Harness Volatility for Better Performance

As the world’s global markets have experienced significant selloffs and volatility levels reminiscent of the 2008/2009 Global Financial Crisis, a critical take away for all investors should be;  Am I taking too much risk in trying to meet my objectives? 

Clearly, conventional asset allocation and relative benchmarks have dominated the majority of retail advised and superannuation industry portfolios.  This has equated to many “Balanced”  portfolios in Australia recently holding between 60 to 80% allocation to growth assets when including listed equities, real estate, infrastructure, credit and private market holdings. This phenomena has multiple causes including the need to meet expected return objectives in the Zero Interest Rate Policy (ZIRP) environment.   

 However, as growth asset returns are driven by GDP economic factors, they are susceptible to negative impacts to growth rates. As we witness the market repricing of risk, portfolios with high levels of growth assets exposure should experience relatively high levels of loss, regardless of the moniker on the tin.

 Its seems that we re-visit this dilemma every time we experience a major systemic event.  Yet few within the industry deviate from the conventional SAA approach , instead somehow find comfort in knowing most peers have performed just as poorly.

In an increasingly competitive world, advisers and fiduciaries need to re-evaluate the shortcomings of their SAA approaches and build better portfolios that are more resilient for the next period in investment markets.  Solutions can include smarter lifecycle de-risking , pairing explicit protection (derivative overlay) for higher risk portfolios and/or build more fundamentally diversified portfolios as a first step.

Human Behaviour

Unfortunately, poor human behaviour and selling when markets are stressed is a real risk to actual investor investment performance over the long term. We suspect many investors will succumb to the stress of near term portfolio loss once they review their investment account statements.

Advisers and product development teams should be focused on the actual performance for their investors not asset class performance and take this expected human behaviour into account in the creation of their solutions.

 Historically, 'real return' and 'absolute return' objective solutions have been developed to meet the growing demand for maintaining wealth, minimising loss and earning a stable 'real' return, which due to their lower risk profile and volatility can be expected to reduce the worst of poor investment behaviour.  

However, as the returns of various “real return’, “absolute return” and “alternative investments” begin to be reported, investors may be disappointed with the amount of market risk their popular solutions may have actually held.

It is important to remember, with a large dispersion of strategies; outcomes will also be wide ranging within these sectors. Further, while many may have performed well in this recent negative environment, they may have performed relatively poorly for years.

Solutions that have held high allocations to cash may have weathered this current storm admirably, but had provided measly returns over the recent bull market years.  For example, one of the most popular multi-asset strategies, Schroeder’s Real Return Fund (CPI +5%) had returned 3.98% p.a. (post fee) for 5yr at end of January 2020.   

Instead, a fundamentally risk-balanced approach built to maintain capital, deliver attractive returns without over-reliance upon risky assets should find utility within portfolios seeking to improve long-term outcomes. They do exist.

 Logical Asset Allocation with Stable Returns

An example of an alternative approach to portfolio construction was Harry Browne’s Permanent Portfolio strategy made famous in the US in the 1980’s. Contrary to the traditional asset allocation philosophies that are dominated by equity risk , Harry Browne built one of the first all-weather portfolios to provide a stable growth rate whilst being prepared for expected market surprises. 

The portfolio invests equally across 4 sectors (cash, bonds, equities, and precious metals) in order to be prepared for all potential economic environments including recessionary or growth, deflationary or inflationary periods.   An important difference from risk parity would be the lack of leverage within the fixed income portfolio.

Critically, an underlying belief in this logical approach was the knowledge that historical asset class returns and their variable correlations was a flawed premise to build portfolio diversification and risk management. Correlations between all growth assets tend to become stronger in a ‘risk off’ environment.   This 2020 market sell-off has seen correlations between growth assets move to 1, underscoring potential diversification breakdowns and risk of significant capital loss.

 Permanent Portfolio + Volatility Harnessing Strategies

 In Australia, the Melbourne based boutique manager; Cor Capital has built upon Harry Browne’s original strategy by increasing expected return of its similar core portfolio through a systematic approach to portfolio re-balancing aimed at harnessing volatility.  Importantly, the re-balancing strategies can add return without holding high levels of equity/growth market risk.  

Cor Capital Fund holds equal weights in cash, equities , bonds and physical precious metals.  As these core components of the portfolio are diversified within their economic factors they have a more fundamentally derived portfolio diversification.

The offsetting nature of the Fund’s core exposures work to keep capital stable but the relative movements between the assets are adjusted actively by the Manager. These adjustments will by their nature be contrarian. Volatility is captured as the Fund tends to buy assets at low prices and sell them at high prices.

To elaborate, Stochastic Portfolio Theory states that there are two components to the Portfolio Growth Rate:

The Excess Growth Rate depends on portfolio weightings, individual variances and covariances. It does not depend on asset growth rates. This is why relatively volatile positions with low correlation are deemed valuable to the process.

The Cor Capital Fund seeks to maximize profit from both average asset growth rates and from excess growth and has superior positioning to do so given a balance of lower correlated assets.

Performance

While academic theories are great for a discussion over drinks, Cor Capital’s performance since 2012 has established solid evidence in support of their approach.

Additionally, the 40 year track record of the US based Permanent Portfolio’s risk adjusted performance underscores the risk management credentials of the core portfolio. (https://permanentportfolio.com/permanent-portfolio.html)

As the core portfolio holds relatively low levels of equity risk, the expected rate of return from that portfolio is lower. However, Cor Capital Fund returns have been higher than most peers – illustrating the attribution and power of re-balancing of their added strategies. 

The markets will always surprise, but investors need solutions that can weather the storm to avoid poor investor behavior.   The ability to harness volatility can provide more absolute return outcomes without high exposure to risk assets .

As the recent market sell-off has uncovered, those stellar returns gained from equity rich exposure within the fund management industry over the recent record setting bull market was not a free lunch.

Michael Armitage CAIA- ([email protected]) has over 30 years of experience across capital markets, hedge fund strategy research and development, asset consulting, and strategic consulting with asset management product development teams including retirement solutions .

The aim of this article is to highlight 1. The weakness of conventional asset allocation 2. Potential ideas for further review and research .

Michael serves as a strategic consultant for Cor Capital and other asset management companies. A common theme among clients: a focus upon asymmetric exposure to risk. Within investment strategy research, Michael has partnered with IIR IM, on the delivery of specialized research for HNW and family office investors.

 Disclaimer

This material is intended to provide background information only and does not purport to make any recommendation upon which you may reasonably rely without further and more specific advice.

Past performance is not a reliable indicator of future performance, and no representation or warranty, express or implied, is made regarding future performance.