You can’t predict the future — but investors can work to better understand the risks that are on the horizon. And they can position portfolios accordingly, says Peter Fitzgerald, CFA and global head of multi-assets with Aviva Investors, adding that we saw a stark reminder of this with the outcome of the U.K. referendum, which took many by surprise.
“Models didn’t predict a U.K. exit from the European Union,” Fitzgerald explains. “But a portfolio manager that didn’t plan for it wasn’t doing their job.”
Fitzgerald parses the different definitions of risk — relative versus absolute. “There are two different approaches to risk,” he explains, noting that relative risk involves tracking error, information ratios and beta. On the other side, absolute risk encompasses annual volatility, the Sharpe ratio and alpha.
That’s the technical approach — but what really matters is how the industry defines it and how their clients view it. While portfolio managers might adhere to specific terms and metrics, clients only want to know three things — “How much money can I make? What’s my expected return? And how much could I lose?”
BEYOND 60/40
And, at the end of the day, a traditional balanced portfolio of 60% bonds and 40% equities isn’t going to cut it, he says. Take equities, for example: “Over the long-term they deliver a decent return,” he explains. “However there are long periods when you cannot rely on this asset class to generate all the growth in your portfolio. And there are periods when you will lose a significant amount.” At the same time, fixed income isn’t going to provide much needed growth or the protection required to cushion the blow during times of market stress.
A better approach to balancing the need for risk management and growth is in portfolio construction itself — and that’s where a multi-asset, multi-strategy approach really works.
Instead of focusing on typical asset classes, it allows investors to focus on what each strategy or holding does in a portfolio. Growth assets, for example, become a category for selecting from equities, high yield or emerging markets debt.
A defensive bucket, on the other hand, is a decision point for sovereign, investment grade or corporate bonds.
Absolute return strategies and property work as uncorrelated assets. Looking at portfolio construction in this way allows investors to see how assets work together and how they serve (or do not serve) your goals. Hedging in a multi-asset, multi-strategy context becomes unnecessary — “The idea is to come up with investment ideas that will add returns when things go wrong in other areas,” explains Fitzgerald.
Stress testing is a huge part of the process, he says. “You must stress test to see how robust the portfolio is in the face of historical events — but you must also test against hypothetical events, like a Brexit.”
From there it’s much easier to add up where the risks are — and find the right balance.