Diversified growth: a health warning
The challenge of understanding complex multi-asset strategies in line with fiduciary duty means other alternatives may be more suitable for investors, finds Nathan Gelber
Multi-asset or diversified growth strategies have become increasingly popular with both institutional and retail investors. While we acknowledge that these strategies, in theory, appear to offer appealing risk and return characteristics, they are subject to a range of serious weaknesses. They purport to provide investors with a single portfolio solution that aims to generate absolute positive returns by investing in a range of asset classes while mitigating material drawdown risk through perceived diversification and adroit market timing between asset classes.
Such aspirations, however, are susceptible to a wide range of challenges that can seriously undermine the ultimate achievement of the stated investment objective and even adversely impact the volatility profile. While we embrace the concept that strategic asset allocation is critically important to manage risk and target returns over longer time horizons, we remain sceptical about more tactically driven asset allocation approaches that are largely dependent on correctly predicting short-term outcomes combined with an ingrained reliance on the persistence of past return correlations of different asset classes. When assessing multi-asset strategies, the following issues merit serious consideration.
Macro and market timing
Propositions with a broad investment remit are typically predicated on the notion that asset classes offer expected returns that are not perfectly correlated and that can be forecast by taking a view on a wide range of future outcomes such as macro-economic growth, interest rate movements and direction, equity and bond market volatility and other top-down macro factors.
There is considerable evidence that foretelling these outcomes correctly is inherently difficult, if not impossible, with a reliable rate of consistency over time. While a minority of multi-asset strategies may employ a bottom-up and value-focused philosophy, many others rely on market timing-driven approaches to alter portfolio positioning in an attempt to exploit expected asset price movements. Academic research has conclusively evidenced the fallibility of such endeavours and the difficulty of correctly anticipating the short-term behaviour of asset prices, given that they are impacted by a multitude of imponderables, including fear and greed.
“Each year the prediction industry showers us with $200bn in (mostly erroneous) information. The forecasting track records for all types of experts are universally poor….”1
The fact that on-going success is characteristically highly uncertain means it is impossible for investors to make a reliable determination between skill and luck. There are many instances where favourable track records are rapidly tarnished by missing key inflection points in asset price movements.
While periods of mark-to-market drawdowns associated with bottom-up and value-led propositions can potentially be recouped by exercising patience for valuation related fundamentals to reassert themselves, losses associated with market timing strategies are frequently realised and capital impairment crystallised if price behaviour turns contrary to expectations. Furthermore, this can precipitate whipsaw behaviour, where an incorrectly positioned manager attempts to ‘chase’ the market in a vain attempt to claw back investment returns.
Correlation and diversification
While market timing represents an important tool in many multi-asset strategies, another central belief that attempts to insulate portfolios against unexpected drawdowns is a stable historic relationship for statistical correlations among asset classes and risk factors. However, the crucial underlying problem is that there is no guarantee that past relationships will continue in the future. A recent example of this was when the US Federal Reserve publicly discussed tapering its quantitative easing programme, leading to a sell-off in both Treasuries and equities – two asset classes, which had been negatively correlated for a prolonged period, suddenly moved in concert with the effect of invalidating the presumed diversification benefits. The more recent environment has proved particularly challenging for multi-asset strategies with embedded ‘risk parity’ approaches, where each component is expected to make an equal contribution to expected volatility. These propositions are heavily reliant on historical correlations and volatilities persisting; yet such reliance can too easily end up being the Achilles heel for many of these asset allocation orientated strategies.
“For long-term investors, we believe that attractive rates of return should be attainable without the need for leverage, thereby avoiding the potential for adverse outcomes in such strategies or for purposes of prudence avoiding counterparty risk often associated with derivatives”
This frequently constitutes an implicit feature of multi-asset strategies and is typically achieved through borrowing against portfolio assets, the use of derivatives or a combination of the two. In such instances, the headline accounting leverage frequently becomes a secondary consideration as the focus is typically on statistically defined ‘risk factor’ exposures of the portfolio. However, this focus can only be justified if asset class or risk factor behaviour remains consistent with expectations – for example, if leverage is employed to dampen predicted volatility across two assets with an offsetting risk profile and that relationship breaks down, it will invariably amplify rather than nullify the risks within the portfolio.
In a low-interest-rate environment, leverage is frequently applied in an attempt to generate enhanced rates of return. However, even at muted levels, leverage can leave the portfolio vulnerable in turbulent market conditions, especially if interest rates climb or yield curves shift unexpectedly. UCITS funds that extensively use derivatives usually adopt the value-at-risk (VaR) regulatory approach to risk management, choosing absolute VaR limits with a broad one-month maximum VaR of up to 20% of net asset value. As there is no explicit limitation on gross exposure, multi-asset strategies therefore have the regulatory freedom to employ significant leverage, often in the range of seven to 12 times of the portfolio’s capital.
For long-term investors, we believe that attractive rates of return should be attainable without the need for leverage, thereby avoiding the potential for adverse outcomes in such strategies or for purposes of prudence avoiding counterparty risk often associated with derivatives. It would be remiss not to highlight some of the disastrous consequences that have been largely attributable to leverage. To be clear, leverage cannot improve an investment decision; it can merely accentuate its impact in either direction and dramatically foreshorten a manager’s intended time horizon for a position where severe asset/liability mismatches develop. Equity market turbulence or rising interest rates can also lead to predicaments where the ability to roll existing positions is compromised or margin requirements become burdensome. Unlevered strategies, on the other hand, allow an investor to adopt a more patient approach to wait for investment decisions to come to fruition over time.
The ability to observe and understand these often highly complex investment processes can be obscured by managers’ unwillingness to provide unadulterated disclosure. From experience we have also learned that it is virtually impossible for outsiders to assess the frictional costs embedded in such portfolios so one is unable to gauge the added value that is actually required to meet the stated investment objective over time, net of all costs and expenses.
Furthermore, many portfolios invest in other commingled vehicles and complex derivative positions, both of which present challenges in assessing the quality of the investment proposition, historic results and repeatability of favourable investment decisions, overt and covert risks, and the implications of leverage and illiquidity in different market environments.
Without sufficient clarity on how portfolios are actually structured and managed, including unequivocal evidence of how managers have handled risk and generated returns over time, the focus of investors will be drawn to headline results and other inadequate statistics highlighting those providers that appear to have performed well over the short term. Such a naïve method of strategy or manager selection is sharply vulnerable to outcome bias whereby favourable end results simply imply that the process employed to generate them is robust and repeatable.
“Without sufficient clarity on how portfolios are actually structured and managed … the focus of investors will be drawn to headline results and other inadequate statistics highlighting those providers that appear to have performed well over the short term”
To have confidence in a multi-asset strategy and its ability to deliver expected returns in the future without the assumption of undue risk or unintended consequences, it is imperative to have full historic transparency on the activities embedded in the portfolio and to be able to monitor them in real time on an on-going basis. Otherwise one may fall into the trap of heading for the exit as returns deteriorate, simply because there is no other measure to retain confidence in the investment proposition.
We urge investors to be vigilant when considering the underlying characteristics of multi-asset strategies; in particular the extent to which leverage can be deemed to be palatable, combined with the requirement for transparency based on a wide range of fiduciary as well as investment related reasons. We believe there are other strategies available for investors with the potential to deliver more favourable risk and return profiles not fraught with the almost insurmountable challenges embedded in multi-asset diversified growth fund offerings.
Nathan Gelber is chief investment officer at Stamford Associates