Risk Allocation - In Concert with the Markets

This article is contributed by William G Ferrell, CIO of Ferrell Capital Management and the author of a new course on Global Risk Academy - "From Asset Allocation To Risk Allocation"

Risk Allocation - In Concert with the Markets

Since Harry Markowitz introduced Modern Portfolio Theory in 1952, Asset Allocation has been accepted as the standard for investment portfolio construction.  Managers make risk and return forecasts for categories of investments and combine them to make the most efficient portfolio possible at that point in time.  The portfolio is based on static statistics, and the future is based on hope.  Time reveals the outcome for investors.

Traditional investment theory overlooks the dynamic nature of market behavior.  Technology allows investment models to be agile and adaptive, to manage adaptive portfolios, counting on the environment to change.

Risk Allocation allows us to diversify investment risk in three critical ways:

-       Allocate the amount of risk desired for each exposure, and fund the investments to meet the risk criteria. 

-       Continually measure market changes and their impact on portfolio exposures.

-       Change the exposures whenever necessary to adapt to market behavior.

  • Reduce or remove exposures to market turmoil.
  • Increase exposures for portfolio components with the best risk-adjusted returns.

The result is what we call “Staying in Tune with the Markets”.  This allows investors to get the best reward when markets perform well and avoid losing money during financial crises.

Narv Narvekar, the new CEO at the Harvard Endowment eludes to a “Risk allocation framework”, that “focuses less on the portion of portfolio dollars invested and more on the portion of portfolio risk coming from those exposures.  Columbia developed such a framework in 2004 and has been very well served by it.”

Marginal Impact on Risk, Returns and Sharpe’s

At the heart of Risk Allocation practice is the incorporation of incremental or marginal attributions of each investment to the risk of the whole portfolio. Individual “Contributions to Risk” are based on the percentages of the risk associated with each exposure to the total portfolio risk.   “Marginal Risk” attribution takes into consideration the correlations between portfolio components.  It is possible that a marginal risk may have a much larger or smaller proportional impact when deleted from a portfolio.  Considering additions to a portfolio must also weigh the interaction between existing components in the portfolio and the new entry impact. 

When returns are added to the mix, it is possible to calculate the marginal risk-adjusted return (expressed as Marginal Sharpe) impact on the portfolio performance.  Investment opportunities with Sharpe values lower than the portfolio may have a positive impact on the portfolio Sharpe if its correlation is sufficiently low.  By the same rule, an attractive investment may negatively impact the Sharpe of the portfolio if its correlation is too high.  Further calculation of the relative reliability, the second derivative of Marginal Sharpe, can be used as way to adjust allocations to favor the best investment opportunities. 

Risk Allocation and Marginal Sharpe help risk allocators build portfolios that outperform market benchmarks, by replacing forecasts with real time exposure changes which adapt to market conditions as they unfold.



Smart Beta has a New Competitor:

Smarter Beta That Keeps On Learning

Smart Beta sponsors re-assign allocations to the index components they believe will outperform.  The research is based on the available information at the moment when the portfolio is created.  Some are smarter than others, but all have a fundamental problem


Time unfolds the future, and the future may not resemble the forecasts that went into the portfolio assumptions.  If the forecasts are wrong, the portfolio suffers.  When this occurs, there is nothing Smart Beta can do but lose its edge and money at the same time.

A Smarter version of a Beta Investment learns from the future as it unfolds.  As conditions change, adjustments to market exposure protect investment capital.  The Artificial intelligence of Risk allocation is not emotional or subject to judgment, feelings or future forecasts.  When some of the Index Components behave badly, the Smarter Beta methodology reduces or removes exposures.  When it becomes safe to restore the market exposure, Smarter Beta re-positions to participate.


If you want to study more about Risk Allocation, please check out the new course developed by William G Ferrell, CIO of Ferrell Capital Management - "From Asset Allocation To Risk Allocation"
If it's a fit for you and you want to join, please hurry up - the current introductory offer is valid during the short period of time only.

As an additional bonus you will get a 1-month subscription for money . net valued at $150.



Ferrell CONCERT has a proven track record of outperforming the benchmarks, through the use of these emerging investment methods.  Please refer to the Ferrell CONCERT International and Ferrell CONCERT DOW descriptions at our FerrellCapital.com web site for further information.

We wish you prosperity and freedom from concern about your investments!

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