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  • Home>Research & Insights>Spotlight>A New Way to Interpret Equity Risk

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    A New Way to Interpret Equity Risk

    Our risk model helps investors spot the factors that influence returns.

    Lee Davidson, 10/04/2016

    The relationship between a financial advisor and his or her client is typically rooted in a conversation about risk. By studying factors such as age, financial health and well-being, and retirement goals, the advisor can assess just how much a client’s portfolio should be exposed to certain asset classes. After all, both parties want to create a portfolio that won’t need to be altered because a client couldn’t stomach the latest round of market turmoil.

    But a true assessment of risk goes deeper than a simple gut check. In today’s global financial system, advisors—or any party that manages money, for that matter—must gauge risk on a myriad of levels, as events around the world such as the Brexit vote, terrorism, quantitative easing, slow economic growth, or sovereign debt crises ripple across markets. Portfolios from India to Iowa can eventually feel the pain, putting a dent in the checkbooks of millions of Main Street investors.

    Morningstar is constantly working on tools to help advisors and institutions do their jobs more effectively. In a new example of this effort, Morningstar’s quantitative research team has designed the Global Risk Model, which uses 36 factors to decompose the sources of return and risk for a stock or an equity portfolio. Many of these factors are based on Morningstar’s proprietary ratings, such as Quantitative Fair Value Estimate and Morningstar Quantitative Economic Moat. But the model also includes style, sector, region, and currency characteristics. The idea is to provide investors with a powerful lens with which to understand the potential risks of a stock or portfolio. While the model is focused initially on equities, it will be expanded to include other asset classes.

    Understanding the Model
    Risk is inherent to investing. Developing a prospective view of risk allows investors to make investment decisions tailored to their individual risk preferences and ultimately increase the utility derived from their investment portfolio. A risk model forecasts the distribution of future asset returns. This distribution contains all the information needed to assess the riskiness of a portfolio. As the forecast distribution widens, that indicates more uncertainty about the future return potential of the portfolio. As tail probabilities increase, that indicates the portfolio has higher risk of experiencing an extreme loss. With this forecast, investors are empowered to evaluate the riskiness of assets or portfolios of assets.

    In essence, the model seeks to identify a small number of independent, latent sources of return. Movements in these sources drive the movement in a comparably small number of interpretable factors. An example of a factor is the exposure to particular currencies; for example, how much does an increase in the euro/U.S. dollar exchange rate drive an increase in the value of a stock? Movements in the factors drive asset returns.

    Several methodological choices must be made when building a risk model. Our choices were made with the goal of creating a unique, interpretable, responsive, and predictive model. We began with the following assumptions about asset returns that shaped our methodological choices.

    • There are a small number of independent sources of market movement that drive the majority of variation in asset returns.
    • Asset returns are not normally distributed.
    • The distribution of asset returns changes through time.

    These three concepts are well-recognized and noncontroversial, although some or all of them are often ignored for convenience by risk-modeling practitioners.

    Under the Hood
    Several features make the Morningstar Global Risk Model unique:
    We use proprietary fundamental-based factors that we believe are superior drivers of returns. Morningstar’s research group provides forward-looking ratings on assets, which have been successful in predicting the future distribution of returns. Factors based on these ratings also tend to be uncorrelated with traditional risk factors, making them a complementary addition to our risk factor model. Likewise, we have distilled Morningstar’s proprietary database of mutual fund holdings into factors that are also uncorrelated predictors of the future distribution of returns.

    is an ETF analyst with Morningstar Europe.