Multi-Asset Investing, Diversify, Different
In the aftermath of the financial crisis, largely expansive monetary policies and unprecedented quantitative easing experiments by the major Central Banks have created areas of mispricing of credit and asset price inflation, which may translate into less potential capital appreciation from directional sources. Moreover, we believe that there are “fertilizing” factors which have the potential to trigger a rise in volatility and alter asset returns: the high levels of public debt worldwide, sub-par growth in both the developed and emerging worlds, the eventual withdrawal of extraordinary monetary accommodation, and reduced market liquidity as a consequence of tighter regulation. In this new world, we believe that traditional approaches to asset allocation may fail to provide adequate returns and may not be able to protect investor portfolios in critical phases.
Therefore, to build more genuinely diversified portfolios in an effort to enhance returns and try to protect against excessive drawdowns, we believe that a new approach to multi-asset investing is needed. We believe it is time to Diversify, Different. This means focusing on risk: identify the risk factors that drive asset classes and effectively diversify among them; seek to extract the highest potential returns from beta (especially by diversifying into non-traditional asset classes) and strive to exploit alpha1 opportunities. It also means seeking to help protect portfolios as much as possible from extreme events, analyzing the possible impact on portfolios of tail events (stress test), and identifying possible hedges to protect against tail risks.
At Pioneer Investments we believe a well-designed investment process, which searches for effective diversification both in the alpha and beta fields by budgeting risk across multiple approaches, is key to facing the new investment landscape and meeting emerging client needs.
After a relatively benign period in the 80s and 90s, financial history unfolded in a way that challenged the world of traditional asset allocation.
A New Environment for Investors
During the 80s and 90s, investors enjoyed mostly benign market conditions, and asset allocation was a relatively simple task, with a plain vanilla bond-equity mix (i.e. a 50/50 bond/equity allocation) that delivered, for the most part, appealing results. Events played out differently as the 2008 global financial crisis erupted and liquidity issues emerged. In addition, portfolios built on a static, traditional asset allocation approach offered poor diversification, displaying unexpectedly high levels of correlation between asset classes: in many cases hedges did not work as expected and exposures to some particular risks were different than forecasted.2 In the aftermath of the financial crisis, largely expansive monetary policies and unprecedented quantitative easing experiments by the major Central Banks have created a very different investment environment, characterized by low nominal rates and negative real rates.
This backdrop of financial repression has triggered a continuous search for yield and has driven five years of equity and credit bull markets. Areas of asset price inflation and a reduction in the price paid for risk have emerged at a time when economic growth prospects for most of the developed and emerging worlds have remained subdued. At the same time, the secular bull market for bonds has left little upside potential for returns in the years to come.
Today's investors are facing new challenges, as there is a lack of appealing directional sources of return and the presence of multiple volatility fertilizers.
Investors of today are facing new challenges
The first challenge is the lower expected returns in most asset classes. Bond yields are at their lowest levels registered in the last 20 years in most developed markets, and we believe that this asset class will struggle to provide positive results in the coming years. In fact, at current values, there is very little protection from possible losses in the event that rates rise. Equity markets show stretched valuations, although opportunities remain in some EM and European markets.
A second challenge comes from a potential pick up in volatility. Recent expansionary and unconventional Central Bank policies have contributed to keeping volatility at very low levels. Will this be the new normal or will volatility stage a comeback? We believe that there are a number of factors which have the potential to trigger a rise in volatility. Debt deleveraging, structurally slowergrowth, the declining efficacy of unconventional policies, and market liquidity risks on the rise, are among what we call “volatility fertilizers”.
Why Diversify Different?
By looking at the past, we see that phases of financial market turmoil have proven challenging for traditional asset allocation portfolios. In fact, during periods of pronounced market stress, portfolios traditionally diversified by asset classes suffered substantial losses, as multiple asset classes experienced simultaneous drawdowns, despite a history of muted correlations.
The origin of these losses was not only higher volatility across the board but, most importantly, changes in correlation dynamics.
Over the last decade, cross-asset correlations increased significantly compared to the previous decade. This can be seen from the graph below which plots the evolution over the last 20 years of the average correlation among different asset classes and the volatility index VIX. Only in the last few years, amid the low volatility environment created by the Central Banks, have correlations trended lower. But we think this recent trend may be reversed in phases of higher volatility.
The risk associated with a portfolio may change significantly when all asset classes get more volatile and correlations change, making diversification ineffective when most needed.
One of the reasons for this dramatic increase in correlations could be the globalization of capital markets. With financial institutions able to trade any asset class in any market worldwide, extreme movements in a specific region can spread across the globe. In addition, the increased usage of algorithmic trading and risk management tools could also explain why correlations increase the most during periods of severe stress.
The consequence is that the risk associated with a portfolio may vary significantly when all asset classes get more volatile and liquidity dries up, making diversification ineffective when most needed.
In addition, the current environment of financial repression has created an apparent paradox: at a time when downside protection and capital preservation are top investor needs, as results from Pioneer’s regular client surveys indicate, the search for yield has pushed investors up the risk curve. This, in our view, calls for an urgent change of direction from traditional asset allocation, and to identify an investment approach which could help achieve investor objectives, while better managing downside risk. We have attempted to address what we believe are the most important challenges facing investors dealing with this framework of lower expected returns and possible higher volatility:
To build a better diversified portfolio, we believe it is important to focus on risk: identify the different risk factors and diversify among them.
- How can I build a more robust portfolio; one that is better diversified and more risk aware?
- How can I seek to enhance portfolio returns in a low yield environment?
- How can I help protect my portfolio from extreme “tail risk” events?
1. How can I build a more robust portfolio; one that is better diversified and more risk aware?
We believe that the answer to this question relies on 3 steps:
- Focus on Risk
- Identify Risk Factors
- Diversify Among Risk Factor
To seek to enhance portfolio returns, we need to focus on both the alpha and beta components.
2. How can I seek to enhance portfolio returns in a low yield environment?
To answer this question, we need to understand the drivers of portfolio returns:
Investment Return=Risk free returns +Returns from beta +Returns from alpha
To enhance returns, in our view, it is necessary to focus on both the alpha and beta components of returns. On the beta side, this means to utilize opportunistically opportunistically utilizing all appropriate sources of diversification. On the alpha side, we need to understand the main elements driving alpha and how we can act on them. Alpha is essentially a function of the number of independent investment ideas and a portfolio manager’s skill. As the world is experiencing uneven economic growth, specific dynamics at the country/industry/sector levels become extremely important. Divergences in economic conditions and asset class or sector valuations may provide significant opportunities to generate pure alpha. The behavioral aspect of investing is another important element, in our view, in generating sustainable alpha. One of the most important skills in portfolio management is timing the entry and exit of positions, as this will have a big impact on the win/loss ratio.
Going forward, we believe that hedging will become increasingly important, as volatility may increase due to multiple fertilizers.
How can I protect my portfolio from extreme events?
The recent crises have taught investors the importance of protecting portfolios from tail risks, because these events can be highly damaging to the overall portfolio.
We believe that an effective approach to this task should be based on 3 steps:
- Identify tail risks based on alternative macroeconomic scenarios
- Analyze the possible impact on the portfolio of the tail events (stress test)
- Identify possible hedges to protect from tail risks
Once the alternative scenarios have been identified, a stress test analysis on the overall portfolio can be conducted to scope the extent of losses under extreme circumstances for the overall portfolio, as well as for individual asset classes and positions. This can enable an assessement of the most efficient way to help protect the portfolio from extreme losses. Today, there are multiple hedging techniques available to help protect against tail risks, thanks to the development of the derivatives markets. In general, the opportunity to implement these techniques should be assessed based on the stress test results, while also taking into account the cost of hedging. According to our view, it usually makes sense to hedge low probability events which may have extreme consequences, if the cost is not excessive. Going forward, we believe that hedging will become increasingly important, as volatility may increase due to the multiple fertilizers that we reviewed in the first chapter.
We have seen that adding uncorrelated strategies may improve the risk-adjusted return of a portfolio.
A Reality Check
Following the guidelines outlined above, we believe it is possible to address the key concerns of investors by building portfolios based on solid fundamentals, with effective diversification, enhanced return potential and some protection from tail risks. Simulating a portfolio built on a number of strategies driven by different risk factors, we observe an improvement in the risk adjusted return of the sample portfolio (measured by the Sharpe ratio), as the strategies are progressively added to the core traditional asset allocation.
We believe that a well-designed, multi-strategy investment approach can be instrumental in providing efficient investment solutions to clients.
For us, this means that it is possible to build more robust and diversified portfolios, using low correlated strategies. In the effort to achieve this, it is important to focus on research to understand the main macro themes, and on portfolio management skill to identify the most compelling investment ideas that may add return, while attempting to keep risk at reasonable levels.
In conclusion we believe that in this new world, it’s time to “diversify, different”. “Diversify, different” means, to us, moving from asset class diversification approach to a focus on risk factors that fundamentally drive different asset class returns and risk – and identifying, measuring and combining them in an effective way.
It also means not only maximizing the sources of beta diversification and managing them in a dynamic way, but also promoting a culture of alpha generation that tries to exploit all possible alpha sources to enhance returns in a risk conscious framework. Moreover, the concept of risk management takes on a new connotation in this new world, based less on assessing ex-post risks and more on taking a structured approach to building ex-ante a risk-effective portfolio that seeks to protect against extreme events.
We believe that a well designed, multi-strategy investment approach can be instrumental in the years to come in managing the new complexity in a way that provides efficient investment solutions to clients.
1 Alpha — Measures risk-adjusted performance, representing excess return relative to the return of the benchmark. Beta — A statistical measurement of an investment’s sensitivity to market movements in relation to an index. A beta of 1 indicates that the security’s price will move with the market. Betas of less than 1 or greater than 1 indicate that the security will be less volatile or more volatile than the market, respectively.
2The Rise of Liquid Alternatives & the Changing Dynamics of Alternative Product Manufacturing and Distribution Citi Prima Finance, May 2013