Author Details

Reka Janosik

Reka Janosik
Vice President, MSCI Research

Thomas Verbraken

Thomas Verbraken
Executive Director, MSCI Research

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The Risk of Risk Limits

  • During V-shaped market events that coincide with high-volatility regimes, there is a “sour spot” of de-risking at the market bottom and missing out on the recovery.
  • We found that in sharp downturns followed by fast recoveries, investors would have benefited from either having a low risk tolerance and getting out early or having the liquidity and governance in place to ride it out.
  • Risk-limit strategies proved to be most beneficial when the rebound happened after market volatility has subsided.

With the year-to-date performance of the MSCI USA Index approximately flat as of Aug. 4, investors who sat through the COVID-19-related market crisis without touching their portfolios have come out relatively unscathed. In times of heightened volatility, however, tactical shifts are often put in place to protect against further drawdowns. While such measures can be effective in dampening portfolio losses, they may also have an impact on long-term returns, particularly in the case of a sharp V-shaped recovery such as the one we have seen in the past months. Appreciating the tradeoff between limiting drawdowns and hampering longer-term performance can help investors make more informed decisions.

The exhibit below shows the YTD cumulative return of a hypothetical portfolio invested in U.S. equities with a volatility-based risk limit of 20% (annualized).1 Compared to its value at the beginning of the year, the U.S. equity market dropped by 30.5% at the market bottom of the COVID-19 crisis, whereas the risk-limit portfolio only dropped by 17.7%. With the market back at roughly the same level as at the beginning of the year, however, the risk-limit portfolio still underperformed the market by 7.7%. In other words, a risk limit may help limit the drawdown in crisis times, but may also hamper longer-term performance if markets rebound sharply while the risk limit is still reducing exposure to the market.


Portfolio Performance with and Without a Risk Limit


Sour Spot for a Risk Limit

We explored the YTD excess return, relative to the equity market, of a range of risk-limit strategies, by varying the threshold value for the risk limit. The exhibit below shows how, at various points of the crisis, the risk-limit portfolio outperformed the market. For example, on April 1, for each threshold value below 60%, the risk limit reduced the drawdown with varying success: The stricter the risk limit, the smaller the drawdown.

As of July 28, however, the risk-limit portfolio underperformed the equity market for each threshold value below 60%. Thus, a reduction in maximum drawdown during the crisis came at the expense of total return over the period. Furthermore, performance was best for either a very strict risk limit, which was good at cutting exposure very early in the crisis — or a loose risk limit, which did not cut exposure at all.2 Intermediate threshold values, which reduced exposure too late and missed out on a large part of the rebound, led to the largest underperformance. In such scenarios of V-shaped rebounds that coincide with high-volatility regimes, investors would have benefited from either reacting quickly to rising volatility and getting out early or having the liquidity and governance in place to ride it out.


2020 Outperformance of Risk-Limit Strategies at Different Stages of Crisis


Did Risk Limits Harm Simulated Long-Term Performance?

To make an informed decision, investors may want to investigate a variety of potential realistic crises beyond the V-shaped scenario of the recent COVID-19 crisis. We analyzed three categories of simulated hypothetical recovery scenarios, whereby the recovery “shape” varies based on the time to recovery.3

The impact of the risk limit depends on the shape of the recovery. In the case of a V-shaped market recovery, the average impact of setting a risk limit is adverse, because markets recover while volatility is still high. But the less rebound there is during the crisis period when volatility is elevated, the more beneficial the risk limit will be. In the case of L-shaped scenarios, similar to that seen after the 2008 global financial crisis, the same 20% risk-limit portfolio we looked at for the V-shaped scenario would have outperformed the equity index by more than 10% on average.

The interactive exhibit below shows the impact of risk-limit strategies under hypothetical V-shaped, swoosh-shaped or L-shaped recovery scenarios. The top panel illustrates a few simulated paths for each category.4 The bottom-left chart shows the average impact of risk limits with varying threshold levels on portfolio performance one year after the crisis, for the respective categories of recovery shape. Finally, the bottom-right panel provides insight into the distribution of the outperformance of the chosen risk-limit-based strategy (which can be changed by moving the red line on the left chart) relative to the equity market.


Risk-Limit Impact Under Varying Recovery Shapes


A few examples of V-, swoosh- and L-shaped recoveries are shown (top). Applying a risk-limit strategy on a set of scenarios for each shape (top) results in a distribution of excess returns over the equity market (bottom right). The risk-limit threshold determines the excess return (bottom-left shows the average excess return for a given shape and risk-limit threshold value).

Risk limits can be a tool to help protect investors against excessive drawdowns and potentially enhance long-term portfolio performance. But they do not come without risks of their own: In case of a sharp V-shaped market recovery, while volatility was still elevated, some risk-limit strategies may have caused investors to miss out on part of the rebound, thus underperforming a portfolio that rode out the crisis.

The authors thank András Bohák, Peter Shepard, Dániel Szabó and Imre Vörös for their contributions to this blog post.



1This hypothetical portfolio follows a strategy whereby we de-risk as soon as the portfolio’s volatility estimate exceeds 20%. We partly sell the equity position and go into cash to reduce the portfolio volatility to 20%. As the equity-market volatility decreases again, the allocation to equities will be increased. Volatility is estimated using an exponentially weighted moving average with a six-month half-life. The U.S. equity market is proxied using the MSCI USA Index.

2For threshold values above the average equity-market volatility (around 15%), the hypothetical portfolio is typically fully invested in equities and will de-risk by going partly into cash only during more volatile periods. With risk limits below 15%, the simulated strategy effectively becomes volatility targeting: It will never be fully invested in equity markets, but will always keep a mix of cash and equities, so that the risk of the portfolio matches the threshold value. A risk limit of 0% is an extreme case in which the portfolio consists of cash only. That a portfolio with a risk limit of 0% performed identically to the equity market is a coincidence; i.e., the returns were the same because the equity market’s return over the period was flat.

3Scenarios are simulated by the MSCI stochastic volatility model whereby simulation starts from the March 16 MSCI USA Index and VIX levels. V-shaped scenarios are consistent with an expected full recovery on a one-year horizon and a fast decline in volatility levels. Swoosh-shaped scenarios are consistent with an expected 60% recovery after one year and a slower return to normal volatility levels. L-shaped scenarios reflect only an expected 20% recovery in one year and long-lasting elevated volatility levels.

4For readability purposes, the chart shows 10 scenarios only; however, for each recovery shape, 4,000 scenarios were simulated.



Further Reading

Four COVID-19 Scenarios: What Might Happen Next?

Did hedging tail risk pay off?