Diversification reduces the sensitivity of a portfolio to any single market event. It does not eliminate drawdowns, and it does not by itself determine how much risk a portfolio carries at any given time. For a leveraged portfolio, a separate mechanism is needed to ensure that the aggregate risk remains within defined bounds as market conditions change. That mechanism, at Fenyx Capital, is a daily Value at Risk framework.
The VaR framework
Value at Risk (VaR) provides a statistical estimate of potential loss over a defined time horizon at a given confidence level. Fenyx Capital’s VaR is calibrated to a monthly loss limit of 6.5% at 95% confidence; meaning that under normal market conditions, the modelled probability of losing more than 6.5% in a single month is 5%.
VaR is calculated using a historical simulation method. Rather than assuming a normal distribution of returns, historical simulation draws on actual past price behaviour across the portfolio’s five instruments to construct a distribution of potential outcomes. This captures the non-linear relationships and fat-tailed distributions that characterise real financial markets more accurately than parametric approaches.
The limitations of this method are acknowledged. Historical data does not predict future behaviour, and tail events that have no historical precedent will not appear in the model. This is not a flaw unique to historical simulation; it applies to all VaR methodologies. It is a reason to treat the framework as a discipline rather than a guarantee.
Dynamic leverage
VaR is recalculated daily. When rising volatility across the basket causes the modelled loss estimate to approach the 6.5% limit, leverage is reduced mechanically until the portfolio returns within bounds. When volatility normalises, leverage is restored. This process is rules-based and continuous.
The practical effect is that the strategy carries higher leverage in calm markets and lower leverage in volatile ones; the inverse of the pattern that causes leveraged portfolios to fail. A static leverage ratio, by contrast, amplifies losses precisely when markets are most dislocated, because it makes no distinction between a low-volatility environment and a high-volatility one.
The role of diversification
The VaR framework does not operate in isolation. Its effectiveness depends on the diversification properties of the underlying basket. A portfolio of five highly correlated instruments would require very low leverage to maintain the same VaR limit; the diversification benefit would be minimal and the return potential correspondingly reduced.
The structural low correlation between equities, sovereign bonds, and gold is what allows the strategy to carry meaningful leverage within a defined risk constraint. Diversification and the VaR framework are not separate mechanisms. They are two components of the same system.
The 2020 COVID drawdown offers a documented example of both mechanisms operating under stress. It examines how the portfolio behaved during that episode, and what it reveals about the strategy’s design.