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How to pragmatically monitor the risk profile

Asset allocation - although commonly used - is a poor indicator of portfolio risk. On the contrary, the use of the reference allocation will improve the monitoring of the risk profile. It is the benchmark that will determine the risk budget.


It is measured by calculating the volatility of the benchmark allocation. When market volatility rises, the risk budget also rises. The next step is to compare the volatility of the managed portfolio with its benchmark to see if the risk budget is respected.


Emotional factors not to be neglected


It has always been important to define the risk profile in the context of a management mandate. However, with the introduction of the Financial Services Act, the presentation of the risks to which the investment strategy exposes the client must be clearly defined when the mandate is signed and reviewed on a regular basis thereafter.


This is a job that requires know-how, because in addition to the client's technical knowledge and experience in the financial markets, emotional factors play a major role. Moreover, the professional in charge of the evaluation must be aware of his own cognitive biases.


However, the majority of institutions simply rely on a basic questionnaire, and then propose to their clients to choose a reference allocation. The most common are the "defensive" and "mixed" profiles. Some will say that "my institution is tailor-made"; in this case, each client should have his own reference allocation, with or without restrictions. As far as I am concerned, "bespoke" portfolios are a pure marketing argument.


Controlling the implementation


Even if this procedure for discovering the client's risk profile is simplified, its implementation must be monitored. These controls are generally based on the ranges of fluctuations of the asset classes that make up the client's portfolio and within which it is necessary to remain. Sometimes performance is also taken into account, to ensure that it is in line with the average of portfolios with a similar risk profile. Risk management is therefore proud to show, on a quarterly basis, the list of accounts that do not respect their allocation ranges, with a request for an explanation.


Unfortunately, asset allocation is a very poor indicator of portfolio risk. Indeed, a portfolio with 20% of equities can be more risky than another with 40%, as we can see particularly this year 2022 with the deflation of the bond bubble.


The risk budget


So how can we professionally monitor the risk profile? By relying on the reference allocation. This is what will determine the risk budget. We all know that it is impossible to predict the evolution of markets. However, for a given risk budget, it is possible to build portfolios that differ considerably from one another. What is important is how to spend the available risk budget, knowing that one can "play" with correlations to make the asset allocation more robust.


The risk budget is measured by simply calculating the volatility of the benchmark allocation. Thus, when market volatility rises, the risk budget also rises. We then compare the volatility of the managed portfolio with its benchmark to know if the risk budget is respected. The Performance Watcher platform is perfectly adapted to do this in an industrial way. Perhaps there are other platforms.


The use of the risk budget and its follow-up also allows to significantly increase the quality of interactions with clients. For example, it will be possible to quantify the impact of management decisions on risk and ultimately on performance. When they exist, this makes it possible to highlight the impact of restrictions on the quality of results.


The Performance Watcher application also allows you to compare yourself to a community of portfolios with the same characteristics. Thus, each institution can evaluate the quality of its results in relation to the "industry". It is desirable to show them to clients as part of an irreproachable governance and in order to reinforce client confidence.


More quality


A good use of the risk budget allows an easy and methodical control and documentation of the management results. It is also a way to improve the quality of results and to focus on portfolio construction. This last point is too often neglected, even though it is one of the fundamentals of the management profession.

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