Portfolio construction in the real world

Portfolio construction has largely been built on the strong foundation of academic and technical research. There is a tension, however, between the theoretical world and the real world that financial advisers are often required to manage with their clients.
 

These tensions are often between long-term investment objectives and the short-term vagaries of the market, along with the balance between providing various levels of capital preservation and the delivery of sufficient returns to meet investor needs. Traditional portfolio construction can be enhanced to better address these issues.  

The starting point of any outcome-oriented approach to investment is a definition of the end goal and this is typically expressed as an investment return above cash or inflation. In addition, it is important to determine the acceptable trade-off between risk and return that will be appropriate in the pursuit of the investment objective.

The next stage is to track this target in an effective risk-controlled manner and by doing so, aiming to increase the probability of hitting the target and reduce vulnerability to market timing issues, keeping in mind that an investor’s experience is affected by their entry and exit points. We employ some core principles to try and achieve this, which have a common-sense appeal and have been used to some degree by investment managers for decades.

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Our approach to each, however, is subtly different to standard industry practice and the way we blend them together is, in our view, the key to delivering a more attractive return profile.

Diversification is rightly seen as one of the few ‘free lunches’ in the investment world. On its own, it won’t stop negative returns – but it may assist in reducing their probability. From an asset allocation perspective, diversification is normally associated with investing across a range of asset classes. However, there can be so many more dimensions to diversification as it can involve combining different sources of returns – some passive, some active.

Active management has traditionally been thought of as ‘stock picking’ in equity or bond portfolios. Again, it can be more – through smart implementation you can benefit if the investment manager’s views are correct, but it can also potentially add value should some unforeseen events unfold.

Importantly, this approach involves blending the active management of directional risk (market risk) across a range of assets, in conjunction with less directional strategies which aim to deliver returns that are not reliant on broad market movements. By combining these two sources of returns, a broader range of risk premia can be accessed, enabling a degree of diversification beyond what traditional strategies typically offer.

Of course diversification is not just about risk reduction. The broader opportunity set has the potential for return generation in a range of different market conditions.

Moreover, there is a fundamental rationale for utilising both directional and less directional sources of return. It is often the case that environments that are most challenging to managing directional risk (during bouts of market volatility) present the greatest opportunities to take advantage of less directional strategies.

Conventional approaches to asset allocation rely on a long-run assessment of return expectations, risk, and asset correlation to drive a strategic asset allocation (SAA) approach and, whilst a simple and logical solution, may be vulnerable to variability in these inputs. We advocate a more dynamic and flexible approach that places more emphasis on active asset allocation.

Adopting such an approach requires two things: firstly, utilising a sound knowledge of the factors driving asset class performance. Understanding the environments which are conducive for positive asset class performance or those associated with poor or negative asset class performance is a more achievable objective than forecasting the inputs with the degree of accuracy required by a SAA approach.

Secondly, a strategy that does not have the benchmark weightings that accompany a SAA approach needs an alternative approach to determining asset class weightings. Our bias towards asset classes is driven by a fundamental understanding of how they are influenced by macroeconomic factors, valuations and proprietary indicators of market positioning to form a view on their likely performance.

But how much exposure you can afford to have is guided in part by risk considerations. This is where dynamic asset allocation and downside risk management dovetail together. 

Within a multi-asset framework, risk management can take several forms. First, the overall portfolio needs to be diversified – not only in terms of investment holdings, but also in terms of contribution to risk.

Second, different types of investment require specific risk management approaches. For directional assets like equities where large negative drawdowns are possible, we employ a dynamic risk management strategy specifically designed to seek to control drawdown. This provides a guide of how much exposure you can afford to hold which you cross-check against your fundamental views.

This, in our view, represents a more effective form of downside risk management than traditional approaches which tend to rely on hedging strategies or some form of ‘put’ protection. These traditional approaches can assist in managing downside risk but tend to be expensive; i.e. they act as a drag on returns.

For less directional investments, alternative approaches to risk management are more appropriate – where for example the expected distribution of return is less susceptible to large drawdowns or when a strategy involves non-linear pay-off profiles. 

Risk management should not be an afterthought. Rather, it should be a central part of portfolio construction in anticipation of a strategy well-equipped to deliver a smoother return path or a better distribution of returns. 

Diversification through a broader range of return sources, the dynamic management of their allocation in a portfolio, and down-side risk management specific to each exposure, provide a portfolio better suited to the real world.  

Rob Thompson is head of adviser distribution at Insight Investment.