Crisis-Robust Portfolio

Crisis-Robust Portfolio

By Marie Brière, head of fixed income, FX and volatility strategy, Crédit Agricole Asset Management and Ariane Szafarz, professor, Solvay Brussel School of Economics and Management, Université Libre de Bruxelles.

As a result of the latest financial turmoil, the asset manage-ment industry has experienced structural shocks and felt a pressing need to adapt to investors’ new expectations. Recent research has focused on investigating new ways of taking account of the impact of financial crises on asset allocation in order to make portfolio performance more robust.

Financial crises cause the volatility of most assets to increase. There is also closer correlation between asset returns. This contagion, between assets and markets in a globalized financial world, makes diversification less efficient. Asset managers have to deal with this double risk of higher volatility and correlation. Their usual response is to sell off volatile securities and reallocate to safer assets.

Some academics recommend designing two portfolio types—a quiet-regime portfolio and a crisis-regime portfolio—and changing the asset allocation when a crisis erupts in order to mitigate its harmful effects. This approach has proven quite successful in FX markets. However, the difficulty lies in the timing, i.e., watching the market carefully for signs of an oncoming crisis in order to switch portfolios early enough to avoid the worst initial effects.

The alternative we propose is a new concept: the “crisis-robust portfolio,” which minimizes the volatility ratio between crisis and quiet periods. This type of portfolio is less demanding on the investor than switching between regime-based portfolios. In practice, a crisis robust portfolio enables asset managers to honour the risk thresholds set by their clients or the fund documents. The risk thresholds produced by our model ensure that crisis periods interfere as little as possible with a portfolio’s composition and risk. Since the most risky securities suffer most from market upsets, the portfolio contains only a small proportion of risk-exposed assets.

Although general, the concept of a crisis-robust portfolio is particularly appealing when applied to fixed income markets, which exhibit a flight-to-quality tradeoff in crises. As the volatility of all asset classes increases, the correlation between the safest bonds (sovereigns and, to a lesser extent, investment-grade corporates) and the riskiest (high-yield bonds) drops. As a result, the diversification effect increases and the overall rise in volatility is partially offset by the lower correlation between returns. This risk-offsetting mechanism makes it possible to create a fixed income portfolio that mitigates the negative impact of crises.



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