes is critical in managing risk.

In fact, research shows that global equities start to move in lockstep in distressed markets.⁵ Equity-only managers therefore have no recourse other than to reallocate between their equity holdings and cash, viewed by some as merely “rearranging the deck chairs on the Titanic.”  A multi-asset manager, in contrast, has multiple asset classes that can be rearranged to manage risk.

A forward-looking exercise

Anticipating volatility is a hallmark of our investment approach.  We continually survey macroeconomic and geopolitical conditions across the globe to identify potential sources of risk that could arise. Our goal is to adjust portfolio exposures before volatility strikes.

We use the portfolio’s equity allocation as the primary lever for adjusting its exposure to risk.   When we expect some event – such as an election, political instability or change in monetary policy – to cause a spike in market volatility, we typically reduce exposure to equities.  Conversely, when market conditions normalize, we restore the equity allocation to a normal range, generally 50-70%⁶.  Display 1 shows how we have adjusted equity exposure in anticipation of various global events over the past two years.

DISPLAY 1: Equity exposure adjusted as we anticipate changes in volatility

Source: GBaR representative portfolio, MSIM, DataStream, 30 April 2020. Subject to change daily. Provided for informational purposes only and should not be deemed as a recommendation to buy or sell securities in the asset class shown above. Each portfolio may differ due to specific investment restrictions and guidelines. Accordingly, individual results may vary. The information shown herein represents supplemental information, which supplements the composite presentation for the Global Balanced Risk Control Commingled Composite. Effective weights incorporate the impact of options. Target weights are the weights targeted at the time of the team’s rebalancing.

Case in point

In early 2020, to help manage volatility during the COVID-19 pandemic and unprecedented shutdown of the global economy, we reduced the equity allocation of our flagship portfolio, which has a volatility-target range of 4%-10%. This reduction comprised two elements: firstly, from late February to early March we reduced equity exposure from 55% to 29.5%, a position we maintained as volatility remained elevated. Secondly, in February we had implemented an enhanced tail risk hedging strategy, incorporating the use of options. For example, on 23 March our physical equity exposure remained 29.5%, but when the synthetic exposure from call options is taken into account, the portfolio’s total effective equity exposure was as low as 17.5%, helping to further mitigate the impact of extreme downside volatility.

In terms of the impact of our tail risk hedging strategy, over the year-to-30 April 2020, the MSCI AC World Index (euro) plummeted nearly 11%, versus our flagship portfolio which fell just over 4%.⁷

Final thought:  The psychological benefit of managing volatility

The COVID-19 pandemic, though unprecedented in scale and scope, is just one of many events that can pose investment risks over time. Though there is no assurance that a strategy will attain its volatility target, resilient strategies that aim to keep volatility within a pre-set range will appeal to those who like the idea of ongoing, research-based risk management. Given their aversion to volatility, high net worth investors, in particular, might be willing to sacrifice some upside potential in order to seek to reduce sharp drawdowns.

 

¹ Volatility is a statistical measure of the dispersion of returns for a given security or market index. The Global Balanced Risk Control (GBaR) team measures volatility on a forward-looking basis using the manager’s proprietary risk management system. Volatility target is an indicative range. There is no assurance that targets will be attained.

² Lazard, Dynamic Volatility Targeting, 2017.

³ Sharpe ratio is a risk-adjusted measure calculated as the ratio of excess return to standard deviation. The Sharpe ratio determines reward per unit of risk. The higher the Sharpe ratio, the better the historical risk-adjusted performance.

⁴ Journal of Portfolio Management, The Impact of Volatility Targeting, Fall 2018.

⁵ Vanguard, Dynamic correlations: The implications for portfolio construction, April 2012.

⁶ This represents how the portfolio management team generally implements its investment process under normal market conditions. There is no assurance that these targets will be attained.

⁷ Global Balanced Risk Control Fund of Funds is the GBaR team’s largest registered fund. Past performance is not a reliable indicator of future results. Returns may increase or decrease as a result of currency fluctuations. Performance data is calculated NAV to NAV, net of fees, in euro and does not take account of commissions and costs incurred on the issue and redemption of units. The sources for all performance and Index data is Morgan Stanley Investment Management. The investment team do not target a benchmark index when managing the portfolio.

Risk Considerations

Diversification does not protect you against a loss in a particular market; however, it allows you to spread that risk across various asset classes.

There is no assurance that the strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. In general, equities securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks.  Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. The use of leverage may increase volatility in the Portfolio.

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