Holdings-Based vs. Returns-Based Analysis: Deciphering the Best Method for Forecasting Fund Risk Profiles

For investors engaged with funds that are actively managed, understanding the risks introduced by the fund manager is paramount. Many lean towards a detailed examination of a fund’s holdings to gauge this risk, believing a comprehensive look at each position could hardly go wrong. Yet, is this method as foolproof as it seems? This blog post delves into the comparison of holdings-based and returns-based methods for risk prediction, exploring their effectiveness in various scenarios.

The risk profile of a fund manager can be evaluated through two primary lenses:

Returns-Based Analysis (RBA): This top-down approach employs regression analysis of a fund's returns against multiple benchmarks to gauge the fund's risk persistence. It excels in identifying historical correlations between the fund's returns and benchmark indices, shedding light on the fund's market exposure. Despite its strengths, RBA's reliance on past relationships may not accurately predict future risks, especially when the fund's exposure to various factors changes.

Holdings-Based Analysis (HBA): In contrast, HBA adopts a bottom-up approach, offering a granular examination of the fund's individual holdings. This method aggregates data from specific snapshot days to craft a comprehensive view of the fund's overall risk profile. However, its effectiveness is contingent on the consistency of the fund's holdings, which may fluctuate over time.

Illustrative Analysis of Two Simulated Funds

To compare these methods, consider two funds investing in the S&P 500 ETF:

Fund 1 remains fully invested at all times.

Fund 2 employs a long/short trend-following strategy with 180 days lookback period.

Table 1. Comparison of Risk Forecast between Returns Based and Holding Based Methods

When analyzing these funds using Volatility, Value at Risk (VaR), and Stress Test as ex-ante risk measures, both RBA and HBA forecast similar volatility and historical VaR (see Table 1). However, they diverge significantly in their Stress Test predictions: RBA suggests a 10% fall in the S&P 500 index would result in an 11.4% gain for the trend-following fund, while HBA predicts a 10% loss.

Delving into the Logic Behind the Predictions

The disparity in Stress Test outcomes stems from the inherent assumptions of each method. HBA, evaluating the fund as of a specific snapshot day, assumes the fund’s long position in the ETF persists, thereby mirroring the S&P 500's risk profile. This assumption fails to account for the dynamic strategy of the trend-following fund, which may shift to short positions post-evaluation, altering its risk profile.

RBA, on the other hand, captures the fund's strategy of alternating positions, maintaining a continuous, beta-adjusted exposure. This method accurately predicts the fund's performance inversely related to the index's movements, as demonstrated in the Stress Test scenario.

Conclusion and Insights

The duel between HBA and RBA in forecasting fund risks highlights the limitations and strengths of each method. RBA's ability to capture the persistence of risks, through consistent market or indices exposure, makes it superior in certain scenarios. However, its accuracy diminishes when a fund frequently changes its investment style, e.g. from large market cap stocks to growth stocks exposure. Conversely, while HBA demands high transparency and offers a detailed risk profile, it may not accurately predict future portfolio adjustments due to its reliance on static snapshots. When positions within a portfolio are altered, it may become necessary to reassess the associated risk profiles.

Ultimately, the choice between HBA and RBA should be guided by the investor's objectives. For long-term active risk estimation, RBA may be more suitable, offering a broader understanding of a fund’s exposure to market movements. In contrast, HBA might be preferable for short-term, dynamic assessments, especially when the fund's holdings are consistent. The decision hinges on the fund’s trading turnover and the investor's time horizon.