Evaluating risk mitigation strategies

Increasing risk to meet return targets makes strict risk management vital for investors

Jul 17, 2018 | Invesco Quantitative Strategies team

In brief
Risk mitigation strategies seek to create an asymmetric risk-return profile. But benchmarking against the underlying investment is not a valid approach given the potentially stark difference in risk profiles. We discuss how to appropriately calibrate and assess portfolio insurance strategies based on the ensuing return distribution to better fit a given client’s risk preferences.

In light of the sustained low yield environment, investors have increasingly taken on more risk to meet their return targets. Yet, their ability to cope with higher risk is limited, which is what makes strict risk management and suitable portfolio insurance techniques so important.

In a previous article1, we discussed a variety of risk mitigation approaches for a given underlying investment strategy. In particular, we investigated portfolio insurance strategies ranging from static stop-loss techniques to option-based strategies and dynamic portfolio insurance techniques. We concluded that an active portfolio insurance strategy based on a dynamic risk forecast is a cost-effective way to limit a portfolio’s maximum loss at a high probability.

In this article we go further and explain how to calibrate such a strategy to individual risk preferences. Since portfolio insurance is meant to accommodate conservative clients’ need for an asymmetric return profile, adding a risk overlay ultimately boils down to reshaping the portfolio return distribution. Essentially, the aim is to significantly reduce the probability of suffering from severe tail events while sacrificing some of the underlying strategy’s upside potential.

The mechanics of dynamic portfolio insurance
Our preferred dynamic portfolio insurance strategy is rooted in the classic CPPI (constant proportion portfolio insurance2) strategy. It typically sets the exposure in a given risky underlying in such a way that a chosen floor level is not breached within a specified investment period. 

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1 See Theory and practice of portfolio insurance, Risk & Reward #2/2017.
2 For more on CPPI strategies, cf. Perold (1986), Black and Jones (1987, 1988), Perold and Sharpe (1988).