Aurèle Storno explains how a risk-allocation approach can serve to protect multi-asset portfolios from the effects of rising bond yields
Today's environment is tougher than ever for bond investors. Interest rates are low, risk is high and the process of buying and selling bonds has become harder and more costly given major changes in the market. As a result, bonds are no longer fit for purpose when it comes to a number of investors' key aims - protecting capital and gaining diversification against stocks.
We believe a well-thought-out multi-asset strategy is better suited than bonds to deliver the capital preservation and diversification that investors need, making multi-asset a suitable replacement for a portion of investors' bond portfolios.
So what do we mean by ‘well-thought-out'? For us, a multi-asset strategy should make highly liquid investments; be truly diversified across asset classes; have a strong focus on downside protection; and be built according to desired risk exposures rather than crude capital targets.
This last point - a risk-based allocation approach - may surprise some investors. A common criticism of multi-asset portfolio allocation according to risk targets is that it tends to allocate a lot of capital to fixed income and is, therefore, ill-suited to an environment of rising interest rates.
The big advantage of allocating risk rather than capital, however, is it results in portfolios whose risk and return metrics are more robust over time by achieving a better balance of exposure across the key drivers of risk and return.
Many investors are now aware that, for a traditional portfolio that allocates 60% of capital to bonds and 40% to equities, 90% of the portfolio's risk comes entirely from the equities portion.
That has, however, led many to adopt a rather simplistic ‘risk parity' approach, which tries to equalise risk contributions based on the long-run historical volatility of each asset class, before scaling up the overall portfolio risk exposure to achieve the desired expected return. This can indeed leave investors with a higher sensitivity to changes in interest rates than they might like when rates start to rise.
We believe there is a more sophisticated way to do risk allocation that not only preserves the advantages of balancing risks for stable returns, but can help position investors favourably for rising yields. This approach deploys some or all of the following three elements.
Be smart about dividing up risk
Do not assume each asset class should contribute equal risk. Instead, consider which risk allocation has worked well through the full range of economic cycles, from recession through expansion and inflation.
Take account of the dynamic and diverse nature of risk
Do not ‘set and forget' risk allocation, or base it solely on long-run volatilities. There is more to risk than just volatility of returns.
If the objective is a better balance of risks, it is important to try to achieve a balance between them all, including the valuation risks (the risk that an asset is over or undervalued by the market) and extreme-scenario risks attached to assets, for example. And of course, as the relationships between these risks change over time, portfolios must adapt to maintain genuinely stable levels of risk allocation.
Have a flexible attitude towards risk
Do not ‘set and forget' overall portfolio risk level either. When global market risk is high, the same expected return can be achieved with lower overall risk. Also, there are points in every cycle when confidence in your model for allocating risk will be high, and points when it will be not so high.
When confidence is not so high, it can make sense to reduce overall portfolio risk. This can be done on a discretionary basis but, as the risk-allocation approach is itself an expression of humility about our ability to forecast the future, we feel there is a very strong case for maintaining a purely systematic approach - for example, by reducing overall risk exposure in response to a persistent drawdown.
These three elements are among those that inform our risk-allocation process for multi-asset strategies. The cumulative impact through 2016 has been eye-catching. Our capital allocation to sovereign bonds has been cut by almost one-quarter, while capital allocation to developed market equities has increased by almost 50%. At the same time, our overall portfolio risk exposure has increased by 11%.
Put it all together and, while our fixed income exposure marginally reduced through 2016, total equity exposure increased by 60% - and the portfolio's effective duration more than halved, meaning the strategy has become much less sensitive to moves in interest rates.
Far from delivering excessive exposure to rising bond yields, a risk-allocation approach enhanced in the ways we suggest has positioned itself to meet the challenge head-on.
Aurèle Storno is head of multi-asset allocation and the lead portfolio manager of the All Roads Multi-Asset strategy at Lombard Odier Investment Managers
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