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Modeling Risk for Global Low Volatility Strategies : The impact and role of base currencies![]() “Not taking risks one doesn't understand is often the best form of risk management.” In today’s investing world, we use a simple definition of risk: the volatility of returns on an investment. Although simplistic, this definition allows for systematic and quantifiable measures, which could be used as a basis when comparing investment options and building investment strategies. But how do we forecast the risk of a foreign investment and does the risk modeling currency matter? Providing an answer to this question may seem easy at first glance but has proven to be more difficult without first answering other questions, like where is the investor located and in which country is the investment being made? Or is this the only foreign investment the investor owns or are there others in the same or other countries? The importance of risk models for low volatility strategies Low volatility equity strategies are particularly dependent on the choice of equity risk models. There is an unlimited number of risk models that could be used to build a low volatility strategy. As a matter of fact, we don’t even need a model; any measure of volatility could be used to rank the investments and construct a low volatility portfolio. However, it can become more complicated if you consider foreign investments. With this complexity top of mind, Yuriy Bodjov, Vice President & Director and member of the TDAM’s Quantitative Equity Team recently authored an article titled Risk Model Estimation Currency and its Impact on Global Low Volatility Funds. The paper focuses on and investigates the role of the base currency in equity risk modeling when applied to global low volatility strategies.
The article discusses the dynamics related to the choice of the base currency for modelling risk as well as how TD Asset Management (TDAM) approaches that question when making investment decisions. Some of the highlights of the article include:
Modeling the risk in Canadian dollars results in low volatility portfolios that are more exposed to cyclical sectors such as Energy and Materials, because the Canadian dollar itself is sensitive to commodities and moves up or down in-sync. Consequently, these sectors will likely look less risky for Canadian investors. In a global low volatility fund, having a higher proportion invested in Canadian stocks also seems to reduce the risk for Canadians. In contrast, if we model the risk in U.S. dollars, the resulting low volatility portfolio will be more exposed to sectors such as Information Technology, Health Care and Consumer Staples. Incidentally, these sectors were the best performing sectors year-to-date. Such a portfolio will also hold a larger proportion of U.S. stocks.
Using a risk model based on Canadian or U.S. dollar may lead to similar low volatility portfolio risk forecasts, but the choice of the base currency and the resulting portfolio structure can have a significant impact on the performance depending the market direction. Finding the right balance between achieving the lowest possible volatility and good performance in normal and strong markets, and still having downside protection during crisis requires skill and is indictive of the investment decisions that have to be made by our Quantitative Equity Team. Our utmost priority is to safeguard, and grow, the invested capital of our clients; by ensuring that our investment actions are empirically sound and supported by research that reflects current market and economic facts.
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January 21, 2021
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