Opinion: Regulators, industry must embrace strategic risk allocation

In a groundbreaking 1986 report, Brinson, Hood and Beebower showed that approximately 90% of a portfolio’s risk and return can be explained by its strategic asset allocation. Since then, people in the wealth management industry have been using the report to bolster the argument for focusing on asset mix above all else.

The obvious flaw in the research is that it did not consider product costs. That alone is a serious and possibly disqualifying omission, given the recent reductions in expected return and risk premia. Further, risk and return are undeniably related, but the relationship is not static. Sometimes, you have to take on more risk just to get the same return you could have had previously without the additional risk.

Regardless, previous tests for suitability revolved around the clients’ strategic asset allocation — their target allocations to cash, bonds and stocks. But for the past two-and-a-half years, Canadian regulators have insisted that financial advisors work with a new paradigm for portfolio suitability. The new test for suitability has two prongs: risk tolerance and risk capacity. Of critical importance, individual holdings are rated not by asset class but by risk characteristics. The question has shifted from “Are the holdings cash, bonds or stocks?” to “Are the holdings low, medium or high risk?”

This shift in how regulators “keep score” regarding suitability is something many advisors have not fully recognized. As paradigms for suitability evolve, it is important that our recommendations evolve with them.

A challenge, however, is that diversified baskets of securities that make up investment products like mutual funds and ETFs are rated and categorized based on the underlying assets, not the underlying risk.

Here’s what I mean. An ETF that invests in the S&P 500 offers exposure to U.S. stocks. As a result, a product such as this is almost certain to be rated as medium risk. While the underlying strategic asset allocation will never change (the S&P 500 will always represent U.S. stocks), the risks associated with those stocks might change over time — even if the risk ratings do not.

Specifically, valuations change as market cycles play out. The same benchmark can be trading at 15 times earnings or 25 times earnings or even 35 times earnings. And a market trading at 35 times earnings is far riskier than a market trading at 15 times earnings.

Products offered by prospectus seldom change their risk ratings, and when they do, the re-rating is rarely based on expanding or contracting valuation metrics. That ought to change. It’s time for product ratings to take market circumstances into account.

A diversified product that has a medium risk rating could be re-rated as a low- to medium-risk product if the price-to-earnings (P/E) ratio dropped below 10. It could be re-rated as a medium- to high-risk product if the P/E ratio exceeded 30. And it would be entirely in keeping with the principles of risk suitability to re-rate that product as a high-risk product if the P/E ratio came to exceed 40.

Stated differently, a portfolio can become more or less risky over time even if you don’t buy or sell a single thing. That’s the challenge. Risk is dynamic, but product ratings are static. Investors and advisors alike have been slowly taking on more risk as multiples expand while product ratings remain unchanged. This is both insidious and dangerous.

People who have been invested for a few years who are slow to rebalance (i.e., are not entirely faithful to the Brinson et al. research) might be adding to their risk by having an even higher exposure to higher-risk assets as a direct result of not rebalancing.

A 60/40 portfolio might have evolved into a 70/30 portfolio with valuations near generational highs for the 70% equity component. Even an investor using a 60/40 asset mix will be putting 60% of their money to work in markets where valuations are stretched.

To be clear, I believe the move away from asset allocation in favour of risk ratings is positive. My concern is that it doesn’t go far enough.

If you simply assign all asset classes with a corresponding risk rating that never changes no matter the circumstance, you’re not really addressing the principle of client suitability based on risk tolerance and risk capacity. We need regulators that will proactively re-rate products before there is a major drawdown. Doing so after the fact is barring the door after the horse has left the stable.

Here’s a hypothetical example. The S&P 500 is currently trading at a cyclically adjusted P/E (CAPE) ratio of nearly 36 times — more than double the historical average. Accordingly, if prices were to drop by 50%, the market would only then be depicted as being fairly valued. Regulators, in their wisdom, might be inclined to belatedly re-rate products that offer exposure to this benchmark as being riskier than they had been previously. Or not. 

Do you see the irony? Either products that were rated as medium risk when the market was expensive were later depicted as being higher risk only once the market dropped and returned to a reasonable valuation level, or the risk associated with such products was cut in half and the rating remained unchanged. Both options are troublesome.

I agree with the direction regulators are moving, but I also believe they could do a better job in operationally adhering to the principles they hope to uphold. It’s time we enshrined strategic risk allocation the way we once enshrined strategic asset allocation.