By Thomas Nehring
DGFs have experienced a surge in popularity in the UK over the past few years and have fast become the most sought after new investment mandates.
To keep pace with this growth in demand, multi-asset providers are keen to innovate and differentiate themselves. The range of multi-asset strategies available to investors is therefore increasing – but the goals of these multi-asset solutions are typically the same, with these strategies attempting to meet the generic investor needs: attractive returns, good downside protection, and diversification.
The investment approaches employed to achieve these targets vary widely. Each investment philosophy is different and can include a broad range of financial assets. This is where investors need to be highly vigilant.
One common challenge for DGFs today is to ensure robust diversification for investors, thus providing good downside protection of capital during volatile market periods – such as what we have witnessed this summer.
Many DGFs seek to achieve returns by simply investing broadly into asset classes such as equities, fixed income, and alternatives such as property, infrastructure, private equity etc. The premise behind such an approach is that returns will be generated through Strategic Asset Allocation decisions and risk will be managed by the diversification between these asset classes. But history has taught us that in a time of crisis; both returns and the diversification benefits evaporate – leading to potentially significant losses.
That is exactly what happened during the taper tantrum of 2012, when correlation between Global Equities (represented as MSCI ACWI) vs. Global Bonds (represented by Barclays Global Aggregate Total Return Index) reached the elevated levels of 0.37, severely impacting what were supposed to be well diversified portfolios.
Not only have correlations between Global Equities and Global Bonds increased in recent years, other asset classes that were regarded as diversifying are moving in greater lockstep. Investors need to explore new ways to diversify their portfolios.
Again, what matters in terms of risk reduction is the degree of correlation between the particular assets – and not necessarily the number of different assets. Many DGFs have learnt this the hard way.
This is why we took a decision almost 10 years ago to shift our investment focus away from asset class investing – such as top down or directional/beta investments – to focus on risk/return drivers, or risk premia. One of the primary reasons for this important distinction is that most asset classes include several risk/return drivers exhibiting significantly different characteristics over time, and by separating these we are able to run a much more robust correlation analysis.
For example, by splitting the risk-adjusted return characteristics of investment grade bonds into sub-components – duration and credit spreads – it is possible to see the potential diversification benefits due to the fundamentally different individual return drivers that may have missed otherwise.
By focusing on carefully selected risk/return drivers that complement each other in recessionary and recovery periods, an investment strategy does not necessarily need to make the correct macroeconomic call in order to achieve a positive total return over time and in different periods of the economic cycles.
We believe the old fashioned and simple approach to balanced fund portfolio construction is fundamentally flawed. Investors now require a process where risk contributions are allocated to the underlying return drivers, resulting in a better chance of weathering any kind of market environment.
As volatility returns to markets, as we have witnessed in recent months, it is vital for investors look under the bonnet of the varied strategies on offer in the deepening DGF universe to ensure a solution truly offers diversification and can meet requirements through the cycle.
Thomas Nehring is head of institutional & wholesale distribution UK & US at Nordea Asset Management
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