We are committed to creating risk-rated portfolios that avoid any unwelcome surprises for clients. We have developed an intuitive set of maximum loss and volatility constraints to ensure compliance to portfolio constraints and risk profile. Risk and its management are integral to our investment process.
Defining investment risk: the probability of an investment losing some or all of its value when the client needs to sell it. This risk, the risk of permanent loss of capital, is important but is not the end of the story. For portfolio management, the ongoing valuation of a portfolio matters and the amount by which that valuation changes over time is the key determinant of risk. The level of acceptance to this variability is rightly a key determinant of risk tolerance. We understand that for advisers to select the appropriateness of any model for their clients we need to monitor and stay within stated short term volatility constraints. This volatility is essentially what we mean by risk.
At Rivers Capital Management, we monitor, and publish, two primary measures of this risk – annualised daily volatility and maximum loss. The volatility tells us the extent to which a model portfolio will vary in value and the maximum loss is the amount by which we would not expect a model portfolio to fall by, over any time period. Our preference is the latter as it is less ambiguous and it ensures that we concentrate more on the ‘tail-risk’ or worst case scenario.
More important than statistical analysis of an investment’s volatility is the combined effect of that investment to the characteristics of the whole portfolio. Assuming adequate liquidity, which is a necessary condition before any investment is made, the inter-relation between individual components of a portfolio is of primary importance. A focus on this will ensure we maximise diversification. Research demonstrates that portfolio diversification will provide better long term risk adjusted returns.
Strategic portfolio construction will ultimately define most of the risk characteristics of an investment portfolio. Studies have shown that as much as 80% of the overall long term return and risk of a portfolio comes from the strategic asset allocation. In that regard we think the traditional Bonds-Equity-Alternative investment categories fail to adequately account for the changing investment environment. Given the vast expansion of complex investment strategies in recent years we believe this ‘Asset Class’ based portfolio construction methodology needed reviewing. At Rivers, we believe the categories of ‘Anchor’, ’Enhancer’ and ‘Diversifier’ avoid several of these complexities and ensure that strategic portfolios are focused on more relevant risk criteria. Historically where Cash and Bond assets built a core of low volatility investments, we prefer to begin our process by designing what we can “Anchor” to the portfolio. Assets which “Anchor” the portfolio do include traditional Fixed Income instruments, but only those with very high credit quality. Anchor assets can also be found in certain Low Risk absolute return opportunities although liquidity often prevents inclusion. Essentially “Anchor” investments are selected for low market correlation, low risk and capital preservation. Long term capital risk and volatility is low but interest rate risk can create liquidity concerns.
Where higher returns are required and risk can be increased we add “Enhancer” Assets to the portfolio by adding equity related risk. Enhancer assets can be direct equity, public equity or credit with a high correlation to equity growth. Enhancer assets should offer long term attractive returns but the capital risk and volatility is high. Enhancers will significantly follow economic and market trends and need to be moderated for portfolios with limited maximum loss constraints.
Having added Enhancers, the primary concern switches to diversification and the selection of “Diversifier” investments. These include commodity investments, macro timing funds, uncorrelated credit funds, real estate and other market neutral uncorrelated funds. The individual volatility of these investments is less important than the minimal or negative correlation to either interest rate or equity market risk. These assets often have high positive returns but their inclusion is primarily to diversify risk and therefore the non-correlation is the primary driver.
By using risk related categorisation and by monitoring the correlation between investments we are seeking to create efficient diversified portfolios. These portfolios are adapted and managed using this same process while ensuring that our objective remains that portfolios remain within pre-determined and controlled levels of risk.Back