Easier said than done
Often the solution to a problem is as complex as the problem itself. And a lot of things are easier said than done.
These are the implicit acknowledgements of our special report on portfolio construction this month. Pension funds have taken huge strides to make portfolios more robust by recognising the risks - especially the extreme-loss risks - to which they are exposed. Part of that process is seeing that balancing allocations to asset classes rather than to risk factors - and failing to tilt these weights in accordance to the economic cycle - exposes them to nasty correlation surprises; part of it is improving understanding of managed futures, options and other ‘long-volatlity’ strategies that they once regarded with suspicion but now recognise as potential hedges against extreme-loss risk. Some of our commentators take us further: if extreme-loss metrics are so useful for preparing us against ‘tail events’, asks Boryana Racheva-Iotova of FinAnalytica, why not test out how useful they can be as inputs into day-to-day portfolio optimisation, alongside the usual variance input? Very useful, it turns out.
But each advance raises its own set of questions. Writers from MSCI Barra, itself a pioneer in the area of factor risk, applaud investors’ attempts to think in those terms rather than in terms of ‘equities, bonds and alternatives’, but point to work that still needs to be done to schematise all those idiosyncratic factor risks into manageable but coherent portfolio ‘groupings’. Investors who would emulate the excellent work on equity option overlays done by the likes of Cardano with PNO Media or the Rabobank Pension Fund will also have to accept that such innovative solutions take us far away from the safe world of strategic asset allocation and quarterly rebalancing. We conclude (as Cardano’s work also suggests) that the best way forward is to bring these portfolio construction and rebalancing issues into a solvency management framework.
But even that is easier said than done. Not to mention cheaper! Few things were ever improved without it first adding to cost. As State Street’s Will Kinlaw and Jay Moore explain, once you introduce illiquid instruments and complex payoffs into your portfolio, cost-effectiveness and risk-optimisation is not about rebalancing regularly or often, but rebalancing well, across the right instruments at the right time.
These are difficult questions. But take heart: if we’re asking them, we must have already answered some of the easy ones.