MSCI: The risk of risk limits

Aug 10th, 2020 | By | Category: Equities

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By Reka Janosik, Vice President, and Thomas Verbraken, Executive Director, MSCI Research.

The risk of risk limits
MSCI: The risk of risk limits

With the year-to-date performance of the MSCI USA Index approximately flat, as of Aug. 4, investors who sat through the COVID-19-related market crisis without touching their portfolios have come out relatively unscathed.

In times of heightened volatility, however, tactical shifts are often put in place to protect against further drawdowns. While such measures can be effective in dampening portfolio losses, they may also have an impact on long-term returns, particularly in the case of a sharp V-shaped recovery such as the one we have seen in the past months.

Appreciating the tradeoff between limiting drawdowns and hampering longer-term performance can help investors make more informed decisions.

The exhibit below shows the YTD cumulative return of a hypothetical portfolio invested in US equities with a volatility-based risk limit of 20% (annualized). Compared to its value at the beginning of the year, the US equity market dropped by 30.5% at the market bottom of the COVID-19 crisis, whereas the risk-limit portfolio only dropped by 17.7%. With the market back at roughly the same level as at the beginning of the year, however, the risk-limit portfolio still underperformed the market by 7.7%. In other words, a risk limit may help limit the drawdown in crisis times, but may also hamper longer-term performance if markets rebound sharply while the risk limit is still reducing exposure to the market.

Source: MSCI.
Source: MSCI.

Sour spot for a risk limit

We explored the YTD excess return, relative to the equity market, of a range of risk-limit strategies, by varying the threshold value for the risk limit. The exhibit below shows how, at various points of the crisis, the risk-limit portfolio outperformed the market. For example, on April 1, for each threshold value below 60%, the risk limit reduced the drawdown with varying success: The stricter the risk limit, the smaller the drawdown.

As of July 28, however, the risk-limit portfolio underperformed the equity market for each threshold value below 60%. Thus, a reduction in maximum drawdown during the crisis came at the expense of total return over the period. Furthermore, performance was best for either a very strict risk limit, which was good at cutting exposure very early in the crisis — or a loose risk limit, which did not cut exposure at all. Intermediate threshold values, which reduced exposure too late and missed out on a large part of the rebound, led to the largest underperformance. In such scenarios of V-shaped rebounds that coincide with high-volatility regimes, investors would have benefited from either reacting quickly to rising volatility and getting out early or having the liquidity and governance in place to ride it out.

Source: MSCI.

Did risk limits harm simulated long-term performance?

To make an informed decision, investors may want to investigate a variety of potential realistic crises beyond the V-shaped scenario of the recent COVID-19 crisis. We analyzed three categories of simulated hypothetical recovery scenarios, whereby the recovery “shape” varies based on the time to recovery.

The impact of the risk limit depends on the shape of the recovery. In the case of a V-shaped market recovery, the average impact of setting a risk limit is adverse, because markets recover while volatility is still high. But the less rebound there is during the crisis period when volatility is elevated, the more beneficial the risk limit will be. In the case of L-shaped scenarios, similar to that seen after the 2008 global financial crisis, the same 20% risk-limit portfolio we looked at for the V-shaped scenario would have outperformed the equity index by more than 10% on average.

The interactive exhibit below shows the impact of risk-limit strategies under hypothetical V-shaped, swoosh-shaped, or L-shaped recovery scenarios. The top panel illustrates a few simulated paths for each category. The bottom-left chart shows the average impact of risk limits with varying threshold levels on portfolio performance one year after the crisis, for the respective categories of recovery shape. Finally, the bottom-right panel provides insight into the distribution of the outperformance of the chosen risk-limit-based strategy (which can be changed by moving the red line on the left chart) relative to the equity market.

Risk-limit impact under varying recovery shapes

Source: MSCI.
Source: MSCI.

A few examples of V-, swoosh- and L-shaped recoveries are shown (top). Applying a risk-limit strategy on a set of scenarios for each shape (top) results in a distribution of excess returns over the equity market (bottom right). The risk-limit threshold determines the excess return (bottom-left shows the average excess return for a given shape and risk-limit threshold value).

Risk limits can be a tool to help protect investors against excessive drawdowns and potentially enhance long-term portfolio performance. But they do not come without risks of their own: In case of a sharp V-shaped market recovery, while volatility was still elevated, some risk-limit strategies may have caused investors to miss out on part of the rebound, thus underperforming a portfolio that rode out the crisis.

The authors thank András Bohák, Peter Shepard, Dániel Szabó and Imre Vörös for their contributions to this blog post.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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