Protection strategies are an important source of risk-adjusted return for multi asset portfolios. Like mountain biking, the end result is a function of the conditions you need to manage en route to the finish line.
Mountain biking is a thrilling, but risky sport. It takes in steep climbs and more perilous descents, generally taken at speed while negotiating various obstacles along the way. Yet a growing number of people overlook or even embrace these risks to participate in the sport. Clearly it is not the prospect of bodily damage that pulls them in, but rather the lifestyle aspects, the competitive nature of the races and the sheer thrill of participation.
One can draw many parallels with managing multi asset portfolios. It requires a clear focus on managing risk. Riders ensure that they have a good understanding of what lies ahead of them, to the extent of walking tracks where practical to assess how best to approach it. Even trails which are well known require continuous evaluation and reassessment. Nothing can be taken for granted if you are to limit the chance of any nasty surprises.
The right equipment is important. Bikes have heavy treads designed to provide more grip; over-sized brakes to provide more efficient braking in wet or muddy conditions; and front and rear suspension that allows the bike to adjust and absorb uneven ground.
Like mountain biking, investing is about positioning yourself and adapting for the terrain in front, knowing you have protected yourself as best you can. It is not all about how talented or skilful you may be, it is as much about being prepared in case something goes wrong. No one layer of protection can save you, but all of them working together can make a significant difference to the condition in which you finish the race.
It is about preparing for the unexpected, with a ‘just in case’ mindset.
Similarly, our active investment approach, in adding various layers of protection to our multi asset portfolios, aims to provide a level of comfort that is designed to result in bumps and bruises rather than something far more serious. Risk management is a necessity, not a luxury. For that reason, managers of our multi asset portfolios are as much risk managers as they are portfolio managers.
Following the traumatic events of 2008, risk and its management have become the most visible subjects for asset owners. The global financial crisis of 2007-08 was remarkably severe, not only in the magnitude of drawdowns suffered by individual asset classes, but also the drawdowns experienced by portfolios thought to be well diversified. As part of the management of risk, hedging has taken centre stage.
Protecting portfolios involves a multi-layered approach. A multi asset manager’s first line of defence is asset allocation, then diversification, and once efficient, various levels of protection may be added.
The conventional manner of protecting portfolios is the use of “traditional” asset allocation techniques, and to complement it with hedges in a variety of markets.
As multi asset managers, our methodology for applying protection in our portfolios is three-fold:
simply reduce the risk in asset allocation (an extreme measure would be to move to an all cash portfolio);
create diversification via instruments negatively correlated to existing portfolio positions (it is not always easy to find true diversifiers);
complement dynamic asset allocation with several protection techniques (both direct and indirect across all asset classes).
The investment manager’s first tool to curb tail risk is typically to diversify among asset classes with low correlation. However, simply diversifying global equity with fixed income, for example, does not always do enough to limit downside risk. A portfolio with a traditional 60% equity, 40% fixed income allocation may derive over 90% of the entire portfolio risk from the equity component alone.
A further limitation to the diversification approach is that asset class return correlations tend to rise in times of crisis, which underscores the challenges when using diversification as your only protection tool. Finding truly uncorrelated asset returns is difficult, and many non-equity asset classes are positively correlated to equities. Furthermore, correlations rise just when they are needed most and your multi asset portfolio could end up behaving like a single asset.
Typically, it is only when markets experience large losses that hedging comes back into fashion, leading to a surge in demand for derivative strategies that drives up volatilities across all asset classes. This, in turn, can reduce the overall effectiveness of protection techniques, emphasising again that proactive consideration and allocation to risk strategies needs to occur on an ongoing basis.
The goal of protection techniques should be to support the portfolio when asset prices fall or rise unexpectedly and should not compromise or undermine the goals of the portfolio. Behavioural economics suggests that investors will overweight the probability of rare events, for example equities falling an extreme 30% in one month, and underweight the probability of more likely or common events such as equities falling 5% or 10% in any given year. Bearing this in mind, multi asset portfolios need to consider forms of ‘just in case’ protection to help enhance risk adjusted returns.
Traditional diversification strategies may help weather a normal bear market, but protection for risk management purposes could help prepare for other situations; not just to mitigate their effects but ultimately to benefit from them.
Not only can protection mitigate losses in a significant downturn, but appreciating value in the protection portfolio has the potential to provide greater liquidity in the portfolio that may allow the portfolio manager to be a buyer when others are forced sellers.
Hedging strategies further add value by allowing for a more aggressive portfolio, tilted towards more attractive risks, since steps have been taken to help cushion the downside exposure.
Even though the ‘crisis’ is now over five years old, memories of risk-management mistakes are fresh in investors’ minds. Quiet markets, low volatility and a lack of visible risks on the horizon can lead to complacency and increasingly overweight positions in riskier assets. In doing so, these conditions could set the stage for the next cycle of deleveraging and potential losses in portfolios. With market volatility currently at historically low levels, this is a key area of focus within our investment process.
Multi Asset Solutions Specialist, Ashburton Investments