Rethink portfolios with risk management

Innova Asset Management, the funds management arm of Fortnum Financial Advisers, is rebuilding its range of model portfolios using a new approach to portfolio construction that pays little attention to investment returns.

According to Innova managing director Dan Miles, risk management, not return optimisation, should be at the heart of the investment process.

“There are some very serious flaws with traditional portfolio construction because 60/40 portfolios don’t work and never have. Essentially, if growth assets go down, the whole portfolio goes down, so the concept of risk reduction has been completely misunderstood,” he said.

“A better form of portfolio construction is to understand risk based on risk factors and using diversification of these risk factors to build more robust portfolios.”

Innova’s new approach has been developed in conjunction with Milliman and focuses on the core drivers of return within any asset class, given that multiple asset classes are often driven by common risk factors. For example, equities and bonds often share similar, or the same, risk factors, which is why their correlations are often positive.

“Traditional portfolios have almost their entire risk budget tied up in equities, and this large exposure to equities leads to an over-exposure to the drivers of equity risk, which may also exist in other asset classes,” Miles said.

According to Josh Corrigan, principal and consulting actuary at Milliman, investors would prefer lower returns with lower volatility provided the portfolio met their needs.

“Most frameworks are focused on return optimisation and concentrate on the assets that are likely to outperform with a simple, narrow definition of risk. However, individuals think about risk in respect to their objectives.”

“People now recognise that the way things have been done in the past haven’t worked and have led to some poor outcomes, so we’re approaching the problem by looking at risk exposures across a range of different asset classes,” he said.

Innova Asset Management and Milliman are urging other funds managers to rethink how their risk management works to ensure clients’ needs and liabilities are appropriately matched and married with assets. Read the full report here.