4 Questions Risk Models Can Help to Answer

Risk models can help investors understand potential investment outcomes

Catherine Elliott 2 August, 2021 | 1:20PM
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Risk and risk management are essential components of investing. For financial product providers, understanding and protecting both themselves and investors from unnecessary risks are two must-haves when it comes to garnering investor trust and successfully scaling practices.

Risk models are a key component of this. A good risk model helps answer a range of important questions and can provide insights into the potential outcomes of taking on particular assets or liabilities in a portfolio. With this forecast, investors are in a much better position to evaluate a range of investments and select those most closely aligned to their own risk profile.

Here are some key questions that a robust risk model can help firms, product developers and investors answer

Portfolio Risk Exposure

How sensitive is a portfolio to exchange rate fluctuations? Or which holdings contribute to a portfolio’s stronger competitive advantage?  

Risk models allow investors to evaluate a fund or portfolio’s exposure to risk factors as compared to a benchmark, and view exposure of individual holdings of a fund to risk factors.

They can also to help determine which holdings in a portfolio are likely to keep their competitive edge and prosper over very long periods of time. This is known as a company’s economic moat. Morningstar’s Economic Moat Rating, for example, indicates which companies our analysts believe have the competitive advantages to provide superior long-term returns and is a key component of our global risk model methodology

Return and Volatility

How much of a portfolio’s active return can be attributed to the financial health of the holdings?

A good risk model allows sources of return and volatility in a portfolio to be easily identified without requiring an advanced quantitative background to make sense of the data.

Portfolio managers can demonstrate using an effective visual format that they are both making investment decisions with the potential impact of a variety of market conditions in mind while working in alignment with their clients’ risk tolerance - all in a way that makes sense to end investors.

Stress Testing and Scenario Analysis

How will a portfolio perform if oil prices drop, if unemployment rises, or if the FTSE 250 increases by 10%?

Risk modelling and stress testing means firms and product developers can effectively evaluate their products to see how they are likely to perform in a variety of different market conditions and best/worst case scenarios.

This is of particular importance during product creation - new financial products must comply with certain regulatory requirements intended to protect investors from dubious products, unscrupulous firms and unnecessary risk.

Modelling allows product creators to answer pivotal questions regarding risk exposure before they launch a new product. Variables can be modified to explore the potential impact of economic events on investment performance, or how changes to a single index or security can affect an investment or portfolio.

Validating Outcomes During Product Creation

Do the risk outcomes of a portfolio match with the original strategy pre-product creation? What adjustments need to be made to align with the original investment objectives of the product?

For product creators, risk modelling means that initial hypothesises can be validated and refined to ensure products are delivering on expectations within the confines of an appropriate risk margin. 

Morningstar’s Risk Models

Morningstar has a long history of independent financial research with decades of proprietary methodologies and data on portfolio risk modelling and analysis.

For investment professionals that haven’t had access to easily digestible risk visualisation and insights, Morningstar’s Risk Models leverage our historical holdings database and proprietary factors so users can perform advanced analysis to uncover and communicate how specific factors affect risk and return to inform product strategy, positioning and client conversations.

The Morningstar Global Risk Model provides a powerful tool to make comparisons across portfolios and benchmarks on a standardised, objective basis. Users can create custom market scenarios, perform what-if analysis on market movements, and gauge their portfolio exposures to as many as 36 distinct factors.

To find out more about the benefits of risk modelling and how Morningstar’s offering can help your firm, read our new Guide to Risk Modelling and Analysis.

Read Our Guide to Risk Modelling and Analysis

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Catherine Elliott  is a content writer at Morningstar

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