Risk management can be more informed when it draws on the full range of quantitative, fundamental and data-science insights.

This edition of CIO Weekly Perspectives comes from guest contributor Ray Carroll of Neuberger Berman Breton Hill.

Many of the clients we speak to at the moment, whether institutional or individual, are exploring ways to reduce their portfolio risk.

Some are concerned that the cycle is growing old. Some look at the gains they have made across all asset classes over the past decade, and their narrowing deficits, and want to realize some of that progress. Many would tick both boxes.

But right now, reducing portfolio risk is easier said than done.

Issues

The traditional solution of selling some equity exposure in exchange for core government bonds is not the obvious choice with yields at current levels.

Some may think about buying equity index put options to try to hedge some tail risk. We think this works only for those who believe they can time the market—over the medium or long term, it tends to be costly.

Maintaining the same asset allocation while tilting the equity portfolio toward lower-risk and high-quality factors is another approach. The lower-risk factor, identified since the 1970s, is associated with higher long-term risk-adjusted returns than the broad equity market, and has performed well recently.

In our view, this approach—which could capture some attractive high-growth, large-cap names for the portfolio—certainly holds appeal, but it has its issues. Many lower-risk, high-quality stocks look particularly expensive, and no well-diversified long-only equity strategy is likely to get a portfolio’s market sensitivity much below 80 – 90%.

Premia

Instead, we think investors might consider reducing exposure to the equity risk premium and replacing it with some alternative risk premia.

That might involve selling put options, rather than buying them, to aim to harvest the portfolio-insurance premium.

It might involve seeking out “carry” in bond markets—by going long higher-yielding European bonds funded by shorts in lower-yielders such as the U.S. or Japan, for example—rather than simply going long. There can be similar opportunities in currency markets, particularly shorting low-yielding currencies like the euro, Hungarian forint or Israeli shekel to fund high-yielding emerging markets positions.

And it might also involve trying to harvest the lower risk premium with a long-short, as opposed to a long-only equity strategy. Instead of lowering portfolio market sensitivity to 80 – 90%, these strategies can lower it to more like 0 – 20%.

All of these alternative risk premium examples have been performing well over the past year.

Inefficient

In the past, investors may have adopted fairly simplistic approaches to these alternative risk premia. To take the well-known value premium, for example, they would simply go long the stocks with the lowest price-to-earnings or price-to-book ratios and short those with the highest, for example.

We think that has always been a somewhat crude and inefficient approach, and today we believe it can be risky, too. Sometimes, an irrational craze for expensive stocks creates a huge contrarian opportunity to invest in great businesses at very attractive valuations. The dot-com bubble is the classic example.

Today, however, the challenge is that a lot of the market looks expensive or fully valued. On the one hand, some great businesses remain attractive investments despite their P/E ratios being higher than usual. On the other hand, it makes it more likely that businesses trading with lower-than-usual P/E ratios have something fundamentally wrong with them—the classic “value traps.”

We think investors should ask their alternative risk premia managers how they identify stocks like these, which do not pass neatly through traditional quantitative screens.

Smarter Implementation

At Neuberger Berman, we have two key elements to that process:

The first is that our quantitative team draws heavily on the experience and expertise of our counterparts in traditional fundamental research (and we return the favor in different ways). This is not the “quantamental” trend you often read about in the investment press, which often amounts to little more than mixing together quantitative and fundamental portfolios. This is about genuine, systematic collaboration and sharing of insights, which can make a quantitative team aware of material data, specific to industries or individual companies, whose implications may not be showing up in the traditional ratios. My colleague Ram Ramaswamy has written about this in some detail.

The second element is gathering and analyzing alternative datasets—so-called Big Data. These data, which can include everything from satellite photographs to credit card transactions to natural language processing of websites and earnings-call transcripts, have the potential to give us richer and more timely insights into expected future cash flows—insights that can vary substantially from what is implied in past P/E ratios.

You can read much more about that here, including how alternative data can enhance the all-important dialogue between quantitative and fundamental investment research.

In short, managing portfolio risk in today’s environment is unlikely to be easy. Smarter strategies have the potential to fare better than traditional ones—but even smart strategies can benefit a lot from smarter implementation.

In Case You Missed It

  • China Consumer Price Index:  +5.4% year-over-year in January
  • U.S. Consumer Price Index:  +0.1% month-over-month in January and +2.5% year-over-year (core CPI increased 0.2% month-over-month and 2.3% year-over-year)
  • Euro Zone 4Q 2019 (Second Preliminary):  +0.9% annualized rate
  • U.S. Retail Sales:  +0.3% in January

What to Watch For

  • Monday, February 17:
    • Japan 4Q 2019 GDP (Preliminary)
  • Tuesday, February 18:
    • NAHB Housing Market Index
  • Wednesday, February 19:
    • U.S. Producer Price Index
    • U.S. Housing Starts and Building Permits
  • Thursday, February 20:
    • Japan Consumer Price Index
    • Japan Purchasing Managers’ Index
  • Friday, February 21:
    • Euro Zone Purchasing Managers’ Index
    • U.S. Existing Home Sales

– Andrew White, Investment Strategy Group

Statistics on the Current State of the Market – as of February 14, 2020

Market Index WTD MTD YTD
Equity      
S&P 500 Index 1.6% 4.9% 4.9%
Russell 1000 Index 1.8% 5.0% 5.1%
Russell 1000 Growth Index 2.3% 6.2% 8.6%
Russell 1000 Value Index 1.1% 3.6% 1.4%
Russell 2000 Index 1.9% 4.6% 1.3%
MSCI World Index 1.2% 3.9% 3.3%
MSCI EAFE Index 0.0% 1.8% -0.3%
MSCI Emerging Markets Index 1.4% 4.2% -0.7%
STOXX Europe 600 0.4% 2.7% 0.2%
FTSE 100 Index -0.5% 1.9% -1.5%
TOPIX -1.7% 1.1% -1.1%
CSI 300 Index 2.3% -0.4% -2.7%
Fixed Income & Currency      
Citigroup 2-Year Treasury Index 0.0% -0.1% 0.4%
Citigroup 10-Year Treasury Index -0.1% -0.6% 3.1%
Bloomberg Barclays Municipal Bond Index 0.1% 0.0% 1.8%
Bloomberg Barclays US Aggregate Bond Index 0.0% 0.0% 1.9%
Bloomberg Barclays Global Aggregate Index -0.1% -0.8% 0.4%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.2% 0.0% 0.2%
ICE BofAML U.S. High Yield Index 0.5% 1.1% 1.1%
ICE BofAML Global High Yield Index 0.3% 0.7% 0.8%
JP Morgan EMBI Global Diversified Index 0.5% 0.7% 2.2%
JP Morgan GBI-EM Global Diversified Index 0.6% 0.5% -0.8%
U.S. Dollar per British Pounds 0.6% -1.3% -1.8%
U.S. Dollar per Euro -1.1% -2.1% -3.4%
U.S. Dollar per Japanese Yen 0.0% -1.3% -1.0%
Real & Alternative Assets      
Alerian MLP Index 0.4% 0.2% -5.4%
FTSE EPRA/NAREIT North America Index 3.1% 4.7% 6.0%
FTSE EPRA/NAREIT Global Index 2.6% 3.8% 3.4%
Bloomberg Commodity Index 0.9% 0.8% -6.6%
Gold (NYM $/ozt) Continuous Future 0.8% -0.1% 4.2%
Crude Oil WTI (NYM $/bbl) Continuous Future 3.4% 1.0% -14.8%

Source: FactSet, Neuberger Berman.