• News
• 2024-07-26

Optimizing Fund Portfolios with Risk Budgeting

On September 26, 2024, with the approval of the Central Financial Commission, the China Securities Regulatory Commission and other relevant departments jointly issued the "Guiding Opinions on Promoting Medium and Long-term Capital into the Market." Under long-term investment, risk control in investment is also a concern for people. Among them, "risk budgeting" is one of the methods to control and manage the risk of investment portfolios. Can it help long-term fund investors?

I. Seeking the balance between risk and return, "two allocation methods" have their differences

Long-term investment in funds cannot be separated from risk control. However, different investors have different attitudes towards risk. For example, some investors prefer risk and pursue high returns and high profits; some investors mainly hold steadily and are worried about the loss of principal. This reflects the different "risk tolerance" of different investors.

Simply put, risk tolerance refers to the maximum level of risk that investors are willing to accept. The goal of risk budgeting is to adjust the investment portfolio so that its risk distribution conforms to their own risk tolerance.

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It should be noted that risk budgeting is a "tool," not a direct numerical reflection. When investors invest in different fund assets, through risk budgeting, they optimize the balance between risk and return in the investment portfolio, with the goal of achieving "controllable risk."

The traditional asset portfolio method allocates funds based on the expected returns of assets, usually known as "capital weighting" or "value weighting" strategies. Under this strategy, the composition of the investment portfolio mainly depends on the value ratio of each asset. However, this method may not fully consider the differences in the risk contribution of different assets to the entire investment portfolio.

In contrast, risk budgeting (also known as risk quota or risk weight) is a method focused on controlling and managing risk in the investment portfolio. This method does not simply allocate funds according to the value of assets, but allocates funds based on the contribution of each asset or strategy to the overall portfolio risk.

This means that even if the value of an asset is low, if it brings high risk to the portfolio, it may also receive a larger risk budget, and vice versa.

When we talk about risk budgeting in fund investment, we are actually discussing how to allocate risk among different types of funds.

Top-Down Approach and Bottom-Up Approach are two different risk budgeting allocation methods, each with its advantages and applicable to different situations.The top-down approach begins with a macro perspective, starting from the overall investment portfolio and first determining an overall risk budget. Then, based on the expected contributions of various assets, strategies, or sectors to the portfolio's risk and return, this overall risk budget is allocated to different parts.

To illustrate with a fund portfolio, the approach starts from the whole to the parts, first determining the risk budget for the entire fund portfolio, and then allocating the budget to various types of funds according to the risk level of each different type of fund.

The bottom-up method is the opposite; it starts from a micro perspective, determining individual risk budgets at the level of each asset, strategy, or sector, and then aggregating these individual risk budgets to form the overall risk budget for the investment portfolio.

The former is easier to grasp the overall risk level of the fund portfolio, but there is difficulty in allocating risk budgets to complex investment portfolios; the latter has a deeper understanding of the internal structure risks of the fund portfolio, but the allocation process may require more time and resources for analysis.

II. How does risk budgeting "adjust" the risk of a fund portfolio?

Controlling and managing the investment portfolio using risk budgeting, investment funds show "convenience" from this aspect. Funds are collections composed of various underlying assets (such as stocks, bonds, money market instruments, etc.), which means that funds themselves are not a single type of asset, or they can be considered "composite assets."

By constructing a diversified investment portfolio and using risk budget management methods, investors can choose funds that match their own risk preferences. This method not only allows the asset composition of the selected funds to match the investor's risk tolerance but also helps investors effectively control and manage the risk of the entire investment portfolio.

In addition, fund managers will also "help out" by controlling the risk of the managed fund asset portfolio.

The implementation steps of risk budgeting involve several key points, starting with risk measurement, followed by risk decomposition (the process of allocating the overall risk of the investment portfolio to its components), setting profit and loss target ranges (determined according to the investor's risk tolerance), and dynamic rebalancing (adjusting in a timely manner after market changes to restore the appropriate risk budget ratio).

For fund investors, setting profit and loss target ranges may be considered a simplified but important step. However, investors holding several funds with different risk types can also try risk budget allocation.Let's translate the given passage into English:

For example, under two different types of funds with varying risks, one should first determine their own risk tolerance for gains and losses, and then review the past performance of the two funds, analyzing the range of net value fluctuations.

Consider an investor who has invested in two funds. One of them is the Chuangjin HeXin CSI Low Volatility Index A, which is an index-type equity fund and belongs to the medium to high-risk category. Its annual returns for 2021-2023 were 24.99%, 3.27%, and 10.52%, respectively. The standard deviation could be set around 13%, indicating that the fluctuation in returns might be around 13%. This value is primarily derived from calculating the mean of the annual returns. The other fund is the Huaxia Medium and Short-term Bond A, which is a bond-type fund focused on medium and short-term bonds and belongs to the medium to low-risk category. Its annual returns for 2021-2023 were 4.68%, 1.39%, and 4.18%, with an average close to 3.4%. It is important to note that while the mean can be used for reference, this method may not be perfect.

Subsequently, based on one's own risk tolerance, one should "weight" the different levels of return volatility of the aforementioned funds and then calculate the allocated risk budget.

For long-term investments, a risk budget can help investors adjust according to their own risk preferences in different market environments, maintaining an investment portfolio at an appropriate risk level and gradually achieving long-term sustainable returns.