I have written previously about how we use two proprietary, forward-looking risk models to guide portfolio construction. I would like to expand on that topic, explaining how we quantify the unusual risk environment in which we currently operate.
Current Versus Normal Risk
First, a quick review of our risk models.
When thinking about risk, we begin with a very long-term view, which we call Equilibrium. This model encompasses a long-term view (20 to 30 years into the future) that can be thought of as a “normal” state of risk. It is unaffected by near- and intermediate-term cycles such as market, growth, earnings, and business cycles.
Because a true normal state of risk rarely exists, we derive from Equilibrium a shorter-term view of risk we call Outlook. This framework is more consistent with the existing and near-term risk environment.
Our Outlook model originates with our Equilibrium model; we just twist—or distort—the Equilibrium model to reflect the ways in which the current risk environment is non-normal.
There are two main ways in which we do that: by looking at current relationships between broad (and key) exposures, and by looking at non-fundamental influences.
Relationships Between Large Exposures
A foundational example of a key relationship we analyze is the one between stocks and bonds, two major building blocks of the investment landscape. The objective is to account for how we believe those capital markets are behaving relative to one another.
In Equilibrium, stocks and bonds are mildly positively correlated. Their returns are ultimately derived from the same underlying economic engine. Years of observations through varying market environments confirm this, and we can simulate it on a forward-looking basis for hundreds of years.
Because a true normal state of risk rarely exists, we use our shorter-term risk model to arrive at a framework we believe is consistent with today’s current risk environment.
However, in Outlook, which represents the current investing environment, the positive correlation between stocks and bonds does not currently hold true. That is to say, over the next few years, we expect stocks and bonds to be negatively correlated, as they have been recently.
This is important because in a normal risk environment, being long one of those assets and short the other would have a diversifying effect on a portfolio. In the current risk environment, however, we must remain aware that being long one and short the other actually compounds risk in the portfolio.
Another way we quantify how and why we are not currently in a normal risk environment is through the modeling of non-fundamental influences. These influences do not affect Equilibrium but are influential in the current environment—two major ones are macro themes and geopolitical developments.
We do not stop at discussing these influences simply as topics of interest, but rather define and memorialize our views on the influence these themes and geopolitical scenarios have in the current environment.
We want to understand which markets and currencies are influenced by these issues, as well as the direction and degree of influence.
A current example of a theme is Energy. We believe that the movement of energy prices is influential in the market today. What does that really mean? How can we make that more tangible?
There might be 10 or 15 “constituents” of a theme. Russian equities, for example, are one constituent of our Energy theme. In analyzing how this market plays a role in the theme, we model things like the direction (positive or negative) and the degree of influence (low, medium, high) the theme has on this market.
We put these metrics together within a proprietary risk analysis system that aggregates these themes and geopolitical scenarios and quantifies the amount and degree of influence they have in Outlook. It is an investing environment that ultimately differs from Equilibrium.
These themes don’t exist in a “set it and forget it” environment. On a regular basis, the team revisits the direction and degree of influence. The constituent lineups also evolve over time.
There may be a time, for example, when Russian equities are no longer a part of the Energy theme. Ultimately, while typically remaining relatively stable on a day-to-day basis, there are many moving pieces within each theme and it can sometimes be fluid over intermediate horizons.
This information and how it changes over time feeds our risk framework. It must remain a very robust tool because at any point in time there may be as many as four or five themes or geopolitical scenarios, each with various constituents, each having their own degree and direction of influence.
And, importantly, one theme may have an overall degree of influence but another may have a full or partial countering influence on near-term risk.
Being able to quantify and memorialize all of these influences on an ongoing basis helps us understand how our positions are influenced by these themes and geopolitical developments, and the direction and degree of influence.