There are a number of key components to multi-asset investing that need to be considered when managing a portfolio. Investment selection, asset class blend, geographic exposure, sector and market diversification, the list goes on. However, there are key areas of portfolio construction that investors could be accused of neglecting.
Acceptance of today’s market environment requires investment managers embrace volatility management as a core component of multi-asset investing. In recent times, we have seen that the benefit of bonds as a diversifier for equities has been eroded away. During the first half of 2018, whenever the 10 year Treasury yield either approached or breached 3%, both equity and fixed income markets fell sharply. From 2000 to the start of 2018, there were fifty occasions when the S&P 500 lost 0.5% or more and the 30 year US Treasury bond yield also rose 3 basis points or more. Since the start of the year, we have witnessed eight more occurrences. This has had a considerable impact on traditionally constructed portfolios made up of equities and bonds, particularly passive life-styling type funds, as their construction does not lend itself to protection in volatile markets at the best of times. When bonds and equities are moving downwards in tandem, this negative impact is compounded.
By considering the volatility of the overall portfolio, rather than simply accepting asset allocations that have historically been known to represent a certain type of client, an investment manager is able to adjust for the higher levels of correlation between bonds and equities and, if necessary, include additional asset classes that provide diversification from risk assets. By analysing and monitoring the volatility within a portfolio and the contribution to risk of the underlying investments, an investment manager is also able to identify concentration risk, sector risk and correlation risk within an asset class allocation of a portfolio. An example being whether or not there is true diversification within the global equity bucket. Time and time again over recent months we have seen the damage concentration risk can do to a portfolio in a market environment that repeatedly proves to be driven by momentum investing. Clear examples of this are the oil/energy trade at the start of this year or the tech rally that has been sustained at all odds despite more general global equity market weakness). Alternatively, on the other side of the trade, value investing which looked finally to be having its day in the sun, has since been mercilessly dumped by investors who opted instead for the safety of the compounding stocks for the ninth year in a row.
As we approach what is widely accepted to be the ‘mature end of the market cycle’, the importance of managing a portfolio with volatility in mind will only rise. Investors will have to search harder and more ruthlessly to select investments/sectors/geographies with upside potential, and on the flipside accept that the slightest hint of central bank error, as the Fed attempts to manage a mass-scale liquidity squeeze, could likely trigger a cascade of market fear, taking both equities and bonds with it. Despite what can only be described as a rosy macroeconomic environment for the world’s largest economy, it is important to not underestimate this risk and one should consider the impact it will have on portfolios run simply to crude equity/bond allocation splits.
Being held to ransom by a defined volatility band ensures that a portfolio manager is obsessive about diversification. The huge advantage to this is the resultant smoothing of the return profile of the portfolio, and a client and adviser that feel comfortable sleeping at night. The portfolio manager will not just be running a portfolio to a target return objective, but he or she will also be neurotic about the journey it takes to get there.