Institutional Investor Teach-in Part 2: Risk Budgeting Methodology

The Art of the Risk Budgeting Methodology -
How Much Equity-relative risk should we take?

We utilize a set of qualitative factors that determine roughly how much equity-relative risk we are willing to take subject to the risk-band that is appropriate for the reader/client. It is a holistic approach. As displayed in the checklist below, overall portfolio risk metrics will fluctuate with changes in the market outlook. Unless otherwise specified, an “impression” is formed visually by making simultaneous use of weekly (5 year), daily (2 year), and hourly (3 month) timescales using open/hi/low/close charts:

• Implication for equities based on impression of defensive assets (Yen, Precious Metals, Treasuries, Utilities)

_____     _____     _____

Good      Average  Poor

• Impression of cyclical assets (Emerging Markets, Non-Precious Metal Commodities, High Yield Fixed Income Relative to Low Yield, Energy/Materials/Industrial S&P GICS Sectors)

_____     _____     _____

Good      Average  Poor

• Equity Market Participation (Russell 3000 performance relative to S&P 500 and DOW 30)

____     _____     _____

Good      Average  Poor

• S&P 500 Chart Pattern
• Hovering near highs at abovementioned timescales?
• Stready trend in-tact at abovementioned timescales?
• Hovering near lows at abovementioned timescales?
• Stready downtrend in-tact at abovementioned timescales?
• Bullish "traps" over abovementioned timescales?
• Bearish "traps" over abovementioned timescales?

Based on Yes/No Above

_____     _____     _____

Good      Average  Poor

  

Beta Targets >>                           Aggressive            Balanced

Mix Good/Avg or All Good         0.75 or higher       0.50 or higher

All Avg or >=1 of Each                0.65 - 0.75            0.40 - 0.50

  Mix of Avg/Poor or All Poor              0.65 or lower          0.40 or lower

  Ex. Asset Allocation                          Eq/FI/Alt                 Eq/FI/Alt

Mix Good/Avg or All Good          >90%/5%/5%       >80%/15%/5%

All Avg or >=1 of Each                80%/10%/10%      70%/20%/10%

Mix of Avg/Poor or All Poor               <60%/25%/15%     <50%/40%/10%

There is a lot “going on” in the table above. To be precise, the message is: when market conditions deteriorate, we generally take equity exposure down, and vice versa. In the next section, we’ll examine how we select individual securities.