Quantitative strategy - diversification
13 June 2022
By Nikola Vasiljevic, Zurich, Switzerland, Head of Quantitative Strategy
With elevated levels of volatility likely to persist in financial markets this year, inflation and rates climbing, and signs of growth faltering, how should investors allocate portfolio assets? Finding fresh return sources to bolster portfolio performance may be needed, including illiquid markets.
At times of market dislocation, having the right investment process matters. Investors’ preferences and risk profiles lie at the crux of the investment process. When allocating assets, several factors must be considered. The optimal asset mix depends on the investor’s reference currency, ability to take risk, liquidity needs and preferences, liabilities, foreign currency exposures and investment styles. An investor’s objectives, such as specific lifestyle, aspirational, and legacy goals, should be borne in mind too.
A common practice for many investors is to set a concrete return target that can help them navigate the investment landscape and adjust their asset allocation accordingly. Typically, the key portfolio performance objective is expressed as an absolute - or relative-return target.
Setting an absolute-return option can be helpful and even necessary sometimes. However, two issues should be addressed before the metric is used to compute the required return for an investment portfolio.
First, defining an absolute-return target might seem arbitrary. However, it is specific for every investor and can be rationalised based on their financial needs, investment goals, and risk profile.
Second, aiming for a fixed return-target can disconnect from macro and financial conditions at times. A more dynamic approach may be preferable – otherwise investors might chase unrealistic expectations or be exposed to unwarranted levels of risk.
On balance, a relative-return target might be a better candidate. It can be expressed either as the risk premium or real-return target, or the required return above the risk-free or inflation rate, respectively.
The rest of this article considers the consumer price index-plus (CPI+) approach which is widely used by professional investors. The return target is defined as the sum of the inflation rate – based on the rate of change in the CPI – and a required real-return component (for instance, CPI+2% ).
Such an approach is likely to be the most plausible solution over the long term, as preserving the purchasing power, and maintaining your lifestyle, is one of the fundamental goals for any investor.
Moreover, a CPI+ approach lets us compare optimal asset mixes for a given return target across different reference currencies, possibly drawing conclusions in an international setting into the bargain.
Defining a return target can help to devise an asset allocation that can assist investors to reach their investment goals. But what does this mean in practice when the framework is tested with real market data?
To address this question, we calculated optimal five-year asset mixes for US dollar-, sterling-, euro-, and the Swiss franc-based investors on a rolling-window basis since 2005. More specifically, we did this based on CPI+2% and CPI+4% return targets (see charts).
Although we observe some deviations across the board, the optimisation results for the CPI+2% and CPI+4% targets paint a similar picture. As such, average cross-currency allocations provide a good overview of the common trends in return-target-driven asset allocation over the past two decades.
Over the past 20 years, the asset allocations that satisfied our CPI+ objectives, and minimised portfolio volatility, over a five-year investment horizon have been drifting away from cash weightings. Developed government bonds have filled the gap, but the overall shift to holding more low-risk fixed income assets has fallen substantially.
More specifically, allocations to cash and developed government bonds and corporate debt have decreased by about a third from its starting level in CPI+2% portfolios since December 2005. For CPI+4% portfolios the decline has been larger, falling by half. Simultaneously, allocations to risk assets, such as high yield bonds, equities, and commodities, have crept up, adding a more risk-on flavour to holdings.
The changes in the asset mixes highlighted above come as little surprise, given the strong predictive power of yield to maturity for subsequent realised bond returns.
Since cash rates and bond yields have fallen substantially over the last two decades, core fixed income assets have lost much of their power to generate high enough returns to meet certain CPI+ targets.
The yield to maturity for developed government bonds and corporate debt hovered between 2-2.5% at the end of April. These levels – albeit elevated in comparison to the ones observed just twelve months earlier – are still low by historical standards and barely match long-term inflation forecasts.
Based on our analysis, it may take at least another couple years before bond returns make core fixed income assets shine again in a long-term CPI+-oriented portfolio. However, this does not mean that cash and government bonds have no role to play. On the contrary, they remain important “safe-haven” assets.
Naturally, drifting away from risk-off assets to meet a return target comes at a cost. The next chart shows the evolution of the optimal portfolio volatility, averaged across the four reference currencies described above. Indeed, the volatility almost quadrupled when using the CPI+2% approach and tripled for the CPI+4% approach between 2005 and 2022.
Admittedly, the starting levels were low (0.9% and 2.2%, under CPI+2% and CPI+4%, respectively) due to the high allocation to cash at the beginning of the sample. Nevertheless, we observe a clear upward trend in volatility, with occasional risk outbursts (which tend to happen around market downturns, given the exposure to risky assets).
Investors have substantially increased their exposure to risk-on assets this century, and in so doing are stomaching more market risk to meet their return targets. Meanwhile, meeting CPI+ objectives is much more difficult during periods when interest rates are low.
We can gain further insights by looking at the real returns for USD cash and developed government bonds over one- and five-year investment horizon (see chart).
First, we observe that five-year real returns are more stable. Year-over-year real returns substantially fluctuate, hence indicating that additional return can be generated through a tactical asset allocation process.
Second, the USD real cash rate has been in the negative territory for more than ten years, whereas the real return for developed government bonds has been mostly range-bound between our two CPI+ return targets.
Last, but not least, real returns have plunged in the last 12 months due to soaring inflation. As such, the real returns for core fixed income assets have become negative, over both shorter (tactical) and longer (strategic) investment horizons.
Consequently, reaching CPI+ objectives is likely to be much harder for some time and asset allocations may have to allocate more to risky assets and inflation hedges in particular.
Our analysis shows the impact of realised macro-financial trends on CPI+-oriented portfolios over the last two decades. In reality, we have to build forward-looking views regarding return and risk, instead of relying on historical inputs.
To showcase how investors can achieve their return targets in the future, we draw on our five-year capital market assumptions (CMA). We start from cash and gradually move asset allocation toward a traditional 60/40 portfolio of equities and bonds. In a second step, we venture beyond these asset classes, and include commodities, hedge funds, and private markets.
The key message is that investors should build a well-diversified strategic asset allocation to harvest different risk premia while managing the overall portfolio risk.
The next chart shows that public equities and illiquid assets can be key components of portfolios. Private markets appear very desirable in trying to reach a CPI+4% return target. Moreover, due to their relatively low correlation with traditional assets, investing in private markets can reduce portfolio risk as well.
Financial markets are in constant flux due to secular trends, economic cycles, and tactical gyrations. Active investors react to economic and market news by revising their expectations and asset allocation policies.
But sometimes uncertainty can be extremely unsettling and lead to hasty and irrational investment decisions. Impatience and bad timing can further hurt portfolio returns and inflict additional emotional pain on investors.
This can be avoided if investors remain composed and disciplined, stick to the plan, and focus on the long-term performance.
CPI+-oriented portfolios have required a gradual increase in allocations to risk-on assets over the last two decades. Elevated inflation levels and our five-year CMA suggest that this will likely be needed for some time yet.
As such, it is critical to be well-diversified across a wide range of risk premia. Additionally, tactical asset allocation and security and fund selection processes, along with foreign currency overlay strategies and smart hedging practices, are likely to be required to unlock enough investment potential to reach your required returns.
This month we take a look at the major trends at play in the financial markets and the implications of surging inflation, central bank rate tightening, and slowing economic growth prospects. We also look at how private markets might be needed to bolster diversification, and what investors can do to limit the effect of what may continue to be a volatile end to the year.
