March 08, 2023
March 08, 2023
The Case for Stable Risk-Adjusted Returns: Why Now?
March 08, 2023
High correlations across fixed income and equity asset classes reduce diversification benefits and increase portfolio risk, leaving the door open for significant drawdowns. While this tenet is well-established and demonstrable, it is often forgotten in the good years; in 2022 however, market returns made it painfully obvious. This change in market dynamics toward higher correlation risks is not new, it has been with us since 2018 and it is likely to be with us for the foreseeable future. When high correlation risks produce substantially negative returns investors take notice; while in the good years it is ignored. Perhaps the bigger question is: what is an investor going to do about it? As intimated earlier, we have a solution: our Global Balanced Risk Control Strategy.
Better to get balanced and control risk than get defensive The solution is to construct a portfolio with a better balance of offsetting risks, instead of just utilizing what have been traditionally known as defensive assets. The difference is that balance is a portfolio construction decision to reduce risk, while becoming defensive is an asset allocation decision.
In high correlation markets, assets’ performance is highly correlated, thus defensive asset allocation decisions provide less of a hedge to drawdowns than they historically had in the past. For instance, in 2022 high quality investment grade bonds also lost value and did not provide a meaningful defensive offset to equity as it had prior to 2018.
We suggest a different approach: construct a portfolio that balances the risks of the asset selections against each other to reduce the portfolio risk. This is accomplished by targeting a level of volatility and managing risks within a specified range around that volatility target, or balancing the risks in order to provide stable risk-adjusted returns over time.
Put simply, the traditional multi-asset manager approach to creating a diversified portfolio by making a simple asset allocation decision, such as 60% equity versus 40% bonds, will not work well when both asset returns are highly correlated. Employing a balanced and active management approach to achieve more stable risk-adjusted returns may prove superior and the overriding goal of the Global Balanced Risk Control Strategy.
Diversification is good, but being balanced is better. Given the vicissitudes of the market, holding certain investments in certain markets could be potentially disastrous. Research shows that, in distressed markets, equities across the globe start to move together in lockstep. Equity-only managers have no recourse other than to reallocate between their equity holdings and cash. We have previously referred to this quandary as “rearranging the deck chairs on the Titanic.”
Fixed income is often viewed as a safer investment in volatile markets. But we have seen bond funds lose money, and they have historically delivered lower long-term performance than equity.
Diversification is often the pat answer to managing volatility. It entails building a portfolio with both equity and fixed income assets in some fixed proportion based on an investment horizon and risk profile. And it’s a good idea.
Until it isn’t.
In our minds, a passively-managed portfolio, no matter how diversified, fails to protect capital during significant market drawdowns. Imagine an investor holding a 70% equity/30% fixed portfolio: If the equity allocation is down -30% and fixed income is unchanged, simple maths indicates the total portfolio is still down -21%, i.e., bear territory.
In contrast, a multi-asset manager allocates across multiple asset classes that can be rearranged to manage risk. But in our view, there are two keys to managing a multi-asset portfolio successfully: One, that the manager is a truly active manager, and two, that they manage to a volatility target, not a benchmark.
“An actively managed global multi-asset strategy anticipates risk and can adjust its asset mix to capture the best opportunities as market conditions change.”
Active management is forward looking
Simply defined, multi-asset managers manage equity, fixed income and cash in the same portfolio. In our case (and others), we manage commodity-linked notes as well. Multi-asset funds are not “target date” funds, where allocations between equity and fixed income change at prescribed intervals over the life of the fund, based on the age and risk profile of the investor. While target date funds are a good fit for certain investors, they generally do not make tactical adjustments based on market conditions over the life of the fund.
As we see it, diversification is only effective if a portfolio is actively managed. In our case, active management is a forward-looking exercise, and anticipating volatility events is the hallmark of our investment approach. Yes, that means we are, in fact, trying to forecast the future. But not with tarot cards. Our dedicated team of 251 investment professionals continually surveys macroeconomic and geopolitical conditions across the globe to identify potential sources of risk that could arise. Our stated goal is to adjust portfolio exposures before volatility strikes.
In our portfolios the equity allocation is the primary lever for adjusting our risk exposure. When we expect some event—such as political instability, exacerbated trade tensions or a significant change in monetary policy— to cause a spike in market volatility, we typically—actively—reduce exposure to equities. Our goal is to get ahead of the “bad” news, as opposed to a post-volatility correction. In the same way, when we expect a reduction in the volatility level, we actively increase exposure to equities, to take advantage of the upside potential. Display 1 shows how we have adjusted equity exposure in anticipation of various global events over the past two years.
As you can see from Display 1, we make significant changes to our asset mix based on what we see as upcoming risk events. Our equity allocation was near 80% in mid 2018, but when US-China trade tensions were exacerbated globally by political factors, we shifted that allocation to close to 25% by the summer of that year. In early 2020, to help manage volatility during the COVID-19 pandemic and unprecedented shutdown of the global economy, we reduced the equity allocation of our flagship portfolio from around 55% to 20%, a position we maintained as volatility remained elevated.
Providing the benefits of compounding returns by managing volatilityOn one level we are managing a multi-asset portfolio, but in truth, what we are really managing is volatility. In our case, we manage our multi-asset portfolios to a pre-defined risk budget, also defined as a volatility target range. In our representative Global Balanced Risk Control portfolio, launched in November 2011, we target volatility in the range of 4%-10% (see Display 2). Typically, we expect volatility to be towards the middle of this range, but in extreme conditions we may make fuller use of the range, for example to mitigate the impact of volatile down markets. Our goal is to deliver competitive returns and minimise downside market participation within these volatility parameters.
This is quite a different approach from most investment managers, who designate a benchmark to evaluate their fund’s performance. But evaluating any investment relative to a benchmark is tricky: If the broader market is down -35% and a portfolio only -30%, the manager has in fact beaten their benchmark, which is great for the manager. The client, however, has still lost close to a third of their investment.
We benchmark our portfolios based on volatility and our investment process begins with risk. As discussed, we specify a target range of volatility, e.g., 4%-10%, within which we aim to maintain the strategy’s volatility. Typically, we expect this to be towards the middle of the range i.e., 6%-7%. As stated, our multi-asset portfolios hold a mix of equities, fixed income, commodity-linked notes and cash, and this flexibility to diversify across asset classes is critical in managing risk.
In the industry vernacular, we are often referred to as, not surprisingly, a “volatility manager.” A paper from the Yale School of Management, “Volatility Managed Portfolios,”2 indicates that volatility management is an investment approach that can produce superior investment results.
From the paper’s abstract:
Furthermore from the research:
Perhaps the simplest explanation of what we are trying to achieve, is an investment process that provides a stable return profile that enables clients to compound their returns more predictably within a volatility range, as seen in Display 2.
The The Portfolio Solutions Group's multi-asset portfolios
2020 is a good example of what we believe are the advantages of an actively managed multi-asset portfolio benchmarked to a volatility target.
As can be seen in Display 3, our multi-asset representative Global Balanced Risk Control (GBaR) portfolio, captured the same returns as the MSCI All Country World Total Return Index (EUR) over the course of 2020. Yet, its maximum drawdown during the year was less than half that of the index—approximately 17% vs 33% for the MSCI ACWI TR (EUR) achieved with less than half the volatility—approximately 7% vs 15% for the MSCI ACWI TR (EUR). In our view, delivering competitive performance without extreme volatility is particularly appealing for the vast majority of clients.
In fact, we find that our approach to multi-asset investing often meets the needs of both high-net-worth (HNW) investors and smaller clients. In particular, as a core portfolio allocation for the former and as a holistic strategy for the latter. Over the years, we have come to understand that investors are often more concerned with keeping their money than with growing it aggressively. Having said that, we see that both HNW and smaller investors do want to grow their money, but with less volatility and most importantly, with no surprises. These investors (and others) realize that massive drawdowns have the potential to cause even the most sophisticated investors to sell at the bottom—often the biggest disaster of all. Instead, true active management and flexibility within a volatility target/risk control framework are required to mitigate the downside during the most volatile periods. The speed of execution and available tools (futures and options, among others) in order to achieve these results are also factors to consider when an investor delegates part of their portfolio to a multi-asset manager with a risk control framework.
ESG and multi-asset investing
There has certainly been an uptick in demand for Environmental, Social and Governance (ESG)-run products in recent years—and multi-asset is no exception to this trend. As a team, we believe that the market ascribes value to ESG factors and that companies with strong ESG profiles are more attractive investments; emphasising such companies therefore provides an opportunity to add value to portfolios. Likewise, avoiding companies that perform relatively poorly on ESG criteria, and could be expected to suffer in the new environment, is an additional risk management tool.
For this reason, the Portfolio Solutions Group seeks to enhance portfolios’ ESG profiles, or ESG “friendliness,” through a process of “tilting” towards securities with relatively high ESG ratings. In addition, the team excludes securities with exposure to significant ESG controversies and seeks to actively engage with company management on ESG issues for a targeted set of companies held in our portfolios. Ultimately as an increasing number of ESG factors represent material investment risks, incorporating ESG in an investment process is no longer simply a matter of personal conviction, but in our case is a natural extension of our risk control philosophy.
Our investment team and process
Investors are faced with continually changing market conditions. In our years of active fund management, our team has invested during economic recessions and recoveries, momentum markets and bubbles, rising interest rate and inflationary environments. Not to mention those “black swan” events that can take even the most astute investors by surprise.
We expect that markets will be more volatile in the future and that our investment process that controls for volatility to create a more stable return profile and produce higher quality risk-adjusted returns will offer better long-term results for investors. Our process is paramount.
An approach that adapts – so that you don’t have to
We believe that multi-asset portfolios can navigate a variety of environments by employing an approach that actively manages allocation decisions, while managing the entire portfolio to a volatility target. This is an approach that adapts the asset mix so that you don’t have to.
Simply put, our goal is to deliver competitive performance with minimized participation in distressed markets.