Optimizing portfolios amid market volatility:  tools for navigating stormy seas 

Risk and portfolio managers have been sailing through stormy seas in recent years. In 2022, for example, a portfolio with 60 percent US large cap stocks and 40 percent investment-grade bonds was in choppy waters, suffering a nominal loss of 18.1 percent as the two asset classes failed to diversify each other. Consequently, last year was one of the worst years on record for the 60/40 portfolio.

While risk and portfolio managers might have experienced a slightly smoother ride in the first half of 2023, there were still moments of volatility that had them clutching their financial life vests. The most notable were the days following the collapse of Silicon Valley Bank.

“There were some very volatile days at the outset of the banking concerns spurred by Silicon Valley Bank. While substantial, the crisis stemming from its failure was hardly unique, and events that shake investors will always continue to happen,” says Melissa Brown, Head of Applied Research at Qontigo.

“When we discuss risk and volatility, it is not always negative. Typically, when volatility increases, it also creates opportunities. However, you need to understand the risks and how the expected volatility impacts your portfolio. You can either avoid the pitfalls or exploit the opportunities, or both, which is the idea behind our tools,” Brown says.

During times of currency stress, even a small exposure to this factor can have a substantial impact on performance.

Melissa Brown
Head of Applied Research, Qontigo

Pay attention to exchange rate sensitivity

Since 2021, SimCorp clients have had the opportunity to seamlessly integrate Axioma's Multi Factor Risk Models, Axioma Portfolio Optimizer™, and Axioma Risk™ into their investment management platform via standardized APIs. 

Asioma’s risk management and portfolio optimization tools help portfolio managers not only mitigating downside risks but also unlocking possibilities, when volatility takes the spotlight.

While fund managers typically remain aware of their exposure to well-known style factors like value and momentum, one often overlooked risk factor on the Axioma Risk platform is exchange rate sensitivity, according to Brown.  

Exchange rate sensitivity measures the relationship between a stock's price and the return of its base currency relative to a basket of currencies. Positive exposure indicates that the stock is expected to rise as the currency strengthens. 

"During times of currency stress, even a small exposure to this factor can have a substantial impact on performance. Investors, who are unaware of how their performance correlates with this factor, may appear to be skilled managers during favorable times but, in reality, are simply fortunate. This is the type of factor that we frequently advise portfolio managers to closely monitor," explains Brown. 

Investors often overlook exchange rate sensitivity because its long-term return typically hovers around zero. However, during specific periods, it has shown a significant impact on performance, such as the substantial appreciation of the USD in 2022, or the decline of the euro during the European debt crisis.  

Optimizing the portfolio

The current prevailing theme in the market revolves around the speculation of whether the Federal Reserve has reached the end of its interest rate hike cycle following a substantial 5-percentage-point increase over a span of 15 months.

This period of soaring inflation and rapid rate hikes has been one of the key culprits behind the risk and portfolio managers’ tumultuous journey, as rising yields generally lead to a decline in bond values and a downward trend in stock prices.

The recent robust job gains and low unemployment rates may suggest that inflation is far from being resolved. This ongoing uncertainty has the potential to translate into heightened volatility in the market. However, it is important to note that volatility also brings opportunities for long-term investors, as it drives asset price dislocations.

Axioma's portfolio optimization tool is specifically designed to capture and reflect these market dynamics.

“Our sophisticated portfolio optimizer can assess millions of combinations of stocks, highlighting the ones that offer the desired expected return and risk, thereby providing the optimal portfolio, the one with the best risk-return tradeoff," says Brown.

Keeping tracking error on a short leash

The Axioma global equity risk model operates with two horizons: one focuses on predicting volatility over the next 1-3 months, while the other, referred to as the medium horizon, assesses the next 3-6 months.

The risk models are updated daily, but Brown emphasizes that it is important for investors to strike a balance between noise and signals, as an overly sensitive model leads to excessive trading.

An important question is how often investors should evaluate their portfolio characteristics. According to Brown, there is no fixed rule.

“We advise our clients to pay close attention, especially when risk rapidly escalates in the short-term such as during the failure of Silicon Valley Bank, but it depends on your specific circumstances. For example, some managers may have investment management agreements that specify a maximum acceptable tracking error. Those managers probably need to assess their portfolios daily, to ensure it remains within the prescribed limit," notes Brown.

"Sometimes, even fundamental discretionary managers may not realize that their bet on financial stocks, for instance, has become riskier than intended due to changing market conditions as seen this year. In such cases, it might be prudent to trim positions without making wholesale changes to the portfolio, ensuring that risks align with expected returns," Brown explains.

When the interest rate cut cycle starts, it will impact most portfolios due to the correlation between interest rate movements and equity performance.

"Interest rates have already seen substantial increases, so one might consider testing for a scenario where rates start falling and how they impact of a weakening USD. This is already something that we have been seeing Axioma clients doing increasingly recently," Brown concludes.