A New Approach to Multi-Asset Investing

SPONSORED BY : Pioneer Investments

By Pioneer Investments

Added 18th October 2016

In today’s low yield environment, traditional approaches to asset allocation may fail to provide adequate returns and may not protect investor portfolios in critical phases. The need to build more genuinely diversified portfolios is essential to enhance returns and protect against excessive drawdowns. In essence, a new approach to multi-asset investing is needed.

A New Approach to Multi-Asset Investing

Matteo Germano, global head of multi-asset Investments at Pioneer Investments

To us, this means moving from traditional asset class diversification to a focus on risk. We call this approach “Diversify, different’’ - identifying the risk factors that fundamentally drive asset classes returns, and measuring and combining them in an effective way.

It also means not only maximising 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.

It also means not only maximising 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.

INVESTORS ARE FACING NEW CHALLENGES

During the 80s and 90s, investors enjoyed mostly benign market conditions, and asset allocation was a relatively simple task. Events played out differently as the 2008 global financial crisis erupted, with liquidity and volatility issues emerging.

In the aftermath of the financial crisis, largely expansive monetary policies and unprecedented quantitative easing experiments created a very different investment environment, characterised by low nominal rates and negative real rates.

By looking at the past, we see that phases of financial market turmoil have proven challenging for traditional asset allocation portfolios. 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.

This, in our view, calls for an urgent change of direction from traditional asset allocation, to one that focusses deliberately on allocating the different sources of risk, instead of a simple allocation to different asset classes.

ALLOCATING RISK

In order to build a more robust portfolio, we believe it is important to identify the key factors underpinning portfolio risk, and to ensure that the portfolio is effectively diversified among these factors. Each asset class is exposed to different risk factors. The sensitivity of the asset classes to risk factors and the risk factors themselves change over time and under different circumstances, so it is important to adopt a dynamic approach, relying in part on macro research, in order to interpret the complexity of the system.

Once the major risk factors have been identified, we believe it is important to construct portfolios that are well diversified among these risks, and to continuously monitor overall risk exposure.

In doing so, we believe it’s important to analyse which risk factors most impact the overall portfolio and which dynamics could influence these risk factors going forward. This analysis requires a clear picture of the macroeconomic scenario and financial market conditions.

We have identified three main factors that we expect will drive risk dynamics over the next several years: low inflation, a stronger US Dollar and Federal Reserve interest rate policy.

ALPHA AND BETA WORKING TOGETHER

The second element of the ‘Diversify, different’ approach is the focus on both the alpha and beta components of returns, with the aim of enhancing returns in a low yield environment. On the beta side, this means to utilise opportunistically 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. We combine this with another key element, the behavioural aspect of investing. 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. 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.

DON’T UNDERESTIMATE TAIL RISKS

Finally, recent crises have taught investors the importance of protecting portfolios from extreme ‘tail risks’, as 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
  • Analyse the possible impact on the portfolio of the tail events (stress test)
  • Identify possible hedges to protect from tail risks

To manage extreme events, it is important to analyse the alternative scenarios that could drive significant portfolio losses and identify their probability of occurring. A stress test analysis can then 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 assessment 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.

A REALITY CHECK

After many years of bull markets, investors will likely have to deal with a more volatile world, making the need for protection and capital preservation even more urgent.

“Diversifying, different” aims to build more robust and diversified portfolios, using low correlated strategies. In the effort to achieve this, it is important to understand the main macro themes and, using portfolio management skill, identify the most compelling investment ideas, while attempting to keep risk at reasonable levels.

The Multi-Asset team has evolved its approach to seek to enhance diversified alpha generation, diligently identify potential risks, and address alternative scenarios with hedging strategies. We have worked extensively along these guidelines and designed a multi-asset investment process that searches for effective diversification both in the alpha and beta fields. We believe defining a clear world view while hedging the principal risks, and seeking to maximise alpha opportunities from relative value, are at the forefront of the process and can help clients navigate today’s market challenges.

In our opinion, a well-designed, multi-strategy investment approach will be instrumental in the years to come in managing the new complexity in a way that provides efficient investment solutions to clients. In short, we believe it’s time to Diversify, Different.

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