Risk Constraints in Portfolio Construction
In the process of portfolio construction, risk constraints play a pivotal role. These constraints can be either formal or heuristic. Heuristic constraints are controls that are imposed on the permissible portfolio composition through an exogenous classification structure. These constraints are often based on experience or practice, rather than empirical evidence of their effectiveness.
Types of Risk Controls
There are several types of risk controls that are used in portfolio construction. These include:
Portfolio management involves various strategies to control risk and enhance performance. These include limiting exposure concentrations by security, sector, industry, or geography, such as reducing dependency on the technology sector. Similarly, portfolios often restrict net exposures to risk factors like beta, size, value, and momentum, or to specific currencies, like the Euro, to manage currency risk. The degree of leverage is also controlled, as portfolios might limit their use of borrowed money to manage leverage risk. Additionally, the degree of illiquidity is monitored, with portfolios limiting their holdings of illiquid assets to manage liquidity risk. Trading activities are also restrained to manage transaction costs. Moreover, portfolios might limit their holdings of companies with high carbon emissions to manage environmental risk or avoid companies in controversial industries to manage reputational risk. These strategies are critical for maintaining a balanced and risk-averse investment approach.
Sample Heuristic Constraints
Heuristic constraints are rules that limit a portfolio’s composition based on certain criteria. Some examples include:
In portfolio management, certain constraints are implemented to ensure prudent risk control and adherence to strategic benchmarks. These include limiting any single position to the lesser of five times the weight of the security in the benchmark or 2%. Additionally, the portfolio must maintain a weighted average capitalization of no less than 75% of that of the index. Another important rule prohibits sizing any position such that it exceeds twice the average daily trading volume over the past three months. Finally, the portfolio’s carbon footprint is limited to no more than 75% of the benchmark’s exposure, reflecting a commitment to environmental responsibility.
Risk through Portfolio Characteristics
Managing risk through portfolio characteristics is a “bottom-up” risk management process. Managers that rely on such an approach express their risk objectives through the heuristic characteristics of their portfolios. The resulting statistical risk measures of such portfolios do not drive the portfolio construction process but are an outcome of those heuristic characteristics.
For example, if a manager imposes maximum sector deviations of \(\pm\)3% and limits security concentration to no more than the index weight + 1% or twice the weight of any security in the index, then we could expect the active risk of that portfolio to be small even if no constraint on active risk is explicitly imposed.
The portfolio construction process ensures that the desired heuristic risk is achieved. Continuous monitoring is necessary to determine whether the evolution of market prices causes a heuristic constraint to be breached or nearly breached.
Managers will often impose constraints on the heuristic characteristics of their portfolios even if they also use more formal statistical measures of risk. The investment policy of most equity products, for example, will usually specify constraints on allocations to individual securities and to sectors or, for international mandates, regions. Some may also have constraints related to liquidity and capitalization. Even managers with a low-volatility mandate will have security and sector constraints to avoid unbalanced and concentrated portfolio solutions that may have significant idiosyncratic risk or allocations that are unduly influenced by estimation error.
Formal Risk Measures
Formal risk measures are essential statistical tools that quantify the potential risks within a financial portfolio which includes:
- Volatility: Measures the degree of variation in trading prices over time, reflecting the uncertainty or risk level associated with the asset’s value changes.
- Active Risk: Also known as tracking error, it quantifies the divergence of a portfolio’s returns from its benchmark, indicating the risk taken by active management.
- Skewness: Assesses the asymmetry of the return distribution of an asset around its mean, with higher skewness indicating a potential for extreme outcomes.
- Drawdowns: The peak-to-trough decline during a specific record period of an investment, providing a real-world measure of downside risk.
- Value at Risk (VaR): Estimates the maximum expected loss over a specific time period under normal market conditions, at a given confidence level.
- Conditional Value at Risk (CVaR): Also known as Expected Shortfall, this metric estimates the average loss assuming that the loss is beyond the VaR threshold.
- Incremental Value at Risk (IVaR): Measures the additional risk that a single asset contributes to a portfolio, helping in the risk management decisions.
- Marginal Value at Risk (MVaR): Quantifies the incremental risk added to the portfolio by investing an additional dollar into a particular asset.
Formal risk measures require a predictive approach to risk management. For instance, if a portfolio manager predicts a certain level of risk, and the actual risk deviates significantly from this prediction, the portfolio’s performance may differ from expectations. This divergence can be particularly pronounced during financial crises.
Consider a portfolio manager who has calculated a 5% probability of a one-day loss greater than 1.08% and a 1% probability of a loss greater than 1.77%. The average of these tail losses (CVaR) are 1.50% and 2.21%, respectively. These figures guide the manager’s investment decisions.
Application of Formal Risk Constraints
Formal risk constraints can be applied during portfolio optimization or through an iterative feedback mechanism. For instance, a long-only equity manager may limit sector deviations to 5%, while a hedge fund manager may limit sector exposure to 30% of his gross exposure. These constraints can be expressed on an absolute basis or relative to a benchmark.
Often, investment policies impose both formal and heuristic constraints on a portfolio. The aim is to control for several portfolio and risk characteristics, such as the weight of index constituents, sector weights, exposure to style factors, and limit on volatility.
The Risks of Being Wrong
Consider the case of a hedge fund in 2008 that owned a two-times leveraged portfolio of highly rated mortgage-related securities. Despite the securities having minimal exposure to subprime mortgages, the economic downturn and poor market liquidity led to a steep decline in the prices of these securities. The 2x leverage, coupled with the unprecedented price decline, resulted in a forced liquidation of the assets, leading to the loss of all capital for the manager and investors.
Another instance is a pension fund that created an indexed equity position by combining an investment of short-term highly rated commercial paper with an equivalent notional position in equity derivatives. However, the liquidity crisis in 2008 and early 2009 led to a substantial decline in equity markets and a simultaneous spike in the perceived riskiness of the short-term commercial paper. Both components lost 50% of their value, creating a paper loss equivalent to 100% of the invested capital.
Portfolio Management and Risk Calibration
Portfolios with a very limited number of securities may be more difficult to manage using formal risk measures because estimation errors in portfolio risk parameters are likely to be higher. Measures of risk and their efficacy must be appropriate to the nature and objective of the portfolio mandate. Calibrating risk is as much an art as it is a science. If an active manager imposes restrictions that are too tightly anchored to her investment benchmark, the resulting portfolio may have performance that too closely mirrors that of the benchmark.
Practice Questions
Question 1: In the process of portfolio construction, risk constraints play a significant role. These constraints can be formal or heuristic, with heuristic constraints being controls imposed on the permissible portfolio composition through an exogenous classification structure. These are often based on experience or practice. Which of the following is not typically considered a type of risk control in portfolio construction?
- Exposure concentrations by security, sector, industry, or geography
- Net exposures to risk factors, such as beta, size, value, and momentum
- Exposure to political affiliations
Answer: Choice C is correct.
Exposure to political affiliations is not typically considered a type of risk control in portfolio construction. Risk controls in portfolio construction are measures put in place to manage and limit the potential losses that could arise from adverse movements in market prices, interest rates, currency exchange rates, and other risk factors. These controls are typically based on quantitative measures and are designed to ensure that the portfolio’s risk profile is aligned with the investor’s risk tolerance and investment objectives. While political risk, which refers to the risk that a country’s government will suddenly change its policies, is a consideration in international investing, it is not typically categorized as a risk control. Instead, it is considered as part of the broader category of country or sovereign risk, which also includes economic, currency, and other risks associated with investing in a particular country.
Choice A is incorrect. Exposure concentrations by security, sector, industry, or geography are indeed considered a type of risk control in portfolio construction. These controls are designed to limit the portfolio’s exposure to any single security, sector, industry, or geographic region, thereby reducing the risk of significant losses if that security, sector, industry, or region performs poorly.
Choice B is incorrect. Net exposures to risk factors, such as beta, size, value, and momentum, are also considered a type of risk control in portfolio construction. These controls are designed to manage the portfolio’s exposure to various risk factors that have been shown to drive returns in the equity markets. By managing these exposures, the portfolio manager can control the portfolio’s risk profile and align it with the investor’s risk tolerance and investment objectives.
Question 2: Managing risk through portfolio characteristics is a “bottom-up” risk management process. In this process, managers express their risk objectives through the heuristic characteristics of their portfolios. Which of the following statements best describes this process?
- The resulting statistical risk measures of such portfolios drive the portfolio construction process
- The resulting statistical risk measures of such portfolios do not drive the portfolio construction process but are an outcome of those heuristic characteristics
- The resulting statistical risk measures of such portfolios are irrelevant to the portfolio construction process
Answer: Choice B is correct.
Managing risk through portfolio characteristics is indeed a “bottom-up” risk management process. In this process, the portfolio managers express their risk objectives through the heuristic characteristics of their portfolios. The statement that best describes this process is that the resulting statistical risk measures of such portfolios do not drive the portfolio construction process but are an outcome of those heuristic characteristics. This means that the portfolio managers do not start with a desired level of statistical risk measures such as standard deviation, beta, or Value at Risk (VaR) and then construct the portfolio to achieve these measures. Instead, they start with the desired characteristics of the portfolio, such as the types of assets, sectors, countries, and other factors, and then the statistical risk measures are the result of these characteristics. This approach allows the portfolio managers to have a more intuitive understanding of the risks in the portfolio and to manage these risks more effectively.
Choice A is incorrect. This statement suggests that the statistical risk measures drive the portfolio construction process, which is not the case in a bottom-up risk management process. In this process, the portfolio construction is driven by the desired characteristics of the portfolio, not by the statistical risk measures.
Choice C is incorrect. This statement suggests that the statistical risk measures are irrelevant to the portfolio construction process. This is not true. While the statistical risk measures do not drive the portfolio construction process in a bottom-up risk management process, they are still an important outcome of the process and are used to assess and manage the risks in the portfolio.
Glossary
- Heuristic Constraints: Controls imposed on the permissible portfolio composition through an exogenous classification structure, often based on experience or practice.
- Exposure Concentrations: The amount of funds invested in a particular type of security, sector, industry, or geography.
- Net Exposures: The amount of risk that remains after all diversifying effects are considered.
- Degree of Leverage: The use of borrowed money to increase the potential return of an investment.
- Degree of Illiquidity: The state of assets that cannot easily be sold or exchanged for cash without a substantial loss in value.
- Value at Risk (VaR): A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame.
- Conditional Value at Risk (CVaR): A risk assessment measure that quantifies the potential extreme losses in the tail of a distribution of possible returns.
Portfolio Management Pathway Volume 1: Learning Module 3: Active Equity Investing: Portfolio Construction;
LOS 3(h): Discuss the application of risk budgeting concepts in portfolio construction. Discuss risk measures that are incorporated in equity portfolio construction and describe how limits set on these measures affect portfolio construction