Market Sell-Off Shows Risk Is a Moving Target
Recent volatility reminds us that new risks are testing standard defensive equity strategies. Portfolios that offer downside protection need to go beyond standard risk models and position themselves for changing challenges ranging from trade wars to European political instability.
Managing risk is an integral component of any investing strategy. But standard risk-management tools aren’t always adequate. Tracking error, for example, tells you how much a portfolio deviates from its benchmark, yet it doesn’t really indicate how hard performance might suffer in a market meltdown. Meanwhile, standard risk models are built to work on averages, over long periods of time, but aren’t designed to predict the potential fallout from specific events such as trade wars or Brexit.
Looking Out for Unexpected Risks
Portfolio managers must constantly be on the lookout for new risks. Of course, a solid strategy will be built on clear investment and risk-management processes. But even the best-laid plans can’t anticipate the myriad challenges that will arise along an investment journey.
In today’s markets, risk is a moving target. But three big risks that surfaced this year have escalated in recent weeks. Each requires a creative response. The goal should be to identify companies that are vulnerable as well as those that may present opportunities amid the uncertainty.
Risk 1: Trade Wars
The US-China trade war tops the list of new risks. Nobody can predict how it will unfold, so it would be imprudent to position a portfolio for a particular outcome. Still, it’s important to figure out which types of companies could get caught in the crossfire if things get worse. The technology and industrial sectors are both more exposed to trade winds than most. Yet a closer look within the sectors reveals that not all companies are equally at risk.
We assessed the revenue that is susceptible to trade wars within each sector as well as within key subindustries. For US companies, we defined non-US revenue as exposed, while for non-US stocks, we defined US revenue as exposed. Technology stands out as particularly exposed, but in the semiconductor and hardware industries, about 61% of revenue is at risk, while in software and services, only 42% of revenue is exposed (Display). Within industrials, about a third of industrial goods are exposed to trade wars versus 26% of services revenue. When we search for individual stocks within these sectors, companies with more revenue exposed to trade wars should be handled with care, in our view.