By Parul Gupta, Head of Strategic Asset Allocation
July 8, 2016
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Estimating potential risks is a critical part of the asset allocation process.
There’s no such thing as a “free lunch” in financial markets. Seeking greater returns involves taking on greater risks.  But how should we define risk?
Textbook financial theory typically defines risk as the volatility of returns. One problem with this, however, is that it treats unprofitable volatility and profitable volatility as equally undesirable. So, Citi Private Bank uses a measure that we believe captures a meaningful type of risk for portfolio investors.
Extreme Downside Risk (EDR) estimates how far a particular asset allocation might fall during a period of extreme volatility. It tries to quantify the worst potential loss that an asset allocation might suffer within a rolling twelve-month period over ten years. To reach this figure, our strategic asset allocation methodology looks at long-term asset-class performance spanning many countries.
We believe that looking at a long data history like this is essential. It helps to highlight how often crises have happened in the past and how strongly correlated asset classes can become during such episodes. By contrast, many traditional approaches to asset allocation use much shorter data histories. As a result, they can end up understating the risks that investors may face and overstating the potential benefits of owning a diversified allocation.
 Investors must consider their investment objectives and risk tolerances when seeking greater returns or taking on more risk
Source: Citi Private Bank Global Asset Allocation Team. Annualized SREs and last ten years’ returns as of October 31, 2015; Returns estimated in US Dollars; All estimates are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Strategic Return Estimates are no guarantee of future performance. Past performance is no guarantee of future returns.
The above graph shows our latest estimates of EDRs for ten major asset classes. The more negative the EDR, the riskier the asset class. Private Equity – with an EDR of 87.3% – is currently estimated to be the riskiest asset class, while Cash – with an EDR of 0% is the least risky. You can see all the figures on page 3 of Adaptive Valuation Strategies – 2016.
As well as the EDRs, the graph also shows our methodology’s estimates of annualized returns for each asset class over the next decade, or ‘strategic return estimates’ (SREs). In general, there is a trade-off between risk and return. Private Equity – whose EDR is the greatest – also has the highest SRE, while Cash has the lowest SRE.
EDRs are an integral part of Citi Private Bank’s approach to strategic asset allocation. We believe they can provide a deeper insight into risks, both for individual asset classes and for allocations as a whole. To find out more about our methodology and its latest estimates, see Adaptive Valuation Strategies – 2016.
Extreme Downside Risk (EDR) is a measure used to estimate the risk of an asset allocation. EDR seeks to estimate the typical type of loss, over a 12-month time horizon, that an asset allocation may experience in a period of extreme market stress. It is calculated using a proprietary methodology and database. For a given asset allocation, this approach estimates the loss, over a 12-month time horizon, that the asset allocation may have experienced during historical periods of extreme market stress. EDR is calculated by taking the average loss in the worst 5% of this historical periods of extreme market stress. EDR does not estimate the maximum possible loss. Potential losses for a given asset allocation may exceed the value of the EDR.
Strategic Return Estimates (SREs) are Citi Private Bank’s forecast of returns for specific asset classes over a 10-year time horizon. The forecast for each specific asset class is made using a proprietary methodology that is appropriate for that asset class. Equity asset classes are forecast using a proprietary methodology based on the calculation of valuation levels with the assumption these valuation levels revert to their long-term trends over time. Fixed Income asset classes are forecast using a proprietary methodology based on current yield levels. Other asset classes have other specific forecasting methodologies. Please note that hedge funds, private equity, real estate, structured products and managed futures are generally illiquid investments and are subject to restrictions on transferability and resale. The SRE for each asset class is determined using a forecasting methodology that is appropriate for each asset class. Equity asset classes utilize a proprietary forecasting methodology based on the assumption that equity valuations revert to their long-term trend over time. The methodology is built around specific valuation measures that require several stages of calculation. Assumptions on the projected growth of earnings and dividends are additionally applied to calculate the SRE of the equity asset class. Fixed Income asset class forecasts use a proprietary forecasting methodology that is based on current yield levels. For other asset classes we use specific forecasting methodologies. Each SRE is gross of actual client fees and expenses. Components of the methodology used to create the SREs include the rate of return for various asset classes based on indices. Termination and replacement of investments may subject investors to new or different charges. Past performance is not indicative of future results. Future rates of return cannot be predicted with certainty. Investments that pay higher rates of return are often subject to higher risk and greater potential loss in an extreme scenario. The actual rate of return on investments can vary widely over time, especially for long-term investments. This includes the potential loss of principal on your investment. It is not possible to invest directly in an index.