Q: What are the potential portfolio risks tied to volatile market rates?

A: There are a number of reasons that rates could be moving up or down, and different factors are likely going to outperform or underperform in those various scenarios. For example, if interest rates are falling because inflation is receding but the economy is doing well, and the perception is that the Fed is able to cut rates slowly and achieve a soft landing, certain factors (such as beta, cyclical and high earnings variability) are going to do very well, like we saw in the fourth quarter of last year.

Conversely, if rates are falling because the economy is cratering, and the Fed is expected to rush to cut, factors such as higher quality, stable earnings and defensiveness are probably going to outperform. So, the investing implications are different if you have falling rates in a risk-on versus a risk-off environment, and we try to limit our exposure to those relationships. We also try to limit exposures to other relationships, or unintended correlated positions, that may not jump out at you right away. For instance, if interest rates continue to rise, the odds are that the U.S. dollar is going to strengthen, and that likely would have an impact on emerging market positions.

Q: How do you help PSG’s investment teams manage portfolio risk amid volatile market rates?

A: We try to encourage the teams to limit factor exposure as much as possible relative to their benchmark indexes and focus the majority of their risk budget in idiosyncratic or company-specific storylines. In general, if you limit your relative factor exposure, you can potentially help mitigate some of the risk of being wrong about the direction of interest rates.

In addition to our daily factor analysis and stress test reports, we constantly monitor how our current portfolios would have performed during the large interest rate moves, both up and down, we saw over the past couple years. We find this historical analysis helps us provide a more accurate prediction for how our exposures may perform during potential large rate swings. This is because the impact of a small and gradual rate move on portfolios can be much more muted than a quick 50 to 100 basis point one. This analysis has helped us highlight, and trim, potential rate exposure we may not have otherwise captured.

Q: How is this historical analysis different than what your daily portfolio stress tests capture?

A: If rates are trading within a range, a traditional stress test model may not think certain exposures are that rate-sensitive. But as soon as the speed and magnitude of the rate moves changes, certain exposures may be much more sensitive. The way to pick that up in advance is to look at historical moves. We have a proprietary macro framework of historical analysis for our portfolios—mapping their performance when rates went up and down in both risk-on and risk-off environments. Our aim is for our portfolio value to remain constant across those scenarios, and if it isn’t, then we adjust for the worst-case scenario. I sleep better at night knowing that our exposures to factors and historical scenarios are under control.