Modeling Portfolio Risk Amid Market Uncertainty

As market uncertainties elevate—a trend for the foreseeable future—it’s important to have a good understanding of your portfolio composition and risk profile. By using stress testing tools, we can decompose absolute risk, identify vulnerabilities, and examine drivers of risk at the asset and portfolio levels.

To provide a real-world example of stress testing in this pressured financial environment, we created a few scenarios based on the Fed’s potential changes to interest rates.

In our analysis, we tested three scenarios to understand portfolio movements if 1) The Fed keeps rates flat, 2) The Fed raises rates 25 basis points (bps), or 3) The Fed raises rates 50 bps. A variety of stress tests can be performed, but today we will be using the time-weighted methodology that shocks individual factors to understand the relative impact on a portfolio. This mock portfolio mixes developed and emerging market equities and bonds, both investment grade (IG) and high yield (HY), combined with small allocations to commodities and treasuries.

Source: FactSet

Key Analysis Takeaways

Equities:

• Equities decline in a rate-rising environment as investors may find the higher yields of bonds and other fixed income instruments more attractive; the present value calculation of future earnings/cash flows of these stocks will now be lower

• From a regional standpoint, since the rate hike is being implemented in the U.S., the impact on equities was felt most in U.S. stocks, with an 8.44% loss in the 25 bps rate increase and 16.88% in the 50 bps rate increase

• As you get further from the U.S. in the equity markets, we see the PnL drop becomes less severe in developed international markets (down 5.27% in 25 bps rate increase) and emerging market equities (down 2.24% in 25 bps rate increase)

• In the flat interest rate environment, you can see it benefits the portfolio to be invested in U.S. equities (up 5.88%) and developed international equities (up 2.87%) versus emerging market equities (up 2.2%)

Fixed Income:

• Bond prices have an inverse relationship with interest rates, so the bond funds declining in a rate-rising environment is expected

• In the fixed income portion of the portfolio, high yield bonds lose more (down 1.87% in 25 bps rate increase) than their IG (down .87% in 25 bps rate increase) counterparts when rates rise

• Treasuries (down 1.26% in 25 bps rate increase) were losing more than IG bonds (down .87% in 25 bps rate increase) in the 25 bps and 50 bps shocks, but this was due to a large cash position in the IG fund lowering its overall exposure to IG bonds

• In a flat rate scenario, it’s now better if the portfolio holds more high yield (up 1.42%) and emerging market bonds (up 1.27%) versus IG bonds (up .82%) and treasuries (up .74%)

• Similar to equities, as you get further from the U.S. and into emerging markets, the PnL decrease wasn’t as severe; this can be seen in the emerging markets fund only losing .43% in the 25 bps rate increase and .83% in the 50 bps rate increase

Commodities:

• While the commodity fund was down overall, oil and cotton did make money in both the 25 bps and 50 bps shocks, so these could be viewed as safe haven assets in these scenarios

Stress Testing Options

Especially in uncertain environments, it’s helpful to have a library of historical crisis events and factor shocks that you can incorporate into your portfolio analysis. Alongside that, it’s useful to have the ability to create your own stress tests based on personalized views of the market.

We believe four main stress tests are valuable:

• Factor Time-Weighted Stress Tests: Applies a shock to individual factors, both inside or outside the current risk model, to see the impact the shock could have on a portfolio; also illustrates how sensitive the portfolio is to different factor shocks

• Factor Event-Weighted Stress Tests: Compares historical period changes to the supplied shock value saved with the stress test; periods with changes similar to the shock amount are weighted higher than non-similar periods

• Extreme Event Stress Test: Hypothesizes the current portfolio's return if an extreme event period were to happen again; current factor exposures are used with factor returns from the event to derive the event’s impact on returns

• Extreme Event Simulation: Applies covariances from the date of the shock event with current portfolio exposures; Simulating 5,000 scenarios enables you to investigate downside risk if the event were repeated

Conclusion

Through analyzing the outputs of FactSet’s stress tests for these three scenarios, we can see that there is a consistent message. When rates rise, it’s good to be invested in investment grade/treasury bonds as well as developed or emerging market equities. On the other hand, in a non-rate rising environment, it’s better to be allocated to high yield bonds and U.S. or developed market equities.

To learn more about portfolio risk modeling and stress testing, contact sales.mac@factset.com.

This blog post is for informational purposes only. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.