Addressing uncertainty through risk-based portfolio management

Uncertainty is knocking on the door and presents a somewhat rare configuration for markets. While uncertainty is a constant in our daily investment life, high levels of price fluctuation risk are seldom seen. It's crucial to recognise that uncertainty is not the same as risk and requires different techniques to handle it effectively. Economists have extensively explored the difference between risk and uncertainty. The former can be more easily hedged as it presents a somewhat predictable market direction, whereas the latter involves an indeterminate market direction, adding an increased randomness to the markets.

Our risk-based philosophy puts risk considerations at the heart of our strategic portfolio construction principles, as well as into its continuous rebalancing mechanisms (which some may call ‘tactical’ portfolio management). Modelling risk relies on well-known techniques, which we aim to enhance or diversify further. But modelling uncertainty is a different challenge. While we identify and discuss possible preferences in this article, we would also like to stress that uncertainty calls for flexibility and adaptability which, thankfully, have also been among the core principles of our All Roads strategy since launch. 

Read also: Multi-asset: investing in a period of tariff-induced uncertainty

We have been operating our risk-based solutions for more than twelve years and the constantly evolving environment keeps challenging our approach, driving our commitment to monitor and evaluate our strategies and directing our research efforts to better navigate these choppy waters. 

This quarter, our theme is embracing uncertainty and the implication is clear: now may not be the time to look for trends but rather to rely on the intrinsic yield of assets when their price variations lack clear direction. It’s time for us to reconsider the uncertainty in our strategies and requires a considerable effort to understand possible solutions. Welcome to the 15th edition of our quarterly Simply put, dedicated to rethinking risk-based portfolio management and considering uncertainty-based ideas.

Uncertainty is not uncommon but rarely coincides with risk

Uncertainty is inherently difficult to measure and it's often better understood when focusing on one of its potential sources. Currently, political uncertainty is at the fore and our daily investment activities are increasingly influenced by news flow from the White House. Yet, this situation is not just about political uncertainty but also economic uncertainty, reflecting rising geopolitical tensions and the potentially adverse impacts on growth stemming from the ongoing trade war. It is easy to get lost in the succession of tariff announcements, which then tend to be rolled back or deferred. 

Fortunately, we have access to a tool that can measure and digest this uncertainty: the Economic Policy Uncertainty Index (policyuncertainty.com). This index, which is based on the frequency of newspaper articles addressing economic policy uncertainty, offers a quantifiable measure of political uncertainty. The higher the Index, the greater the political uncertainty. This is illustrated in Figure 1, alongside the VIX Index, which is used here as a measure of market risk since it typically aligns with fluctuations in realised equity volatility (and losses).

FIG 1. Economic policy uncertainty vs VIX and frequencies of high uncertainty and risk¹

 As previously mentioned, risk is not synonymous with uncertainty – a distinction first articulated by Frank Knight in his 1921 book "Risk, Uncertainty and Profit". Essentially, risk involves situations where the probable outcomes are known and occurrence probabilities can be assigned to them. Uncertainty, on the other hand, involves scenarios where outcomes are unknown, making it impossible to assign odds. For example, deteriorating growth conditions, which occur approximately 40% of the time, and are known to depress market valuations and increase volatility are clearly an identified risk (which we can use as a guiding principle for our long-term risk allocation). 

Conversely, the roll-out of economic policies by the Trump administration represents a scenario with uncertain outcomes. We may have a reasonably clear understanding of the President’s political agenda and priorities, but their broader impact and other parties' reaction functions are unknown. The US economy could either strengthen or weaken as a result, and the implications for company earnings, the creditworthiness of global companies and rate fluctuations are extremely challenging to calculate. This is the essence of uncertainty. Figure 1 illustrates how risk and uncertainty rarely coincide: both indices have been high during 30% to 40% of the past 30 years, but – and maybe surprisingly so – they coincide in less than 15% of cases. If uncertainty is distinct from risk, what are the implications for asset returns and investment decision-making? 

Carry trumps trend, as diversification needs support

Now is the time to consider the historical performance of markets and strategies in the context of uncertainty. Our basic assumption is this: since price direction becomes ambiguous, investors should be less rewarded for taking risks, which suggests a move towards lower market exposures. Accordingly, strategies that capitalise on the absence of price variation, such as carry strategies, should outperform those benefitting from clear and lasting market direction, like trend strategies. Figure 2 illustrates the Sharpe Ratio per asset class as a function of the Uncertainty Index, previously discussed.

The key takeaways from this analysis are as follows:

1.	In an environment of heightened uncertainty, Sharpe Ratios tend to decrease across the board. Visibly, Sharpe Ratios decline for most asset classes and strategies, including bonds. Rising uncertainty does not favour bonds as an asset class that typically offers higher than usual returns when risk rises.
2.	Negative impact on trend-focused assets and strategies.  Asset classes and strategies that rely on clear market trends suffer the most during periods of high uncertainty. Emerging market equities (as represented by the MSCI Index which does not reinvest dividends, thereby limiting the carry effect), commodities (known for their durable trends), and explicit trend-following strategies, all display a diminished return/risk profile during periods of uncertainty.
3.	In contrast, carry strategies appear to be the only ones where the Sharpe Ratio improves.

This analysis seems to deliver a clear message: uncertainty justifies lower market exposure. Note that both 50/50 (“equal-weight”) and Risk Parity strategies exhibit a Sharpe Ratio deterioration under uncertainty, so it is not necessarily the portfolio mix that makes a difference, but its total risk or market exposure. 

While diversified portfolios are not expected to generate negative returns under such conditions, they do require some bolstering to enhance their return profile. Carry strategies encompass a broad group of systematic strategies that thrive in uncertain environments by capitalising on the absence of clear price trends to focus on market yields. This is where our research efforts have been concentrated lately, as we recognise the current situation as one that calls for maximising the potential of carry strategies. As uncertainty looms, harnessing carry becomes not just a tactical move, but a necessary building block to help portfolios navigate through turbulent times.

FIG 2. Sharpe ratio per asset class, portfolio allocation and systematic strategies²

 Simply put, uncertainty differs from risk and should prompt portfolios to lower market exposure and focus on carry.