By Toby Hayes
In the wake of the financial crisis, investors and advisers have sought alternatives to classic portfolio construction – solutions that help them achieve their outcomes rather than tracking an index. In many portfolios developed before 2008 – which incorporated an array of asset classes – the investments were found to be moving in concert. New asset classes have since emerged – particularly in the alternatives space – to help shore up portfolio diversification and long-term stability. However, instead of simply adding new diversifiers to traditional asset allocation, a more fundamental question needs to be answered. Why did traditional portfolio allocation fail in the first case?
The answer comes from a better understanding of the composition of asset classes and, specifically, the risk factors embedded in each. For instance, in a typical bond fund, there are a number of distinct risk factors: interest rate risk, credit risk and yield curve risk. In normal markets, interest rate risk tends to dominate the bond fund return, providing useful diversification from small equity-market moves. Yet in stressed markets, credit risk can dominate. As with equities, the credit component of a bond is linked to the earnings power of the company, and when that is questioned, corporate bonds can follow equities lower. Rather than mitigating volatility, the credit risk embedded in many fixed income portfolios pushed correlations with equities higher, and instead of dampening the downturn, the traditional asset classes simply reinforced each other.
So, in more extreme market conditions – when arguably they are needed most, non-correlated assets have failed to generate the intended cushion.
The question is, can these risk factors be isolated and managed out of the portfolio when desired? A number of new financial instruments have been created to do just this. These so-called “alpha-generating strategies” are actually no such thing. Instead, they cherry-pick specific factors inherently embedded in an asset class, and isolate that factor to deliver the desired effect on performance. These exposures, also known as systemic or alternative beta, often involve handsome charges.
A carefully considered multi-asset strategy can give investors access to the potential of systemic beta within a traditional open-ended investment company (OEIC) at a fraction of the cost of most hedge fund vehicles.
The starting point is the development of broad macroeconomic, forward-looking themes which ultimately drive portfolio construction based on diversifying risk factors, not asset classes. Using risk factors rather than asset classes is the most precise means to gain exposure to macro themes. That means segregating and isolating individual risk factors within asset classes and finding ways to invest (or de-invest) in them separately.
As a practical example, take the potential slowing of the Chinese economy. A traditional portfolio approach might be to underweight an emerging markets allocation as many of these markets trade heavily with China. But such an approach muddles the risk that a slowing China has on these economies with the benefits some of those markets are receiving from local interest rate cuts and a lower oil price.
Alternatively, we can look at more specific components of the market that we believe will be more directly impacted by the slowdown in China. Latin America is a heavy commodity producing region with strong trade links with China. Countries such as Brazil have seen a rapid deterioration of their economic prospects due to this slow down and yet are forced to raise rates to fight inflation and protect their currency as their terms of trade deteriorate and yet Australia, also heavily linked to China via iron exports, has entered a rates cutting cycle as deflationary forces push bond yields lower. Given the same macro shock, both countries have responded in different ways, affecting their currencies, bond and equity markets and opening up the opportunity to the macro investor to cherry pick components of these asset classes that most efficiently capture the theme. The resulting portfolio can provide a better diversification profile versus a traditional bond/equity mix, and in my view is better equipped to deliver intended investment goals.
Toby Hayes is a multi-asset fund manager at Franklin Templeton
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