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1 March 2014 CFA Institute Journal Review

Risk Disparity (Digest Summary)

  1. Heather K. Traficanti

The “inter-temporal disparity of portfolio risk” is defined as unequal portfolio risk over time. The author provides a solution: Investors should accept a flexible, rather than rigid, investment policy to maximize return and minimize risk as it changes over time. The research suggests that a flexible investment policy based on the absorption ratio is optimal because it results in a higher return-to-risk ratio and a lower measure of vulnerability to portfolio losses.

What’s Inside?

The objective of the research is to provide evidence of the inter-temporal disparity of portfolio risk (i.e., the inequality of portfolio risk over time). The author suggests that investors adopt flexible, rather than rigid, investment policies. He calculates two different absorption ratio measures to predict shifts in volatility and exposure to loss: the intrinsic absorption, calculated on a portfolio level, and the extrinsic absorption ratio, calculated on the US equity market. His findings indicate that the absorption ratio can be used to determine when to rebalance a portfolio in anticipation of future losses.

How Is This Research Useful to Practitioners?

A high absorption ratio indicates that the assets are tightly linked and delicate; negative shocks will have a greater effect. A low absorption ratio indicates the opposite. The author suggests that practitioners try to obtain low absorption ratios, which will perform better in volatile markets, because they are a more desirable portfolio characteristic.

The target audience for this research is portfolio managers who use a variety of strategies. The strategies include managing policy portfolios according to investment policy statements, maintaining relatively fixed asset weights, and using risk parity. The author suggests that practitioners use a rebalancing rule: When an independent spike of one standard deviation—either in intrinsic or extrinsic fragility (i.e., the absorption ratio)—occurs, half of the portfolio’s liquid equity exposure is exchanged for Treasury bonds, and when both measures of fragility spike simultaneously, the entire liquid equity position is shifted to Treasury bonds. The author’s findings suggest that a flexible investment policy based on portfolio rebalancing to manage risk in periods of increased market volatility is optimal.

The author demonstrates that a jointly conditioned portfolio, which implements rebalancing rules when intrinsic and extrinsic fragility are considered, contributes to an improvement in the long-term growth rate and significantly reduces the portfolio’s volatility and risk disparity, resulting in an improved risk ratio relative to a static portfolio. The proposed rebalancing rule mitigates the inter-temporal disparity of portfolio volatility (i.e., stabilizes the portfolio’s risk profile).

How Did the Author Conduct This Research?

The sample data are from a representative policy portfolio that is composed of the following eight asset classes: US large cap (25%), US small cap (15%), EAFE equity (5%), emerging market equity (5%), US Treasuries (20%), US credit (15%), REITs (5%), and private equity (10%). The portfolio’s returns and volatility from January 1998 to February 2013 are used to calculate loss probability, absorption ratios, correlations, and volatility. To capture extrinsic fragility for a broad market, the US equity market and a select number of industries are used.

The author uses the absorption ratio, or “the fraction of the total variance of a set of asset returns explained or absorbed by a fixed number of eigenvectors.” He includes four portfolio scenario analyses: a static portfolio, an intrinsic portfolio, an extrinsic portfolio, and a combined portfolio. The static portfolio refers to a portfolio managed with a fixed investment policy, whereas the intrinsic and extrinsic portfolios are managed by rebalancing half of the liquid equity positions into Treasury bonds when there is a one standard deviation spike in either intrinsic (portfolio-level) or extrinsic (US equity market) fragility.

The combined portfolio is rebalanced to 100% Treasury bonds when both intrinsic and extrinsic absorption ratios exceed a one standard deviation spike. The author summarizes by clearly indicating that the combined portfolio has the maximum return-to-risk ratio and the lowest measures of one- and three-year disparity. Disparity is a measure of vulnerability to portfolio losses.

Abstractor’s Viewpoint

The author uses the absorption ratio to measure the ratio of portfolio fragility to losses. The methodology would be more robust if, in the combined portfolio, the author converted the liquid equity positions into more liquid asset classes—for example, exchange-traded funds, index funds, and index futures—rather than converting them into Treasury bonds. He mentions these asset classes in the introduction but does not explore the concept more deeply. He does, however, use the absorption ratio in a different application, as compared with the US Treasury Department’s Office of Financial Research (2012), which uses the absorption ratio as an “effective early warning measure of financial crisis,” or extrinsic fragility.

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