Manage Risk, Don’t Track Error

“Volatility Management” showcases a portfolio of multiple risk reduction strategies to complement de-risking and diversification. Research indicates that this combination of strategies may offer a total reduction in volatility of 30% to 40%.

Russell attributes these findings to the realignment of the equity portion of an institutional portfolio to manage volatility rather than tracking error, the behavior of the portfolio in relation to the larger market.

“The investment industry has developed an unhealthy obsession with tracking error, but managing tracking error is not managing risk,” said Michael Thomas, chief investment officer of Americas Institutional at Russell Investments. “If an investor is using tracking error as the primary measure of risk, the only way to remain low risk if the market begins performing poorly is for the portfolio to track downward with it. That’s not what most investors consider effective risk management.”

Three risk reduction strategies the report advocates for institutional investors include:

• Defensive equity: Choose stocks for their lower-than-average risk characteristics, a practice that has historically delivered higher returns than those of the broad market;

• Options-based risk reduction: Exploit a systematic supply/demand imbalance for certain types of downside protection; and

• Volatility responsive asset allocation: Vary the exposure to equities as the level of ambient risk in the market rises or falls.

For these strategies, the cost lies in its tracking error relative to a traditional mandate, so it is not suitable for investors concerned with benchmark-relative returns.

More information is available here.