Risk and Portfolio Construction: Annus horribilis?
Yazann Romahi, JP Morgan Asset Management
Portfolio return 2013: 5.4% (net of fees, launched in February 2013)
• May and June were the most challenging months.
• Equity factors and convertible bonds did well.
• Fixed income struggled, but volatility in those sectors was low.
“As at the end of December 2013, the JPM Diversified Risk Fund, which launched in February 2013, had returned 5.4% net of fees, outperforming its benchmark and a 30/70 equity/fixed income reference index. This was achieved with a relatively low volatility of 5.6%.
“February and March were strong months for the fund, when bond yields were fairly flat. September and October, when US bond yields fell, were also strong months for the fund. In both instances, both traditional and alternative equity-based factors performed well, while exposure to convertible bonds was also beneficial.
“The period through May and June was the most challenging part of the year, which was not unaffected by the Federal Reserve’s tapering announcement and consequent rise in bond yields. The fixed income and emerging market debt exposure of the portfolio detracted in this environment, although this was buffered by the fund’s broad diversification across factors, as the equity based factors in particular continued to deliver strong positive contributions.
“Last year was a very strong period for equity-based factors in general. Exposure to equity beta was beneficial, as equity markets rallied strongly over the year. The alternative equity factors within the fund, including equity value and momentum, also performed well, as dispersion within equity markets was high. In aggregate we estimate that these equity-based factors accounted for about 6.6% of the fund’s total return. Exposure to convertible bonds was also beneficial in 2013, as they participated in the equity market rally and contributed 1.3% to the fund’s return.
“The most significant detractor within the portfolio was the fixed income component. Exposure to traditional duration detracted in a rising rate environment, while the fixed income carry and yield factors also struggled over the period. In total these strategies, contributed about -1.1% to the fund’s overall return.
“The fund targets equal risk exposure to a broad range of traditional and alternative beta factors, based on their long-term risk weights. There will be some fluctuation in the short-term however, and in 2013 we saw reduced risk in the fixed income strategy, where the yield and carry factors have been offsetting one another. This had been the case for some time, but there were signs towards the end of the year that this effect was diminishing, which partly reflects a gradual normalisation of the interest rate environment.
“The volatility from the fixed income strategy has been below average, as has volatility from the FX and commodity factors within the fund. This in aggregate meant that these strategies have made a reduced contribution to return relative to longer-term expectations. In contrast, dispersion within equity markets was high in 2013, which was an important factor in driving returns from alternative equity factors.”
Florence Barjou, Lyxor Asset Management
Portfolio return 2013: 9.4% (net of fees)
• Japanese equities performed well in early 2013.
• Equities and corporate bonds took over later in the year.
• Positive correlations in May and June were a challenge, but macro overlay helped mitigate the effects.
“The Lyxor ARMA 8 fund returned 9.4% (net of fees) in 2013. Gains were distributed throughout the year, with a strong start thanks to a winning exposure to the Japanese Nikkei and from June onwards, as equities and corporate credit advanced.
“The fund lost ground in May and June, during the market sell-off triggered by chairman Ben Bernanke’s hints at an early tapering. During the period, both bonds and equities suffered, as the correlation between these two asset classes temporarily turned positive. Equities were the main performance detractor in the fund during this time. Losses related to bonds were significantly mitigated by the tactical overlay implemented in the fund – a combination of discretionary global macro and trend following techniques.
“The fund had entered the year with an underweight position on bonds relative to its risk budgeting driven neutral allocation, and exposures were slashed as markets turned. Typically, in Arma 8, exposure to sovereign bonds was around 100% beginning of May. It was cut by 50% in just three weeks and then fell to below 10% by the start of the summer.
“Equities were the main performance driver of the fund last year, with a 12.8% contribution to performance. Thanks to the tactical overlay implemented in the strategy, the contribution to performance from sovereign bonds was only slightly negative (–0.6% contribution). In fact, the main performance detractor came from commodities (–2.1% contribution). All contributions to performance are net of fees.”
Ed Peters, First Quadrant
Portfolio return 2013: -1.91% (net of fees)
• Correlations in May and June were challenging.
• Equities and high yield rebounded in the autumn.
• Non-bonds exposure is high, but commodities hurt performance.
“[Our Essential Beta Composite is] targeted at 10% risk. For 2013 the return was -1.91% (net of fees). While certainly May and June 2013 were the worst drawdowns for the year, and bonds were down, stocks and commodities were also down those two months and bonds only contributed to -4.55% to the drawdown of -11.32%. Stocks, commodities, and high yield contributed to the remainder.
“In September and October a rebound of +8.30% occurred of which bonds only contributed +0.58%. The majority of the rebound came from equities though high yield bonds made a significant contribution. Commodities were again down for the period.
“Essential Beta is not leveraged bonds at this stage of the business cycle and only allocates 12.5% risk to sovereign bonds – including inflation linked bonds. The remainder of the risk allocation is 60% equities, 12.5% high yield bonds, and 15% risk to commodities. However, there is a significant option hedging programme in place.
“For the total year equities gave the major positive component of performance with negative contributions coming from bonds, commodities and options with bonds contributing less than half of the negative performance.
“Essential Beta allocates risk based upon the FQ Market Risk Index (MRI) which measures the level of overall market uncertainty through a number of market sentiment and macro fundamental indicators. The MRI has been reading that we are in the lowest macro uncertainty environment since March 2013. Since then risk has been allocated 60% equities, 25% bonds (including sovereign, high yield, and inflation linked bonds) and 15% commodities.
“When macro uncertainty increases, the capital and risk allocations of the portfolio would also change until risk is allocated 42.5% equities, 42.5% bonds and 15% commodities when we reach a level of very high macro uncertainty.
“Essential Beta was up +7.31% gross of fees, +7.21% net of fees in the first quarter of 2014. While bonds were up, bonds contributed +1.33% to total return. Stocks contributed almost an equal amount but the biggest contributor was commodities.
“It was the narrowness of leadership which was unusual for 2013 and had the biggest impact on performance. Investors were penalised for being diversified. So risk parity strategies with less diversification within asset classes – such as not having emerging market or small CAP equities, a limited number of commodities, or inflation linked bonds – fared better than more diversified strategies.”
Carolina Minio-Paluello, Lombard Odier Investment Managers
Portfolio return 2013: 3% (Lombard Odier pension fund)
• Only equities did well in 2013.
• Leverage is not applied.
• Active strategies are a growing share of the risk budget.
“In 2013 only developed equities did extremely well and reached +20–25% depending on the markets. Other major assets posted disappointing performance: credit bonds (investment grade) reached just 1.3%, emerging markets dropped 5.4%, global sovereigns -6.7% and commodities lost almost 10%. In that context, only a portfolio concentrated on developed equities did well, which is the case of many traditional asset allocation benchmarks. In that context, our pension fund [which is managed on a risk-parity basis] reached close to 3% in 2013, in line with its long-term target (cash+3%).
“The maximum drawdown was -3.5% and happened in the May-June sell-off. The performance was not overly dependent on yields only as we seek to have a well-balanced allocation across the five major risk factors – duration, credit, developed equities, emerging and commodities.
“Major detractors to performance in 2013 were commodities, emerging markets and bonds, consistent with overall asset classes performances. Major contributors were developed equities and private equity on the illiquid side. This is very consistent with all comparable diversified multi-asset strategies. In 2013, our pension plan is up +2.8%, which is in line with a long-term cash+3% average annual return target.
“The pension fund portfolio has been relatively stable in 2013, with marginal reallocations only – it is not allowed to use leverage. We have increased the share of active strategies, as low expected returns and potential higher risk as well as loss of diversification looking forward will justify the need of active management at the strategies level.
“The relative level of volatilities obviously evolved constantly over the year, but not significantly enough to justify major rebalancing of portfolios.”