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While it may be impossible to eradicate risk, at Insight Investment we believe having a clear framework to define and describe it offers our investors a robust approach to taking it when the time is right.
Insight’s heritage is servicing institutional clients in the liability-driven investing business. This means we have a tradition of catering to clients’ specific needs with portfolios tailored to their requirements, liabilities and risk budgets.
“Units of risk” is our proprietary risk calibration process that endeavors to allow asset allocation decisions to be inextricably linked to a portfolio’s performance targets. For over 15 years, that’s what has helped Insight Investment — a BNY Mellon Investment Management company — achieve strategic outcomes for our clients.
Here, we explain that approach.
The risk budget of each fund is linked to its performance target and the risk-adjusted return it is expected to generate.
Once the risk budget for a fund is determined, we divide it into eight equal slices, or “units.” These are the units of risk, which a portfolio manager can use to allocate to different assets within the fixed income universe.
We choose eight units primarily because doing so maintains the statistical significance of each denomination and secondly because it presents, in our view, a practical framework to work within.
After combining top-down and bottom-up investment views, portfolio managers can allocate (or “spend”) their units of risk accordingly. For example, if they believe investment grade credit spreads are attractive, they may wish to spend one unit “long.” Similarly, if they believe high yield is unattractive, they may opt to allocate one unit “short.” It is important to state that these are not physical short or long positions, simply our way of expressing whether a manager is favorable towards an asset class or not.
In practice, it is not quite as simple as allocating 1/8th of a portfolio’s active positions to investment grade or high yield. High yield is historically more volatile than investment grade, which means a lower allocation to high yield would likely be required to generate the same level of active risk as an investment-grade allocation.
Insight’s teams have analyzed the long-term historical volatility of each fixed income asset class and we continue to monitor and review these measurements on a regular basis.
We use these to calibrate allocations to different asset classes accordingly, to help ensure one unit of risk can genuinely seek to correspond to 1/8th of the overall risk budget. This is also helpful because it creates a common language for our investment professionals to use when discussing different sectors that have historically behaved differently from one another, increasing our decision-making efficiency.
When allocating risk, Insight portfolio managers selects how many units long or short they wish to be exposed to across each available source of return, subject to hard limits between +3 and -3 in any single asset class or strategy.
The result may look something like Figure 1, where the manager is 1.5 units long asset-backed securities (“ABS”), half a unit short high yield and neutral duration. While the limit on absolute units per strategy is three, in practice, single allocations above two units are rare unless valuations are particularly stretched.
Fixed income markets, such as investment grade, high yield, loans, ABS and others, are likely to be subject to correlation. As a result, allocating units of risk in a similar manner across several asset classes may leave an investor exposed to correlation risk, unwittingly causing the portfolio to exceed its risk budget.
This is why the final step of the units of risk approach is to factor correlations into the analysis. We use our risk system to perform scenario analysis to generate the portfolio’s expected tracking error (the degree to which a portfolio differs from its benchmark).
If these estimates of total risk are outside acceptable limits, the portfolio managers will scale back their proposed units of risk allocations until the required conditions are satisfied. The same analysis will also indicate any potential diversification benefits.
Rather than part of the investment decision, our units of risk process is an essential tool providing Insight portfolio managers, analysts and risk teams with a common language and a unified approach. The result is an entirely bespoke method, with institutional pedigree, that is applied to our full suite of fixed income portfolios and for each and every client.
Please note, the specific investment limits and restrictions as they relate to the BNY Mellon Insight Core Plus fund are outlined in the fund’s Prospectus and Statement of Additional Information.
All investments involve risk, including the possible loss of principal. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Asset allocation and diversification cannot assure a profit or protect against loss.
Investors should consider the investment objectives, risks, charges and expenses of a mutual fund carefully before investing. To obtain a prospectus, or a summary prospectus, if available, that contains this and other information about a fund, investors should contact their financial advisors or visit dreyfus.com. Investors should be advised to read the prospectus carefully before investing.
Bonds are subject to interest-rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. High yield bonds involve increased credit and liquidity risk than higher-rated bonds and are considered speculative in terms of the issuer’s ability to pay interest and repay principal on a timely basis. The use of derivatives involves risks different from, or possibly greater than, the risks associated with investing directly in the underlying assets. Derivatives can be highly volatile, illiquid, and difficult to value and there is the risk that changes in the value of a derivative held by the portfolio will not correlate with the underlying instruments or the portfolio’s other investments.
BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, with $1.7 trillion in assets under management as of 12/31/18. It encompasses BNY Mellon’s affiliated investment management firms, wealth management services and global distribution companies. More information can be found at www.bnymellon.com.
Insight Investment advisory services in North America are provided through two different investment advisers registered with the Securities and Exchange Commission (SEC), using the brand Insight Investment: Insight North America LLC (INA) and Insight Investment International Limited (IIIL). The North American investment advisers are associated with other global investment managers that also (individually and collectively) use the corporate brand Insight Investment and may be referred to as “Insight” or “Insight Investment.” The sub-adviser for BNY Mellon Insight Core Plus Fund is IIIL, an affiliate of The Dreyfus Corporation.
Views expressed are those of the advisor stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Please consult a legal, tax or investment advisor in order to determine whether an investment product or service is appropriate for a particular situation. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. The Dreyfus Corporation, Insight Investment and MBSC Securities Corporation are companies of BNY Mellon. ©2019 MBSC Securities Corporation, distributor, 240 Greenwich Street, 9th Floor, New York, NY 10286.