A new approach to multi-asset investing
In today’s low-yield environment, the need to build more genuinely diversified portfolios is essential to enhance returns and protect against excessive drawdowns. In essence, a new approach to multi-asset investing is needed.
To us, this means 'Diversify, Different' — identifying the risk factors that fundamentally drive asset classes returns and measuring and combining them in an effective way.
Allocating risk
In order to build a more robust portfolio, we believe it is important to identify the key factors underpinning portfolio risk and to ensure that the portfolio is effectively diversified among these factors. The sensitivity of asset classes to risk factors and the risk factors themselves change over time and under different circumstances, so it is important to adopt a dynamic approach in order to interpret the complexity of the system.
Once the major risk factors have been identified we believe it is important to construct portfolios that offer broad diversity against these risks, and to continuously monitor overall risk exposure.
We have identified three main factors that we expect will drive risk dynamics over the next several years: low inflation, a stronger US dollar, and Federal Reserve interest rate policy.
Alpha and beta working together
The second element of the ‘Diversify, Different’ approach is the focus on both the alpha and beta components of returns, with the aim of enhancing returns in a low-yield environment.
On the beta side, this means utilising opportunistically all appropriate sources of diversification. On the alpha side, we need to understand the main elements driving alpha and how we can act on them.
An example of that is the behavioural aspect of investing. One of the most important skills in portfolio management is timing the entry and exit of positions, as this will have a big impact on the win/loss ratio. As the world is experiencing uneven economic growth, specific dynamics at the country/industry/sector levels become extremely important. Divergences in economic conditions and asset class or sector valuations may provide large opportunities to generate pure alpha.
Don't underestimate tail risks
Finally, recent crises have taught investors the importance of protecting portfolios from extreme tail risks, as these events can be highly damaging to the overall portfolio.
We believe that an effective approach to this task should be based on three steps:
I. Identify tail risks based on alternative macroeconomic scenarios
II. Analyse the possible impact on the portfolio of the tail events (stress test)
III. Identify possible hedges to protect from tail risks
To manage extreme events it is important to analyse the alternative scenarios that could drive large portfolio losses and identify their probability of occurring. A stress-test analysis can then be conducted to scope the extent of losses under extreme circumstances for the overall portfolio, as well as for individual asset classes and positions.
This can enable an assessment of the most efficient way to help protect the portfolio from extreme losses. Today, there are multiple hedging techniques available to help protect against tail risks, thanks to the development of derivatives markets. In general, the opportunity to implement these techniques should be assessed based on the stress-test results, while also taking into account the cost of hedging.
A reality check
‘Diversify, Different’ aims to build more robust and diversified portfolios, using low-correlated strategies. In the effort to achieve this, it is important to understand the main macro themes and, using portfolio management skill, identify the most compelling investment ideas, while attempting to keep risk at reasonable levels.
The multi-asset team has evolved its approach to seek to enhance diversified alpha generation, diligently identify potential risks, and address alternative scenarios with hedging strategies. We have worked extensively along these guidelines and designed a multi-asset investment process that searches for effective diversification both in the alpha and beta fields.
We believe defining a clear world view while hedging the principal risks, and seeking to maximise alpha opportunities from relative value, are at the forefront of the process and can help clients to navigate today’s market challenges.
In our opinion, a well-designed multi-strategy investment approach will be instrumental in the years to come in managing the new complexity in a way that provides efficient investment solutions to clients. In short, we believe it’s time to Diversify, Different.
Important Information:
Unless otherwise stated all information and views expressed are those of Pioneer Investments as at November 2016. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This article is for informational purposes, and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security, product, service or investment. The opinions expressed in this article do not constitute investment advice and independent advice should be sought where appropriate.
Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies.