Anurag Mahesh of Deutsche Bank Private Wealth Management discusses some of the trends in managing risk in client portfolios and reviews the tools which are effective in achieving this.
Date: July 2010
Given that for a lot of clients their wealth is for their retirement, they want to focus primarily on making sure the money is safe, before making it grow, he explained.
The tilt towards absolute return investing, therefore, has meant the proportion of fixed income in portfolios has risen, said Mahesh.
Quantitatively, this is a more challenging asset class than equities, he explained, because it involves managing two risks – interest rates and credit.
Tackling fixed income risks
In many cases, Mahesh said he thinks the best way to approach any asset class risk is to do it in different ways.
For fixed income in particular, the rates environment is very different to that of the credit landscape, he explained. Interest rates are at historically low levels in mid-2010 in response to the massive quantitative easing by central banks since the financial crisis. This means it probably doesn’t make sense to invest in the rates market in case of any rises, which would lead to the depreciation in bond prices, he said.
However, added Mahesh, while credit spreads are not as distressed as they were in the midst of the crisis, they are on average a lot higher than their pre-crisis levels.
So a simple example of managing the two risks with fixed income is to employ a derivatives strategy to convert a fixed rate bond to a floating rate bond, said Mahesh. This therefore takes out the not-so-smart risk from an investor’s portfolio and keeps the smart risk in.
Tools to manage portfolio risk
According to Mahesh, various quantitative-based tools exist for private banks to manage portfolio risk. Deutsche Bank, for example, uses a risk metrics tool which essentially looks at volatility, returns, what-if scenarios, stress scenarios and drawdowns.
Drawdowns are important risk metrics for private clients, he explained, as they can be used to assess the psychological and behavioural pain that clients suffer if portfolios fall in value in a given period.
The second part of the quantitative process is to rebalance existing portfolios, he said, to remove and add various asset categories to determine how the new portfolios would have behaved in the past.
While many of these techniques look at what would have happened in the past, it does provide a benchmark for how portfolios would have behaved.
Private banks can also superimpose clients’ views in terms of what they think might happen with different asset classes in relation to returns, added Mahesh, to then see how portfolios might have evolved.
A starting point to look at portfolio construction, he said, might be understanding what clients have in their portfolios – in the form of a diagnostic test. This enables advisers to see whether what clients have fits with their objectives, both in terms of returns and risks.
When looking at the risk and regulatory frameworks, proprietary capital is going to be much less available than in the past, said Mahesh.
This means there are likely to be a lot more dislocations in pricing across different asset classes than in the past, he explained, given the smaller pool of smart money at the banks and hedge funds focused on these opportunities.
This creates the potential for private capital to replace that and exploit these market dislocations. For private banks, therefore, Mahesh said that if they can get these types of quasi-institutional opportunities in front of clients, this is an important differentiating factor when looking to add value in client discussions and portfolios.