What is Risk?

What is Risk?

Craig Basinger, Chris Kerlow, Derek Benedet, Shane Obata

When most investors think of risk, equity market risk most often jumps top of
mind. For an equity portfolio, fund or investment product, if the market
declines by x%, by how much can you expect the investment to decline? And
there are many popular performance-based measurements of this kind of
risk. Standard deviation is likely the most popular, measuring the volatility of
returns over a period. Downside deviation, a slightly different iteration,
measures just the volatility of negative returns over a period. After all, if the
investment goes up 10%, is that really risk? Up and down market capture can
provide insights. This calculates the average up market capture when the
market moves higher and average down-market capture when the market
moves down. Then there is correlation, not really measuring the magnitude
but more the direction of the investments performance-based on which
direction the market is moving.

All of the above risk metrics, while insightful and useful, are only really
capturing or quantifying how much equity market risk an investment contains.
But, much like the rainbow has many colours, risk too comes in many forms
with equity market risk only being one of them. In the following paragraphs,
we will share other kinds of risk that may not be as popular but are becoming
more important for investors. And new methods for calculating or quantifying
certain risks.

Beyond Equity Market Risk

When it comes to building and/or managing portfolios, only focusing on equity
market risk can actually be dangerous. For instance, investments that are
lower in equity market risk can often have higher risk from other factors or
exposures. Understanding how trading one risk for another, which may still be
beneficial for a portfolio, still has other risks that should be acknowledged.
The following are a few types of risk that go beyond simple market risk that
investors should consider.

Purchasing Power Risk – Even though inflation is low, running about 2.3%
in Canada, this is a risk since bond yields are also low. Adding bonds to a
portfolio certainly reduces the overall equity market risk, but it does increase
the purchasing power risk, losing purchasing power over time. The Canadian
bond universe has a weighted yield-to-maturity of 2.75%. Which means if
inflation remained stable, you would earn 0.45% in real terms (chart). If inflation rises or you invested in shorter duration bonds that have a lower return, you are likely trading equity market risk for inflation or losing
purchasing power over time.

Credit Risk – There was a time, not that long ago, when individual investors
used to own government bonds as a core component of many portfolios. As
bond yields fell, investors turned to provincial bonds, then to investment
grade corporates, then to high yield corporates, and now to investments in
bank loans, microfinance, mortgages, etc. This slide down the credit curve
over the past decades in search of yield has resulted in many portfolios
containing a much higher credit risk than decades past. While not necessarily
a bad thing, this is a risk unlike equity market risk that should be considered.

With credit spreads being historically low (yield on investment grade or high
yield bonds over government bonds), it does raise the question whether
investors are being adequately compensated for taking on credit risk (top
chart). In addition to low spreads, the current bull market is now over eight
years old and should a recession be on the horizon, credit exposure may
become a more pertinent risk.

Interest Rate Sensitivity Risk – This is a relatively new type of risk for many
investors as bond yields have been steadily declining over the past few
decades. However, after bottoming in 2016, yields have been trending higher,
thus impacting more interest rate sensitive investments (2nd chart). Bonds fall
into this category but so do many dividend paying equities. Yields, once a
tailwind for utilities, telecom companies, pipelines and real estate companies,
are now becoming a headwind. Divergence among dividend strategies this
year have been notably driven by their respective sensitivity or risk to
changing rates/yields.

Dividend focused strategies, which have historically experienced lower equity
market risk, have a higher interest rate sensitivity risk. Should yields continue
to rise, this risk is becoming more impactful on performance. The advent of
some ‘low volatility’ strategies that focus on equity investments with
historically lower equity market risk have actually traded this risk for interest
rate sensitivity risk.

Sector or Stock Selection Risk – Investments that are very concentrated in
a sector or limited number of sectors are at risk should that sector fall out of
favour. Style-based investing has greater sector selection risk. For instance,
Growth outperformed Value substantially in 2017 based on the S&P 500 style
indices. Tilts in a portfolio that focus on one style may reduce some types of
risk but elevate sector or style risk. Just ask any value manager these days.

This is also evident in portfolios that focus on only a few securities. Or
long/short alternative strategies. A long/short fund goes long some
companies and short others, which certainly reduces equity market exposure
risk, since if the market falls, the shorts will help offset the broader market
risk. However, this strategy trades market risk for stock selection risk. The
longs need to go up while the shorts need to decline. Clearly which stocks are
long or short become the key risk driver.

Measuring Risk – Beyond Standard Deviation

Factor-based risk measurements are becoming more popular. Not just to
quantify risk but also to understand the exposure in a portfolio. These can
include factors such as growth, value, momentum, leverage, size, variability,
dividends and variability to mention a few. Risk is not a bad thing, not
knowing the risk a portfolio or investment is subject to is. Factor analytics can
help isolate the exposure from stock, style, currency, and interest rate

Another approach that is useful is scenario analysis. Events that happened
are not going to repeat but understanding the variance in how different
investments perform under different scenarios helps investors understand
their risk. Bloomberg uses a Global Equity model which can measure the
estimated value at risk under past key events. This can help differentiate the
risks between investments. Understanding these differences, can help
managers and advisors build better quality portfolios.

Investment Implications – Investing is all about risk, managing the
appropriate level of risk to meet your long-term investment objectives.
However, risk goes well beyond simple equity market risk, and understanding
the other types of risk is critical for managing portfolios. Risk isn’t a negative,
if there were not risk there would be no return either. However, the more we
can understand and quantify other risks, in addition to market risk, the less
likely we will be surprised. Surprise risk, one to which you didn’t think you
were exposed, is by far the worse risk out there.

Redwood Asset Management Inc. Disclaimers:
Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.
Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Redwood Asset Management Inc. believes to be reasonable assumptions, Redwood Asset Management Inc. cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

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