DFSPS takes a proactive approach to managing portfolio risk. Our goal is to better manage portfolio risk and we do this through the following steps:
- Identify the prevailing conditions and assess market behaviour to discern changing risk conditions
- Determine the appropriate asset allocation to maintain the risk budget of each portfolio; when the market changes, we adjust the asset allocation to stabilise risk.
- Monitor equity markets for signs that they have become overvalued, and are at risk of significant losses; reduce exposures accordingly.
- Within the asset classes, we maintain a core of active managers (which are selected in accordance with our non-conflicted research process), and use passive funds as an overlay to efficiently control market exposures and trading costs.
We think about risks the way investors do and specifically in terms of: (1) the danger that portfolios will fall short of meeting their objectives; and (2) the anxiety investors feel during periods of heightened market turbulence. We also believe that conventional portfolio management exposes investors to unacceptably high risk when markets are disrupted. Our objective is to stabilise portfolio risk and we do this by changing the asset allocation as we observe changes in risk levels. For example, the chart below shows that while the average risk level (standard deviation) of a conventionally managed portfolio has been 6% p.a., it’s been as high as 12% p.a. and as low as 3% p.a. When clients are exposed to higher levels of risk, they feel anxious and some capitulate. In contrast, DFSPS explicitly manages the risk by targeting the same risk level across ALL market conditions. In doing so, the aim is to provide investors with a smoother portfolio journey where their risk tolerances are unlikely to be breached.
DFSPS applies an additional risk management overlay to better manage equity risk, which is the most dominant portfolio risk factor. Typically, equity risk accounts for 50% of the total risk of Conservative Portfolios and up to 90% of the risk of Balanced Portfolios. Where we determine that equity markets are at risk of significant losses, we reduce exposure accordingly. This additional downside risk management strategy is generally employed during periods where the support for equity markets has broken down and valuations are stretched, as highlighted in the Australian Equity CAPE chart below. The exposures are replaced as soon as the potential for significant loss is reduced
The graph below plots the return achieved by the DFSPS Balanced RPM and Morningstar Balanced Index since January 2012, during which time buoyant market conditions have been generally experienced. The DFSPS investment framework has been built to work during good times as well as the bad and the chart highlights that we have been able to achieve this. Whereas the Morningstar benchmark has benefited from a strong bias to equity risk and bond duration, DFS has managed to out-perform without such permanent biases.