Understanding “Marginal Contribution to Risk”

by: , Chief Investment Officer and Managing Director | IndexIQ

At IndexIQ, we spend a lot of time researching and understanding the types of risks that investors face in their portfolios every day, incorporating what we learn into improving our index and portfolio construction processes.

One key risk measurement that plays a large role in our recently launched high-yield strategy, IQ S&P High Yield Low Volatility Bond ETF (HYLV), is “Marginal Contribution to Risk” (MCR). It’s a term that’s worth looking at more closely.

Essentially, MCR measures the amount of risk an individual security contributes to an overall portfolio. In the case of our fixed-income ETF, we start with an index of a large universe of liquid, high-yield bonds. The MCR is then calculated for each bond using its duration and the difference between the bond’s spread over the U.S. Treasury bond with a similar maturity date and a weighted average spread of bonds in the broader index universe. The result is the MCR score. By standardizing this measure, we’re able to quickly look across a broad universe of bonds, ranking them from most to least credit risk, based on their MCR.

Why incorporate MCR? For one, it can provide the basis for a new way of analyzing a market or an asset class. In the case of MCR, it’s a tool for the construction of an index and portfolio that more accurately measure credit risk. Ratings from credit ratings agencies are often delayed, meaning investors could be making decisions based on old information. With MCR, the scoring is based on market data, so it’s something that’s more like “real time.” Lower-ranked MCR securities are typically less volatile than their higher MCR counterparts.

The economy continues to expand – historically this has served high yield well – but, you can never ignore credit quality. In this asset class, getting paid for the risk is critical to compounding and long-term returns. Marginal Contribution to Risk is a tool that allows investors (or index creators) to visualize risk/return on a continuum that seeks to capture the relative attractiveness of one security compared to another, and then to create a portfolio focused on areas of higher value.

About risk:
All investments are subject to risk and will fluctuate in value. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital.

Consider the Fund’s investment objectives, risks, and charges and expenses carefully before investing. The prospectus and the statement of additional information include this and other relevant information about the Fund and are available by visiting IQetfs.com or calling 1-888-474-7725. Read the prospectus carefully before investing.

Treasurys are backed by the full faith and credit of the Federal government as to the time payment of principal and interest.

Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation.

Credit spread is the difference in yield between a U.S. Treasury bond and a debt security with the same maturity but of lesser quality.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

Marginal Contribution to Risk (MCR) measures the additional risk the bond contributes to the broad market. MCR is simply the difference between the duration time spread (DTS) of the bond and the DTS of a bond trading at the average market credit spread level. MCR serves as a useful estimation of a bond’s credit risk as the higher the MCR, the more implied credit risk the bond contributes to the overall portfolio. Bonds with positive MCR tend to add risk to the broader market, whereas bonds with negative MCR tend to reduce risk of the broader market. Low MCR bonds are bonds ranked 0-50% in the universe and the high MCR bonds are ranked 51-100% in the universe.

The information and opinions contained herein are for general information use only. IndexIQ does not guarantee their accuracy or completeness, nor does IndexIQ assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are as of the date of this report, are subject to change without notice. Past performance is no guarantee of future results.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the mutual fund. NYLIFE Distributors LLC is located at 30 Hudson Street Jersey City, New Jersey 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is Member FINRA/SIPC.

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Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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