Content provided by Joseph Smith, CFA, Senior Market Analyst
- Risk Budgeting makes CLS different in its ability to measure and manage risk in portfolios.
- Risk Budgeting is not the same as managing to a stock-to-bond ratio.
- Stock-to-bond ratios can lead to undesirable levels of risk for long-term investors.
At CLS, we differ from our money-managing peers because we use our Risk Budgeting Methodology to not only measure risk in a portfolio, but more importantly, to manage risk on an ongoing basis. This process, as outlined in our Risk Budgeting Whitepaper, involves incorporating multiple measures of risk to ensure solutions engineered for clients keep them on track to their primary objectives and aligned with their appropriate Risk Budget scores.
So, does Risk Budgeting mean managing to a target stock-to-bond ratio? My short answer is absolutely not! In fact, stock-to-bond ratios are the worst proxies for the amount of risk an investor takes because they lean on a simple rule of thumb that has no bearing on what is currently happening in the markets.
The historical 60/40 portfolio (60% as the Equity Baseline Portfolio (EBP) and 40% as the Fixed Income Neutral Views Portfolio) illustrates this point clearly. In looking at the rolling, 3-year relative risk characteristics of a static 60/40 portfolio versus the EBP, we find risk overall is not consistent with a target expectation of maintaining 60% of the risk of a Global Equity portfolio.
In some cases, the risk associated with a static 60/40 can be modestly higher than what is intended. The only consistent aspect of managing to a stock-to-bond ratio is the stock-to-bond ratio is never moving.
Simply put, Risk Budgeting is a superior method of managing assets because it not only measures risk in a portfolio at all points in time, but it is flexible as risk changes in the markets.
The inflexibility of stock-to-bond ratios can lead to unexpected levels of risks that may not be consistent with an investor’s longer-term objectives or tolerance for risk.