Lombard Odier All Roads fund

While institutional investing is all about the long-term, markets are not averse to the odd lost decade as equities proved in the 2000s. With that in mind, investors are increasingly seeking funds able to produce returns irrespective of the backdrop and that is exactly the thinking behind Lombard Odier’s All Roads offering.

“Even the best asset allocators can only be right slightly more than half the time, which means their portfolios are always catching up in performance terms from the half the time when they are wrong.”

Jean Louis Nakamura

As the name suggests, the vehicle aims to achieve its cash plus 5% target over an economic cycle return however the market is behaving – with the concept of risk parity central to this goal. Run by the company’s solutions group, All Roads launched in 2012 but Lombard Odier has employed a similar strategy on its own employee pension fund since 2009, where keeping shortfalls to a minimum is paramount. Explaining the concept behind risk parity, deputy CIO at the group Jean Louis Nakamura says the traditional asset allocation approach is deeply flawed and often poorly diversified in terms of risk. “Capital allocation is typically based on assumed returns from asset classes and therefore struggles as soon as they fail to meet those expectations,” he adds. “While institutional investing is supposed to be long-term, the reality is that if a fund starts struggling badly, it will face problems in terms of its governance and criticism from stakeholders and the media. This often pressurises managers to change long-term strategies and often go into or out of asset classes at exactly the wrong time.”Traditional portfolios also rely heavily on the performance of a single asset class, usually equities, despite being ‘diversified’ on the surface. Work from JP Morgan has identified the average portfolio allocation for a US pension fund, with 52% in equities, 28% in bonds, 5% in real estate via Reits and the remaining 14% in alternatives. This initially looks like a diversified portfolios, across asset classes, geographies and market caps, but in reality, equity risk is responsible for 90% of the return outcomes. “Such portfolios are highly sensitive to equity market fluctuations and therefore tends to be biased towards growth phases of the economic cycle,” adds Nakamura. In contrast, the approach on All Roads is to offer genuine diversification by equalising the risk contribution from each asset class, basically allocating risk as opposed to capital. According to Nakamura, the strategy centres on collecting risk premia – essentially the return above the risk-free rate for committing capital to an asset class – more efficiently. “The approach does not rely on expected returns, removing the guesswork of traditional asset allocation and making the portfolio more robust in various market environments,” he adds. “Even the best asset allocators can only be right slightly more than half the time, which means their portfolios are always catching up in performance terms from the half the time when they are wrong. Focusing on risk premia and equalising the contribution should mean higher risk-adjusted returns in the long run but will also smooth out volatility and offer a steadier return profile.” To achieve this, the team has an equal risk allocation across five key asset classes, namely developed and emerging equities, sovereign and corporate bonds and commodities.Three phasesCo-portfolio manager Olivier Blin says the team splits the economic cycle into three major phases, namely slowdown/recession, growth/expansion and inflation shock, with different assets outperforming at different stages. “All assets contribute positively in the long run but developed and emerging equities plus commodities do best during growth periods, sovereign and corporate bonds amid recession and commodities against inflationary phases,’ he adds. “While traditional portfolios are less protected in downturns and against inflation, a properly balanced risk parity includes assets that perform well in these different phases and hedge against the risks inherent in an evolving economic cycle.” Although the risk contribution level is set at around 20% for each asset class, Blin is keen to stress the fund is not a ‘prisoner of the model’ and the team rebalances its allocations on an ongoing basis according to market volatility. “We try to keep turnover fairly low but have made some very dynamic capital allocation calls over the years depending on market conditions, shifting heavily into sovereign debt at the height of the crisis much quicker than a traditional fund could for example,” he says. At present, sovereign bonds remain the highest capital allocation at just over 40% – although the position is slightly underweight in risk terms at 18%. Other weightings are 22% in credit and 9.6% in developed equities, both punching slightly above their risk weight at 21% each, with 5.8% in emerging equities and just over 10% in commodities.Leverage and drawdownWhile risk parity is at the core of the strategy, this tactical asset allocation is also integral to performance, as are additional elements of leverage and drawdown management. Taking leverage first, the team uses this to boost market exposure at certain points in the cycle, looking to enhance returns without skewing the risk allocation. Drawdown management on the other hand aims to limit excessive losses, locking in profits at the height of performance. Blin says that while the team cannot guarantee never to lose money, they have set a target maximum drawdown of 10% over a year, with 2008 the closest they came to that level. “To ensure smoother returns, we can adjust the risk budget on the portfolio to avoid drawdowns beyond that 10% level,” he adds. “We can deleverage down to a third of our risk budget, drastically reducing risk but still maintaining some market exposure. We took a large cash position in 2008 for example as well as in May and June of this year when all asset classes were falling together after the Fed’s tapering announcement.” Nakamura admits the extraordinary monetary policy of recent years has distorted the relationship between asset classes, which is a less favourable scenario for a risk parity offering. “We have still performed as well if not better than more traditional asset allocation funds in this environment, with our drawdown management helping to limit short-term losses, and we feel correlations between asset classes will return to historical levels as monetary policy normalises,” he adds.