Risk & Portfolio Construction: The full toolbox
By synthesising an 85-year dataset Thomas Thygesen and Kristina Styf demonstrate the strong diversification benefits to be had from three key hedge fund strategies and seven alternative betas
Asset allocation models have traditionally focused on the two traditional asset classes – bonds and equities. This is partly for historical economic reasons: these markets developed early in the history of capitalism, they fulfil a clear and crucial role in the economic system, and they represent very good long-term investments with a history of positive risk premiums extending over more than a century.
Nonetheless, both bonds and equities have, with regular intervals, experienced very long periods with flat or negative real returns, and they struggle to diversify systematic macro risks: equities need growth; bonds need low and stable inflation.
In this article, we expand the investment universe to include commodity futures, hedge funds and alternative betas.
These assets lack the transparency and track record of traditional assets, but they are less susceptible to the risks that affect traditional assets. The stronger diversification achieved by including non-traditional assets increases the risk-adjusted return of a balanced portfolio, with significant exposure to alternative beta at all risk levels.
Government bonds offer a safe nominal return, but inflation can lead to real return drawdowns that outlast even the most patient investor. Short-term government bonds are a low-risk investment: governments are assumed not to default (although they sometimes do), so the main risk is inflation, which normally moves at a slow speed. However, when inflation does move, bonds can experience drawdowns lasting more than 40 years.
Real equity return has been remarkably stable at around 6% over the past 200 years, but the return has been extremely volatile. 12-month losses have exceeded 40% more than once, and there are regular periods of negative returns lasting as long as 20 years. Real equity returns have had a variable correlation to inflation, with the correlation turning positive when inflation is low, but they have always been negatively correlated to growth.
Credit shares characteristics from both government bonds and equities: the basic ‘bond return’ is similar to that of a government bond with the same duration, while the excess return is closely correlated with equity returns. On rare occasions during times of extreme distress, credit risk becomes much more equity-like. Credit is thus essentially a combination of the two other traditional assets, with a small premium on top to pay for tail risk.
These assets share a common trait: they struggle to diversify systematic macro risk and only do well when growth is strong and inflation is low. Growth hasn’t been strong since the dot-com bubble burst and inflation is more than 30 years into a structural decline that has driven yield to record lows, so it’s natural that investors are looking for more robust alternatives.
Commodity futures have offered a positive long-term risk premium, even though real commodity prices have been falling because commodity producers are willing or forced to insure against falling prices. Short-term commodity returns are mainly driven by unexpected spot price changes and hence have a strong correlation with actual price developments. As a result, commodities stand out as the only asset with a clear, positive correlation to inflation.
This is a very valuable trait, since most balanced traditional portfolios have a built-in vulnerability to inflation shocks. Although commodities have a rather low return per unit of risk compared with equities, a small, diversified exposure is thus a valuable addition to traditional assets in a balanced portfolio thanks to the diversification benefits.
Hedge funds can add diversification in a portfolio, but the average hedge fund does not.
Our hedge fund basket is comprised of three strategies that were found to have stronger diversification properties in the SEB X-asset study ‘Hedge Funds – Avoiding a Simplistic Approach’ (2012): equity market neutral, macro and CTA funds. Each strategy has been a better macro hedge historically and a combination of them is close to uncorrelated with macro risks.
The main drawback for hedge funds is the limited return history of around 20 years. Our analysis replicates historical returns using risk factors that have explained returns in the past 20 years. That is not the same thing as real data – nonetheless, the results suggest that a hedge fund portfolio with these characteristics would be included in the portfolio even with very conservative alpha assumptions, thanks to the diversification it offers.
The last alternative is to invest directly in the risk premiums that aren’t captured by traditional beta. In the companion study to this analysis, ‘The role of alternative betas in long-term portfolios’, we identify seven risk premiums that satisfy three criteria – proven performance over many decades, an intuitive explanation, and backing from academic studies. These are bond-market curvature, credit premium, FX carry, defensive sectors, the value premium, the dividend premium and the small-cap premium. They have all been analysed as long/short positions with collateral interest using more than 85 years of data.
As with commodity futures, a majority of the individual alternative betas have rather low historical risk-adjusted returns and long drawdowns, but they also have very attractive correlation characteristics. They are virtually uncorrelated internally, so a basket of alternative risk premiums is better than the sum of its parts, with a long-term risk-adjusted return that is better than for traditional assets and uncorrelated to both inflation and growth.
The full toolbox
Using parameters based on real returns since 1927 we optimise a long-term passive portfolio for the expanded universe. As described above, the new entrants offer similar risk-adjusted returns, but they allow us to cover a broader range of macro climates.
For the performance histories shown in figure 1, we use resampled mean variance optimisation with value-at-risk set at 15%, with 12-month time horizon and a 98% confidence level. The three hedge fund strategies and the seven alternative betas enter the optimisation as individual strategies. No cost assumptions are included for traditional assets and commodities. For hedge funds and alternative betas, costs are taken into consideration, depending on the underlying asset class.
As figure 2 shows, the alternative betas get a 25-70% allocation along the risk spectrum. Hedge funds have a small stable allocation along the efficient frontier, while the commodity exposure increases with risk level. Non-traditional assets make up around 50% of a balanced, medium-risk portfolio, pushing out fixed-income assets. On the other hand, improved diversification allows for a clear increase in equity allocation, creating an additional annual return of 60 basis points compared with a traditional portfolio at the same level of risk.
Figure 1 shows that expanding the investment universe can thus improve long-term returns, but it is not likely to eliminate losses in episodes of market distress. While alternative returns are less correlated to macro risks and can even hedge away some inflation risk, they still leave a limited capacity to hedge risks from low growth and high inflation, and the increased exposure to equity beta suggests crashes will still hurt.
Even in this limited sample, the portfolio has experienced one decade with no return and one decade with twice the expected risk. Short-term risk has only been marginally reduced, particularly in the high-inflation 1970s, but tail risk remains and real 12-month losses still break the 15% limit during periods of extreme market stress – such as the early 1930s and 2008 – more often than they are supposed to. Alternative assets are thus not the cure for all allocation problems, but they do offer a quite powerful improvement in long-term returns.
Thomas Thygesen is head of SEB X-asset research and Kristina Styf is head of quantitative analysis at SEB X-asset research