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Managing portfolio ‘tail risk’: some common pitfalls


Fundamental risk overlay (FaR) helps manage tail risk in portfolio returns

SMSF investors can exploit repeatable patterns in share price returns by targeting some well-known anomalies. These anomalies represent persistent returns to underlying common factors of stocks and include value and momentum investing. However, factor investing does come with potentially higher risks and solely relying on systematic approaches has often been shown to fail over time. These higher risks represent significant negative returns and large drawdowns of capital and are often referred to as the ‘tail risk’ in the portfolio’s returns.

In this article, we discuss how our proprietary fundamental overlay, Fundamental at Risk (FaR), seeks to protect an equity portfolio from these tail risks that traditional quantitative strategies tend to ignore.

Common pitfalls of value and momentum investing

Value investing is about finding cheap stocks, relative to their intrinsic fundamental value, and profiting when their stock price reverts to their underlying value. It is a popular technique but it does come with potentially higher risk levels. Uncertainty around the future earnings of a company, potential regulatory changes, industry changes and other threats can mean that stock prices need to discount these higher risk levels. In other words, cheap stocks may be cheap for a very good reason because of these higher risk levels.

With our FaR approach we capture these key risk drivers in a forward-looking approach. We don’t rely on historical data, instead capturing the key drivers of a stock and then using a technique to build a picture of the likely distribution of a company’s earnings. It means we can improve our ability to find truly cheap stocks and not simply stocks with unacceptable risk levels.

Momentum investing is very different and is based on an approach that an underlying trend tends to continue over the short to medium term. The reason for this anomaly is often described as an under-reaction to new information. Just like value investing, momentum trading also comes with some significant risks. The most well-known is the problem of ‘crowded trades’ where investors are increasingly attracted to well-performing stocks. Eventually a turning point breaks the trend and investors face the prospect of large losses in trying to exit the trade at the same time.

Our FaR approach is designed to find these potential turning points by capturing the likely upside and downside in a stock’s earnings outlook. It means we can exit a trade in a more-timely manner and potentially avoid the significant losses attached to crowded trades.

Final thoughts

With FaR we look at individual drivers of stocks. We look to see whether there’s a downside or upside to those individual drivers, and bring them together in an overall distribution that tells us whether the forward earnings have an upside skew or downside skew to them.

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