The Elephant in the Room: Portfolio Construction and Systematic Risk

What do all of these steps have in common? The framework for thinking of and measuring risk is all relative to a market benchmark.

Elephant in the Room

So what is missing in this approach?

How does this model sometimes fall woefully short?

The elephant in the room is market risk, sometimes known as systematic risk.

Neither the top-down asset allocation strategy or bottom-up stock selection, explicitly addresses market risk. 

When the market racked up losses of over 50% in 2007-08, both the asset allocators and the stock selectors were able to claim they were doing what they were hired to do – build a portfolio in the asset allocator’s case and pick winning stocks in the stock picker’s case. Yet, we find that neither the asset allocators nor the stock pickers are addressing market risk.

Defining Risk in Portfolio Construction

Swan’s Defined Risk Strategy (DRS) is built differently. At its inception in 1997, the primary objective of the DRS was to remain invested while directly managing and avoiding the large market sell-offs that periodically befall the market.

For Swan, risk management is defined as minimizing the depth, duration, and frequency of losses. For more on the merits of measuring risk in this manner, see our post on the Pain Index and the Pain Ratio.

The Defined Risk Strategy is always invested in the market, and always hedges its investment in the market via protective put options, with the goal of capital preservation in down markets and significant participation in up markets.

It is because of this unique approach to directly address risk that the DRS can replace both the top-down asset allocation and the bottom-up active management. The DRS supplants both traditional approaches by defining risk in terms of losses and actively addressing that risk by hedging.

Marc Odo is the Director of Investment Solutions at Swan Global Investments, a participant in the ETF Strategist Channel.