Manage Portfolio Risk To Eke Out Alpha

Vishal Vij

Founder & Managing Partner
Nestegg Wealth Solution LLP

Risk is an important element in portfolio construction but gets little attention. Risk, per se, is not bad. In fact, if taken with due care, it can lead to rewarding portfolios in the long run. For example, look at the two portfolios below:


Which of the above portfolio looks better? At first glance, investors may choose portfol io A over B. However, it is portfolio B which scores better. Both portfolios generated a return of 9% per annum but portfolio B is less volatile. Portfolio B took far lesser risk to generate similar return and therefore has a better risk-adjusted return profile. As an investor, you are less likely to make behavioural errors in portfolio B as the consistency of the portfolio is far higher than portfolio A.

While there are many tools which can be used to reduce risk in your portfolio, here are a few important considerations which are essential while constructing investment portfolios:

Concentration

1. Asset Level: Are you over or under-exposed to an asset class like real estate, equities or debt, gold, etc.? If your portfolio has higher concentration in real estate, then the portfolio is likely to underperform in the current scenario. If overexposed to equities, the portfolio volatility is likely to be extremely high and that could trigger a behavioural error. If you are overexposed to fixed income, you run a risk of inflation eating into your capital gradually and the portfolio not growing adequately. Arriving at the most efficient asset allocation specific to your goals is half the battle won.

2. Scheme Level: If your debt portfolio had a heavy exposure in IL and FS and its group companies, the portfolio returns would have dropped far more than a well-diversified portfolio. Similarly, if your equity portfolio is overly concentrated to a similar set of stocks through different funds, the portfolio is overly diversified. This is an exercise which needs to be done on an ongoing basis to reduce security concentration risk. Don’t put all your eggs in one basket – it may sound clichéd but is relevant! And it is not only for assets but optimum diversification is needed for schemes too. This ensures that a sudden drop in scheme returns due to uncertain events does not hamper the portfolio return significantly.

Credit Risk
This is relevant for fixed income investors. Fund A generating 7% per annum versus Fund B generating 9% per annum does not necessarily make the latter superior. Fund B may have invested in lower credit quality securities and therefore taken higher risk to generate that return. Merely grading fixed income funds based on their returns is incorrect. Dig deeper into the construct of the funds to evaluate where they stack up on their risk levels and evaluate which one suits your profile.

Interest Rate Risk
This is relevant for fixed income investors. A gilt fund or long duration debt fund is likely to show you the best performance at the bottom of the interest rate cycle. However, it is usually the worst time to invest in those funds at that time and vice versa.

Volatility
Volatile assets, especially equities and gold, tend to get over or under-priced in the near term and mean revert in the medium term. If a fact-sheet of a scheme shows an exceptionally higher return over long-term averages, you need to exercise caution in buying that scheme in bulk as that scheme may mean revert in the near term. However, this is just a thumb rule. Even means can keep changing in growing economies with changing growth rates and inflation.

Asset Allocation
Research suggests that asset allocation contributes almost 90% to portfolio performance. Scheme selection and others contribute only around 10%. Investors tend to focus a lot more on the latter. As a first step, figure out your risk-taking ability specific to your goals, decide the asset allocation which fits your objectives and stay within those thresholds. The other more dynamic way is that you go overweight or underweight in risky or conservative assets in a certain range depending on the prevalent risk in those assets. This however should not be likened to timing the market.

Conclusion
Investors would be rewarded in the long run if their investment approach shifts away from focusing at individual schemes in silos to a holistic portfolio approach with every constituent scheme contributing commensurate to its risk. Managing portfolio risk is the key to eke out portfolio alpha!

Founder and Managing Partner, Nestegg Wealth Solution LLP  Email id : vishal.vij@nesteggindia.com  Website : www.nesteggindia.com