Whiteboard Video Series: Risk Budgeting 101
Watch this short 5-minute educational video to learn more about risk budgeting and how you can structure client portfolios to maximize returns while managing risk.
As part of our ongoing University of Alts content library, today we're going to cover a risk budgeting concept.
Now, risk budgeting has a couple of different meanings, but for the most part and in the framework of this video think about risk budgeting as a way to either reallocate your risk spend to increase the returns of a portfolio or to decrease the overall risk of a portfolio. Today, we're actually going to talk about increasing returns, which is a concept that most advisers don't think about when considering adding alternatives to a portfolio.
So, first, let's define what we mean by risk budgeting. For our definition of risk, we're going to just use volatility that's associated with each asset class. You can see on the chart that there are four different asset classes that we are going to consider: market equity; fixed income, or debt; long/short equity, which is representing our alternative; and our risky asset – think about something like emerging markets. The volatility associated with each one of those asset classes would be 15 for market equity, 4 for fixed income, 8 for long/short equity, and 20 for our risky asset or emerging markets.
Now let's go back through and create a projected return for each one of the assets. Market equity, our projected return is to be 8%. Fixed income, we've assumed 3%. Long/short equity, something less than market, in this example at 7%. And our risky asset, we think that this particular asset class will maybe get us 11%.
So, if you look at a portfolio, a traditional portfolio, we're just going to use a 60/40 percent split here between market equity and debt or fixed income. What you can quickly determine is from a risk budgeting standpoint if you simply just use the weighted average of your allocations you're getting 60% of your would-be 15 risk units to equity, and you're getting 40% of your would-be risk units to your fixed income allocation. Once you add these two together, you can see that your total risk budget for your portfolio is 10.6 risk units.
So, if a client is comfortable with their risk units but would like a way to increase their portfolio returns, how can we use these other two asset classes in an efficient manner to actually have a higher projected return without introducing overall more risk to the portfolio?
For ease of example, let's do this. Let's remove our standard market beta from the portfolio and let's just look at our hedged equity alongside our risky asset. If we split the previous allocation between those two asset classes, what you find is you now have an allocated risk budget that's actually slightly lower than what we had coming from our equity bucket previously.
How you get to that number is you simply again apply the weighted average allocation to each one of the asset classes. So, 30% of 8 would be 2.4 units, while 30% of 20 is 6 units. It's clear here that the equity portion now is contributing 8.4 units to the portfolio, versus its previous 9.6 units. Once you add back in the fixed income allocation, your total portfolio risk unit allocation is now only 10.
Once you review the return, you can see that the return has also increased, which was the original goal of the project. Our projected return now is 6.6%, versus the original 6%.
This has just been one example of how you can think about redistributing the risk across your portfolio to potentially meet different portfolio goals.