An Approach to Downside Risk Management for Multi-Asset Portfolios

When the Russia-Ukraine conflict erupted in February 2022, global markets were rocked by uncertainty. Equities sold off on escalating geopolitical risks, while fixed income declined on global monetary policy tightening to curb inflation. Diversification failed. In this scenario, we needed to quickly lower risk exposures to prevent substantial portfolio drawdowns.

In our view, the above episode highlights the growing relevance of effective risk management for multi-asset (MA) portfolios. MA solutions historically appealed to investors seeking steady returns and income with lower risk by blending investments across multiple asset classes. Going forward, natural diversification may not be sufficient to protect portfolios from losses in periods of heightened market volatility when inflation is sticky or even rising. This may also hinder an MA strategy’s ability to meet other investor-specific objectives, such as delivering consistent income.

Hence, in a market event such as the Russia-Ukraine conflict, a flexible MA portfolio should be able to respond quickly and reduce risk exposures - for example, by utilizing derivatives in a risk overlay. This article provides an overview of our approach to managing downside risks for income-focused MA portfolios. We first outline our process, particularly our active overlay program focused on drawdown management. We then provide more examples that illustrate how our framework would respond to other market shocks— the Covid-19 pandemic and the U.S. election aftermath.

A risk aware approach and active overlay to manage downside risk

In constructing a global MA solution, risk management considerations are embedded throughout our investment process (Figure 1). 

First, we consider the stage of the business cycle to inform our dynamic strategic asset allocation between equities and fixed income. Early in the business cycle we are comfortable taking more equity risk; at a later stage, we prefer a lower net equity exposure. Second, we apply tactical asset allocation seeking to enhance long-term performance, based on cross-asset relative value assessments, global economic conditions, corporate fundamentals, and secular investment themes.

However, as mentioned above, periods of market stress can trigger abrupt, sentiment-driven selloffs. Therefore, we augment our strategic and tactical decisions with an active risk overlay, allowing the investment team to express discretionary views based on non-consensus outcomes that could trigger material downside. As the bulk of the risk in an MA portfolio comes from equities, our overlay is designed to manage equity risk via an iterative and risk-budgeting approach, combining a quantitative framework with qualitative inputs (Figure 2).

Our approach uses two key inputs—a portfolio drawdown target (on a best-efforts basis) and estimates of current portfolio and market volatility—to help determine an appropriate risk budget or target equity exposure. With this information, we can react quickly to shifting market conditions. If we expect risks to rise, we employ hedges to de-risk the portfolio, using instruments such as stock or bond index futures, swaps, options, and currency forwards. Conversely, we might gradually re-risk if we think volatility might ebb. We favor using derivatives to help portfolios benefit from the natural income and potential excess return generated by their underlying holdings. This enables us to adjust portfolio risk swiftly while maintaining our focus on other objectives.

Examples

Below are two more examples of our risk management framework at work:

I. Covid-19 selloff (January 2020)

The initial outbreak of Covid-19 in the first quarter of 2020 is a prime example of the importance of de-risking strategies to react against rapid shifts in sentiment. News of a mysterious disease spreading to more countries began to surface in January 2020, but investors were initially sanguine to the risks. However, our experience with previous infectious disease episodes in Asia gave us pause. We were concerned about the pace and modes of transmission of the virus, while the Chinese government’s decision to impose strict lockdowns and effectively shut down the economy was another worrying sign. 

In our view, the elevated uncertainties associated with the onset of the pandemic was a clear signal to reduce risk positioning. Ultimately, global asset prices sold off significantly in March 2020, triggering the second-fastest bear market in history.

From an investment perspective, the use of put options on the S&P 500 Index during low implied volatility at that time created a cost-effective way to manage downside risk, while the use of index futures helped to lower net equity exposure. Investing in traditional safe-haven assets and currencies with defensive characteristics, such as the Japanese yen, was also helpful to cushion against sharp losses.

II. Post-U.S. election (2024)

Donald Trump’s victory in the November 2024 U.S. presidential election was another signal to lower risk exposures. Worries about the economic impact from expected fiscal, immigration, and trade policies compounded prevailing concerns about the U.S. economy and stretched equity valuations after an extended bull run. President Trump’s announcement of sweeping tariff increases on countries worldwide in April 2025, and a subsequent pause to allow for trade negotiations, induced further volatility.

The combination of recession and trade0related risks pointed to a challenging environment, making it prudent to lower risk positioning and net equity allocation. Our active overlay program allowed us to move to a short on U.S. equities, and short on the U.S. dollar against longs on defensive currencies such as Japanese yen, Norwegian krone and Swedish krona. This also reflected our view of the U.S. economy entering a later stage of the business cycle. 

With fluid developments raising the possibility of both upside and downside risks, we continued to be cautious. However, the bearish narratives were short-lived as optimism about trade negotiations helped markets rebound faster and stronger than expected after the April disruption.

In our view, this episode reflects one of the challenges of our approach—the difficulty of keeping pace with sudden upswings in risk appetite. Our risk-aware style means we prefer adding risk gradually as sentiment improves, in line with strengthening of the fundamental backdrop. In this case, we felt negative macroeconomic impacts were only delayed and masked by supportive fiscal policies. Hence, we look to strike a balance between convexity to market gains and staying alert to the possibility of renewed weakness by identifying opportunities with more defensive or idiosyncratic themes.

Concluding thoughts

In an investment landscape of heightened volatility and unstable cross-asset correlations, proper downside risk management is critical for MA portfolios as significant drawdowns can affect investor returns and the ability to pursue desired outcomes. This means having a toolkit to understand risks comprehensively and respond proactively to shifting market dynamics.

We believe incorporating an active overlay program with proper risk-budgeting assessments, implemented with derivative-based hedges, provides flexibility to adjust risk exposures, supporting underlying income generation or other core investment objectives. 

We believe this approach will better position an MA portfolio to help investors navigate volatility and pursue income preservation, even in challenging environments.