Exposing Vulnerabilities with a Multi-Asset Class Risk System
A direct consequence of the past decade of low interest rate has been the trend towards multi-asset class investing. This has in fact become so prevalent that the lines between asset classes are increasingly blurred, and correlations often change direction unexpectedly. The best practice is to match the coverage of the risk model used with the assets in the portfolio in order to explain cause and effects for that portfolio. But given today’s cross-asset class links, limiting the risk analysis of an equity portfolio to an equity risk model might turn into a pessimist’s paradise: if it looks good, don’t count on it, and if it looks bad, it’s probably worse.
Many factors go into the investment thesis behind any equity portfolio. Some of these factors may have had an asset allocation component formed by certain views on the direction of asset classes other than equity. Other factors may be formed by outlooks on commodities, the future direction of interest rates, currencies, or even volatility regimes, all or any of which may impact an equity’s future fortunes. By augmenting the portfolio analysis to include its sensitivity to other asset classes, you not only ensure that it is in line with all the aspects of the investment thesis, but also that your risk management framework will provide valuable information about unintended cross-asset class bets. An equity portfolio with an under-weight position in the Energy sector may still have a large sensitivity to changes in oil prices. Similarly, an under-weight in materials might still mean a positive exposure to Gold and other minerals. How will the portfolio perform under certain historical scenarios driven by non-equity asset class shocks?
We recently published a paper that discusses how the analysis of a global equity portfolio can be enhanced through the use of a multi-asset class risk solution. You can read the full paper here.
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