CastleArk Risk Management: Identifying ‘Source Risk’

Incorporating Economic Risk for optimal portfolio construction.

We believe that conventional methods for describing individual stock and portfolio risks offer only a partial view of the underlying forces that drive them.  While attention to a company’s size and sector exposure are critical to diversification, they can often be undermined by misclassification error.  And while style factors, (momentum, value, leverage, etc.), measure volatility, they lack that the intuition that fundamental investment approaches require.   We believe that a comprehensive approach to risk analysis requires an understanding of how risk is sourced. 

In our view, risk is sourced from the economic forces that drive earnings and valuation.  For this reason, the outlook for economic growth and valuation are as critical to the risk management process as the conventional measures for diversification and volatility.  This is the motivation behind our proprietary economic risk measurement discipline. Our model incorporates key economic indicators that have historically driven equity and bond market returns.  Using real-time proxies allows us to classify stocks based on their sensitivity to cyclical growth, inflation, yield curve and other trends.   By directly measuring economic influences on return patterns, we can describe our economic risks and their impact on portfolio diversification and volatility.  This gives us a true sense for the impact that the economy can have on forward returns. 

After a decade of modest global growth and low inflation, investors have focused on style factors as the primary methodology for risk measurement.   Yet the global pandemic and the rapid changes in economic conditions remind investors of the impact that unexpected economic change can have on returns.  We incorporate conventional measures of size, style, and sector affiliation with an economic factor discipline to give us an edge in generating alpha with well-measured risk. 

Results

Combining a ‘boutique’ culture, a behavioral approach to fundamental analysis, and a comprehensive risk management process has produced strong returns for our clients.  Since inception, each of our marketed strategies have generated returns that exceed their benchmarks.  This demonstrates the