Portfolio de-risking has many faces, but what matters most is which one your portfolio sees when it looks in the mirror. For the sake of clarity, investors can think of them in the standard parlance of evolving technology starting at 1.0, starting from what today would be considered a typical baseline institutional portfolio of stocks, bonds, and alternatives. 

• De-Risking 1.0 reallocates more to bonds, less to stocks, and in general lower-risk asset classes. 
• De-Risking 1.1 replaces the existing equity allocation with core low volatility exposure. 
• De-Risking 2.0 increases the allocation to low-volatility while staying risk neutral to De-Risking 1.0. 

As in the example earlier in this report, the reference time begins in 1999 and carries through to roughly the current day. The chart below compares the performance of De-Risking 1.0, 1.1, and 2.0 in that time frame.

Focusing on De-Risking 1.0 and De-Risking 2.0, assume that the investor is comfortable with a realized risk of 6.75%. What might the investor get for a similar risk budget in De-Risking 2.0, using low-volatility equities as the equity allocation at the core versus a cap-weighted MSCI World allocation? Significant improvement. The risk remains the same, the return increases by about 1.5%, to 7.67% from 6.17%. The Sharpe ratio improves by 0.22, and the maximum drawdown stays about the same. But the investor achieved all this with a greater allocation to equities than is present in De-Risking 1.0. Not a bad outcome when the max drawdown is the same. 

“If we put our assumptions about forward returns into De-Risking 1.0, we’re looking at similar performance to what we’ve seen since 1999 using De-Risking 1.0, or perhaps even lesser performance given where yields are at today,” says Michael Hunstad, Ph.D., Head of Quantitative Strategies at Northern Trust Asset Management.

“That’s the classic knee-jerk reaction to de-risking,” he continues, referencing the move to include more bonds. “But it’s not uncommon. Investors are very cautious about that given where Treasury and bond yields are in the U.S. and globally.”

Even in an environment of tremendous uncertainty, there can be opportunity in de-risking, however. “If you look at De-Risking 2.0, all you have really done is shift the allocation toward low volatility, increase the equity allocation overall, and kept the risk the same,” says Hunstad. “A lot of investors are seeing the lack of value in the bond market, but equities have a lot of potential upside. Our view at Northern Trust Asset Management is we’re not expecting a recession, and we are still risk on in our capital market assumptions within our tactical asset allocation portfolio. We like the equity market, but we want investors to get paid for that risk they take. De-risking within that equity bucket seems to make a lot of sense. It made a lot of sense in the past; it seems to make even more sense going forward.” 

Is there potential for investors to realize even greater excess return in a de-risked portfolio that mitigates for the possibility of a down market? There just might be. Think of it as De-Risking 2.1, and it adds quality factors to low-volatility factors. 

Comparing two de-risking portfolios – one low-volatility only, the other a combination of low-volatility and quality factors – it’s apparent adding quality to a low-volatility portfolio helps to the tune of a 2% improvement in the top decile, and some improvement in the second decile. 

“Volatility measurement is almost exclusively price-based,” adds Hunstad. “By adding a quality dimension, you have more of a view of the financial picture of a company, in addition to that price-based factor. When you meld those ideas – low price volatility, good profitability, cash flow, balance sheet, and so on – that tends to be your best bet.” 

And, quite possibly, a major step toward closing the anticipated return gap investors are projected to face over the next five years.

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