We looked at some well-known portfolio risks in our previous note Portfolio Risk, we shall now look at a few of the lesser-known risks and explore what kind of products or securities they might lie in.
Correlation risk: When portfolios are created by investors or investment managers, there is generally an inherent assumption made towards the benefits of correlation/diversification that might be provided by the mix of assets or securities. For e.g., the classic 60/40 model portfolio which is a mix of equity and debt assumes that in periods of growth both equities and debt will do well, while in periods of economic uncertainty, the performance of debt will offset some of the losses in equities. However, it is entirely possible that there are periods (2022 as an example) where neither of them performs well and there is a breakdown of historical correlation, leading to no tangible diversification benefit. This correlation breakdown could be temporary or permanent and the magnitude of impact would depend on this.
Leverage risk: Leverage can be a double-edged sword and the financial crisis of 2008-09 brought out the evil side of leverage. Leverage could be inherent to an instrument such as derivatives or be applicable at the financial product level. While leverage can amplify returns, it can also do the same to losses, leading to capital erosion. Futures and options are the most well-known form of levered securities, while leveraged ETFs are the most common example of levered financial products.
Style risk: A common risk for actively managed investment products and managers encompasses the risk of a particular investment style or philosophy underperforming for a period of time. In a long only context, the investment style could be value, growth, momentum or contrarian and each of these could underperform depending on the economic cycle or other factors. Similarly, a fixed-income portfolio might be heavily tilted towards financial sector debt, and any financial stress increase could hurt this much more than non-financial sector debt.
Spread risk: This is one of the lesser-known risks and is applicable generally to arbitrage or statistical arbitrage-based products. All such products are based on the convergence of a spread between two or more directly related instruments (stock vs future or options vs future etc) or two or more highly correlated assets (shares of the same company listed on different exchanges or countries). There could be, at extremes, market conditions where such spreads diverge (temporarily or permanently) instead of converging leading to large losses; the LTCM collapse was largely attributed to such conditions.
Roll risk: Not to be confused with debt rollover risk, this is a derivatives market risk were positions in one particular maturity need to be ‘rolled over’ to the next maturity to ensure continuity. This is an especially important consideration for products which invest in futures with a large roll spread (difference between the nearest and next maturity), for e.g., commodity futures ETFs or volatility futures ETFs. Due to the negative roll spread, the return of the product could be significantly worse than that of the underlying asset.
Shock risk: One of the biggest risks for portfolios which are dependent on selling (writing) options, this is the risk of a large discontinuity in price resulting from an extreme market event or due to market interruption. Option writers typically have to hedge their positions based on the movement of the market, and a large ‘gap’ on either side could lead to massive losses due to the negative convexity inherent in such a strategy. Option writers will always refer to this as one of the key risks to monitor.
Identifying portfolio risks is one of the most important aspects of the risk management process and in the next note, we shall try to address how to measure and quantify some of these risks. It is also important to understand that there might be different risks associated with an investment product when compared with the underlying assets and investors should therefore make an informed choice based on any additional risks.
