It’s Time to Challenge Your View on Risk

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Published on January 20, 2020

| 7 min read

Valerie Azuelos, Managing Director, Client Portfolio Manager


New year, new you, right? Every year I seem to go back to the drawing board and evaluate how I can improve myself. This involves self-reflection and insight into where I am and where I want to be. It also involves educating myself on how to get there. The same process holds true when assessing a portfolio: where is it now and where does it need to be? Understanding investment risk is part of the “education” on how to get there. We should all challenge ourselves to better understand and evaluate equity market risk and see how we can learn from it to propel our portfolios forward.

Traditional analysis of market risk generally focuses on stock characteristics – momentum, value, size, quality, etc., along with rationalized assumptions about the global economy. We offer you a different perspective. At Intech, we focus on the interactions between stocks as they form components of a portfolio. This is consistent, of course, with our own philosophical portfolio-centric approach to investing.

We believe that it’s critical – especially today – to rigorously monitor and assess the stability of equity markets beyond the traditional measures of risk. The Intech Equity Market Stress Monitor® is a great place to start. And, right now, the monitor continues to suggest caution in both developed and emerging equity markets.

U.S. Equity Markets

During 2019 in the U.S. market, all risk indicators moved away from typical levels and currently reside at, or near, extreme levels, reflecting a heightened potential for increased volatility in this region. The biggest change we observed was a decline in the index efficiency measure, which currently is near all-time lows. This reflects an increased potential for skilled managers to achieve above-market returns with less equity risk through diversification, but it comes with the risk of being too defensive if markets should rise sharply.

Correlation of returns also increased by a wide margin during the year and is approaching extremes. This reflects increased systematic risk and suggests potential for groupthink in U.S. equity markets. Capital concentration continued to increase during the year as well, a continuation of a trend that began about five years ago, and is now approaching extreme levels.

European Equity Markets

While there’s been some improvement in European equity market risk metrics over the last year, there are still some signs of concern in this region. Like in U.S. equity markets, index efficiency declined significantly during the year and now ranks in the lower half of all observations for the first time since 2016.

Skewness of returns fell slightly from historical highs, but remains high. This measure has now ranked above median consistently since 2014. Skewness measures the asymmetry of index returns around the mean. Typically, logarithmic returns tend to exhibit a left-skewed distribution, meaning extreme returns are below the mean, as investors tend to react more strongly to negative news. High skewness of returns reflects bullishness, even irrational exuberance, among investors.

Emerging Markets

The majority of indicators moved towards typical levels in emerging markets over the last year, however some signs of strain remain. The largest change during the year was in the correlation of returns indicator, which increased significantly during the period.

Dispersion of returns declined notably during the year and is approaching historically low levels. This indicator has been below median levels consistently since 2011. Also known as cross-sectional volatility, dispersion measures whether stocks’ returns relative to their benchmark are converging (low dispersion) or diverging (high dispersion). As dispersion falls, overall market sentiment, rather than individual company results, is driving stocks’ returns.

What Does this Mean for Your Portfolio?

The higher levels of market strain suggested by the Intech Equity Market Stress Monitor® require your full attention on your equity investment – which, even in normal market conditions, constitutes the largest source of risk in a typical portfolio. Regardless of your policy allocation, a more defensive mindset is prudent, including understanding your managers’ active bets and considering complementary alpha sources.

Understand Your Risks

Just because your active managers are taking risks, doesn’t mean you’ll get rewarded for it. Of course, it’s perfectly reasonable to accept underperformance in the short term, due to certain risk exposures, but it’s also vital to understand thoroughly these drivers of risk and the potential downside they create. We believe that the increasing tail risk in today’s environment urgently demands those assessments by asking yourself some vital questions:

  • Do I know my sources of risk?
  • Have they skewed to the downside recently?
  • Are these sources still the primary drivers of risk?
  • How likely will they compensate me in different market scenarios?
  • Will other sources of risk overtake them?
  • Are my managers constraining their exposures comprehensively?
  • How much downside can they actually create?

Answers to these questions require risk management methods and systems equipped to address them. Because risk exposures often need to be state-dependent, risk thresholds should be dynamic and range-based. Such flexibility is important for navigating the potential of shifting risk regimes. Moreover, risk management systems need to be sophisticated enough to immunize you from new or emerging risks for which you might be uncompensated.

Find Complementary Alpha

Today’s environment is also a call to uncover higher levels of portfolio efficiency by assembling an all-weather stable of active strategies that complement traditional active and passive allocations. After all, we’re big advocates of diversification. This doesn’t necessarily mean you should change your policy allocation. Instead of diversifying away from public equities, you can diversify within your equity allocation by including strategies that adapt beta-risk exposure to risk regimes, like variable beta or low volatility equity strategies. These defensive equity strategies seek varying levels of upside equity market participation with downside protection.

If history is a guide, the current environment is not likely to sustain itself. A potential regime change necessitates preparation, beginning with a thorough review of your managers’ active share and risk management processes, and the inclusion of complementary equity exposures. We believe these are important first steps in establishing a more defensive posture for tomorrow’s equity markets.

Learn More About the Monitor

Find out more about the Intech Equity Market Stress Monitor® by downloading an eBook that describes the monitor or our latest quarterly report that offers our analysis of the data.

Consistent with our descriptive approach to understanding markets, these metrics avoid financial and economic assumptions, including that investors are perfectly rational and efficient at all times or, conversely, that they exhibit universal and constant behavioral anomalies. You can use the monitor to add insight to market risk regimes, contextualize beta risk management or to simply complement your conventional risk metrics.

eBook: Intech Equity Market Stress Monitor Download the eBook that serves as a guide to our monitor. Download Now


The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund. Nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. The views are subject to change at any time based upon market or other conditions, are current as of the date indicated, and may be superseded by subsequent market events or other conditions. The information, analyses and/or opinions expressed are for general information only, and are not intended to provide any specific financial, economic, tax, legal, investment advice, or recommendations for any investor. It should not relied on as the sole basis for investment decisions. While every attempt is made to ensure that all information is accurate, there is no representation or warranty, express or implied, as to the accuracy and completeness of the statements or any information contained in this report. Any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed. Past performance is no guarantee of future results. Investing involves risk, including fluctuation in value, the possible loss of principal, and total loss of investment.