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How much of your portfolios risk comes from the
volatilities of the individual investments youve made
and how much comes from the interactions those
investments have with each other? Most portfolio risk
models scramble volatility and correlation together
and do not allow a separation of risk into a pure
volatility component and a pure correlation
component, even though those two measures are key
ingredients in the models. We have devised a method
of decoupling these two important components to
provide a new type of risk attribution.
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We separate the risk measure into two additive
components, one of which is purely dependent on
volatilities and the other purely dependent on
correlations. Schematically, this can be represented
by the following equation:
V aR
2
port
= Risk
vol
+Risk
corr
The !rst component, dependent only on volatility, is
always positive (volatility only adds to risk and cannot
reduce it), while the second component, dependent
only on correlation, can be positive or negative. Note
that it is not the VaR amount that is decoupled into
these two components, but rather the square of the
VaR number.
Calling these parts Volatility Contribution to
Ri sk (VCR) and Correl ati on Contri buti on to
Risk (CCR), the schematic becomes:
Risk
port
= V CR +CCR

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Component Comparison: See what fraction of the risk is
due to volatility & what fraction is due to correlations.
Diversi!cation Measure: Understand the degree of
diversi!cation and dependence on hedged.
Russo Ratio: The ratio CCR/VCR can be examined through
time to understand the portfolios risk dynamics.
Risk Limits: VCR, CCR and the Russo Ratio can all be
monitored, with limits, to better manage risk.
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Si nce the ri sk i s decoupl ed i nto addi ti ve
components, they can each be expressed as a
percent of the total, adding to 100%. But because
the !rst component can only be positive while the
second component can be positive or negative, it is
possible to have more than 100% contribution to
risk from the volatility component. It is not
uncommon for a portfolio to have, for example,
130% or 150% of its risk coming from the volatility
component. The correspondi ng correl ati on
component would be -30% or -50% respectively. In
these cases, the correlation component is shown to
decrease risk: in other words, the correlations are
helping keep the risk lower than it would be
otherwise.
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The ratio of the two components provides a
compact way of expressing the decoupling in one
number. The Russo Ratio (RR) is the ratio of the
correlation component to the volatility component,
and has a lower bound of -1 and no theoretical
upper bound.
RR =
CCR
V CR
RR " -1
Russo Ratio values near -1 mean that the correlation
component removes as much risk from the portfolio
as the volatility component contributes. This can
only happen in portfolios where the total VaR is
quite small because of very tight hedging. The
portfolios low risk depends very heavily upon
correlations being stable since any change in the
correlation structure would result in a (possibly very
sharp) increase in risk.
RR " 0
Values near zero represent situations in which the
correlations contribute little or no risk to the overall
portfolio, neither increasing nor decreasing the risk.
To achieve this, the investment weighted average
covariance between all securities needs to be near
zero. For two securities, this means the correlation is
extremely small.
RR between 0 and 1
Values between 0 and 1 mean that both VCR and
CCR are positive and that the correlation component
is smaller than the volatility component. This
typically represents a somewhat diversi!ed portfolio
in that the risk is dominated by the volatility
component.
RR > 1
Values above 1 represent portfolios in which the
correlations are the dominant contributor to risk
and in which little diversi!cation or hedging is
present. In this scenario, the average correlation
must be high.
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To gain some intuition into the VCR and CCR in
practice, we examined three hypothetical portfolios:
1. Sector Portfolio: equal investments into 10 US
Equity Sectors;
2. Asset Class Portfolio: equal investments into 6
diverse asset classes: Equities, Fixed Income,
Commodities, FX, Real Estate and Hedge Funds;
3. Global Equity: equal investments into three
global equity markets: US, Europe, Japan.
We then computed the VCR and CCR for each of
these three portfolios historically and found that
each is characterized by its own Russo Ratio
si gnature. The Sector Portfol i o i s a hi ghl y
concentrated investment in the US equity markets
and from 2000 to 2014 has a high average Russo
Ratio of 2.96. The stability of this ratio through the
time period, as shown in Figure 1, is remarkable
given than the equity markets have gone through
wide swings in volatility; with the VIX at a low of about
10% in November 2006 and high of about 90% in
October 2008.
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The Asset Class Portfolio, which was designed to be
more diversi!ed than the Sector Portfolio, has a
signi!cantly smaller CCR than VCR. The Asset Class
portfolio has an average CCR of only 30%, while the
Sector portfolios CCR is on average over 80% of that
portfolio s risk. Figure 2 shows the relative
contributions of VCR and CCR to the Asset Class
Portfolios risk level from 2004 through 2014. Over
this time period, the average Russo Ratio was only
0.10, demonstrating that the portfolios risk came
mostly from volatilities. Said di#erently, the portfolio
was well hedged through this time period.
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The third portfolio we analyzed was a Global Equity
portfolio, which we expected to be more diversi!ed
than the !rst (US only) equity portfolio but not as
diversi!ed as the multi asset class portfolio. Figure 3
shows the VCR and CCR for this portfolio, with an
average Russo Ratio of 0.57.
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Like the US Sector Portfolio, the Global Equity
Portfolio exhibits stability of the Russo Ratio over the
past 14 years despite wide swings in equity volatility.
But unlike the US Sector Portfolio, the Global Equity
Portfolio has less than half of its risk coming from the
correlations between the investments, re$ecting
better diversi!cation.
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Our risk decoupling approach can be considered a
form of risk attribution. Rather than attributing a
portion of the portfolios risk to the underlying
investments, the risk decoupling attribution
approach shows how much of the portfolios risk
comes from the securities intrinsically (the volatility
component, VCR) and how much of the portfolios
risk comes from the interaction between the
securities (the correlation component, CCR).
This attribution can be used to measure the sources
of risk within a portfolio for comparison to the
desired sources of risk. Since fund managers design
portfolios to generate alpha through a variety of
strategies, there is no right level of VCR, CCR or the
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Russo Ratio. Highly concentrated portfolios will
inevitably have high Russo Ratios and tightly hedged
portfolios will have negative ratios.
Each portfolios history of risk decoupling should be
examined and compared with standard cases like
those presented above to determine acceptable and
desired ranges of the analytics. Once established,
deviations from these ranges should trigger a
deeper investigation into understanding the causes
of the changes.
Our risk decoupling approach will lead to a deeper
understanding of the sources of risk and will help
portfolio managers make better risk decisions.
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-1 to 0
The portfolios correlations contribute a negative
amount to the overall risk. The closer to -1 the
ratio, the more the risk level relies on
correlations to hedge. Changes in correlation can
have signi!cant impact on the portfolios risk.
Monitor the correlations closely as the portfolios
hedges depend on them
Stress Correlations to estimate the impact on the
portfolio from shifting correlations
Pay close attention to CCR
near zero
The portfolios risk comes almost exclusively
from volatilities. Correlations play a very small
role in the amount of portfolio risk. The portfolio
should not be too sensitive to changes in
correlations.
Monitor volatilities as all the portfolios risk
comes from individual securities movements and
not from their interactions (correlations)
Pay close attention to VCR
0 to 1
The lower the ratio, the more the risk comes
from volatilities. A ratio of 1 means that the risk
from correlations is equal to the risk from
volatilities. All portfolios in this range have some
amount of diversi!cation.
Monitor both volatilities and correlations as they
play contributing roles to the portfolio risk
Consider setting limits on VCR and CCR
over 1
The higher the ratio, the more the risk comes
from correlations, and the less diversi!cation
exists in the portfolio.
Consider diversifying investments as the portfolio
is highly concentrated and correlations contribute
more to risk than do individual volatilities.