Risk Allocation and Position Size

Coverage of the 2017 Risk Management Conference

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stocksnap_xxtek7aplaMost investors have a good sense of where the returns in their portfolio are coming from – but what about the risks? Knowing where they are is just as important from a return

perspective says Dag Wetterwald, Senior Portfolio Manager, Risk & Portfolio Construction with the UK-based Global Equity team at RBC Global Asset Management (UK) Limited.
“One of the big issues in portfolio management today is bet size,” he explains. “How does an investor determine the right size of bet to take in a portfolio?” The answer to the question lies in striking a balance between capital allocation and risk allocation.

All too often, investors focus on the former and spend little time thinking about the latter.

Choosing the right size of position is critical to the risk allocation process so many investors are grappling with today.

To get beyond return distribution and understand the risks in a portfolio it’s important to start with your goals – what are you trying to do with the portfolio?

“We typically allocate capital, but you have to take risk with that capital to generate a return,” Wetterwald explains, adding that when it comes to portfolio construction investors “want to maximize intended risk and minimize everything else, such as unintended risk.”

But looking at both in tandem can help an investor understand a lot about how their portfolio works – where the returns are coming from along with any unintended risks.

As a case study, Wetterwald applied this approach to fundamental managers – stock pickers that invest on a company by company basis and equally weight the investments in the portfolio.

In that case, the notion of an equal weighted portfolio should be turned upside down.

From a capital allocation perspective, that portfolio might be working well – look at it from a risk allocation perspective, however, and it doesn’t add up.

Take Amazon for example – from a capital allocation perspective, it might be a good fit. But there are risks under the hood that should govern how big a bet to take – company-specific issues, U.S. market exposure, consumer trends, all of which add up to multiple risk sources.

“Risk allocation looks at this and is directly related to the expected information ratio of a portfolio,” Wetterwald says. “When a portfolio has the same amount of risk invested in each asset, the portfolio is well balanced.”

At the end of the day, diversification of risks means that every bet in a portfolio is working – and risks that were thought to be undiversifiable can be addressed.

“Investors understand return distribution based on tracking error, but the distribution of risk is also important,” he concludes. “If you don’t take risk, you won’t earn returns.” At the same time, investors focused on capital allocation alone could be taking unintended risks – and their portfolios will be much less efficient.

So, when it comes to sizing up a bet, investors need to look at the risks first and allocate from there. The result will be a more efficient portfolio benefiting from better alpha capture and improved diversification.

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