Tips for Managing Portfolio Risk

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. We are 10 years into a bull market and if investors don't have risk controls on their mind, they probably should. Joining me to share some research on derisking a portfolio is Alex Bryan. He's editor of Morningstar ETFInvestor.

Alex thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex you devoted at least part of the most recent issue of ETFInvestor to how to think about risk management when it comes to your portfolio. Let's talk about how people should approach this. What's the best way to make sure that your portfolio is taking the right amount of risk given your time horizon and other considerations?

Bryan: So I think setting an appropriate asset allocation is the best thing that you can do to keep risk in line with your risk tolerance. So if you are someone who is little bit less comfortable with the idea of losing money, bonds should really play a bigger role in that portfolio then they might for someone who is a bit more comfortable with risk, where stocks might play a bigger role. I think a lot of investors, particularly when you are in the late stages of a bull market, take probably too much risk within the portfolio overweighting stocks, because stocks historically have offered really attractive performance and it may be really tempting to overweight stocks to try to capture some of those performance benefits. But it's important to really take stock of your asset allocation before a big market downturn hits, to make sure that you are comfortable with that asset allocation so that in a market downturn you are not taking on more risk than you can choose. So I think again if you are more risk-averse, bonds should play a bigger role in your portfolio.

Benz: So that's the very big-picture step you could take, but assuming I've done that and I have sort of thought through what is an appropriate asset allocation given my life stage, given my risk tolerance. What if I want to further derisk the constituents of my portfolio? So maybe I want to invest in less-aggressive equity holdings, less aggressive bond holdings, perhaps. How would I approach that?

Bryan: So I think there is a number of different options. I think it makes a lot of sense to favor more-defensive securities within each asset class, if you are more risk-averse. So for example you might overweight short-term investment-grade bonds within the bond allocation of your portfolio. Those types of securities tend to be a bit less volatile and tend to hold up better than longer-duration bonds during market downturns. On the stock side of the equation you might consider something like a defensive low-volatility fund that invests in more-defensive stocks, things like utilities, consumer-defensive stocks, that are a bit less cyclical and can weather market downturns better than most. So I think there are a number of ways you can try to derisk through fund selection if you are happy with the asset allocation you have in place.

Benz: You mentioned short-term investment-grade bonds. Potentially there is an opportunity cost, right? If even within the asset class I am emphasizing some of the lower-risk options, I may earn less over time than someone who is investing in, say, a total bond market index, right?

Bryan: Right. There is generally speaking a positive relationship between risk and return among asset classes. So if I do overweight short-term bonds those tend to have lower expected returns than riskier bonds. That being said, historically the least risky assets, the least risky securities within each asset class have tended to offer a more favorable risk/reward trade off than riskier assets. So there's been a diminishing return to risk-taking. So while longer-duration bonds do tend to offer higher returns than short-duration bonds, they tend to give you less compensation for that additional risk. So if I am just looking to try to get the best risk/reward trade-off, you are really actually taking more risk off the table than you are giving up in the way of return. But it's absolutely true that you are not going to be able to keep pace with a broader market if you tend to overweight shorter-term bonds and things like that.

Benz: So you mentioned that there has been a diminishing return attached to riskier assets. What do you think is causing that phenomenon?

Bryan: I think there is a lot of investors out there that are nearly focused on maximizing returns. So that can make riskier investments more appealing to them, because they (should) and often do offer higher expected returns than less risky assets. So returning to the shorter-term bond example, those have lower yields to mature even longer-term bonds, any time the yield curve is upwards sloping. So if you have an investor who is focused on returns, they may discount the additional risk of venturing into longer-duration bonds or lower credit-quality bonds and bid the prices of those securities up relative to their risk, to where they are offering less compensation for the risk than the safer bonds. So I think that's a big part of it. That same type of return-chasing mentality I think is also at work in the stock market where the riskiest stocks in the market, they do have a lot of upside potential if things work out. So return-oriented investors might be willing to roll the dice on those stocks, which can sometimes pay off handsomely. But in doing so they may cause those stocks to become overvalued, and similarly they may neglect the more steady-eddy boring types of names like Proctor & Gamble and cause those to become undervalued relative to their risk. So I think there is definitely an element of returns-chasing that can cause this diminishing return to risk that we see in the data.

Benz: So let's talk about how investors can play lower-risk funds within various asset classes. Let's start with equities. USMV, this is a minimum-volatility fund, is one that you like for U.S. equity exposure. Let's talk about why you like it.

Bryan:This is the iShares Edge MSCI Minimum Volatility USA ETF. What this does it basically tries to construct the least-volatile portfolio possible from the U.S. large-cap market under a set of constraints. So it's trying to anchor its sector weightings relative to the market. It's looking not only at individual stock volatility, but also at correlations between stocks. So it's trying to make sure that it's not taking on a lot of risk in any one area of the market. It's looking to try to provide a really well-diversified portfolio of defensive stocks. And since it was launched in 2011 it has done really good job of both reducing volatility relative to the market as well as providing better downside protection. So in periods when the market tends to lose money, this fund still loses money, but generally holds up a bit better than the broad market. So I think it's a really good option for investors looking for a core U.S. equity fund if you are a bit more risk-averse.

Benz: And on the fixed-income side you referenced short-term investment-grades maybe being a good place to emphasize if you want to derisk your fixed-income portfolio. Vanguard Short-Term Bond ETF is a fund you like there (ticker BSV). Let's talk about that. I assume low expenses are part of the formula, one of the reasons that you like the fund. What else is appealing about it?

Bryan: So this fund invests in Treasuries as well as investment-grade corporate bonds with between one to five years until maturity. So it has lower interest-rate risk and something that's tracking a broader bond market index. So interest rates are really the biggest risk that you have within an investment-grade portfolio, and by focusing on the short-term part of the yield curve this has a bit less exposure to that. So if interest rates were to go up, that tends to hurt bond prices, but short-term bonds tend to be less sensitive to those interest-rate movements. They don't go down as much as longer-duration bonds when interest rates start ticking up. So I really like it because again there is not a lot of interest-rate risk here and there is not a lot of credit risk here either--about 60% of the portfolio is parked in Treasuries. So this is a very conservative bond fund and I think it's one that's appropriate for someone who really is pretty risk-averse. But I think as far as getting exposure to the short-term part of the yield curve, because yields are low it's really important to focus on expenses and this is one of the lowest-cost ways of getting exposure to the part of the yield curve.

Benz: Okay, Alex timely discussion of risk management. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.

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