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Resilient portfolios for a more challenging world

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This is a sponsored article from Columbia Threadneedle Investments.


The supportive environment in public markets that has lasted several decades is making way for a more challenging world. If investors are to avoid this change having a significant impact on their ability to achieve desired long-term investment outcomes, they must find ways of building more resilient portfolios.

During the period that modern portfolio theory has become widely accepted by the investment community, several powerful themes have driven returns across asset classes. These have now reached a point where they pose significant risks to investors.

For nearly 30 years, falling interest rates in developed markets and, subsequently, the emerging world have supported rallying government bond prices. Since the financial crisis, central banks have prolonged this period through successive rounds of quantitative easing. Similarly, governments and central banks have ‘underwritten’ equity markets in times of crisis, pulling on the wealth lever globally. These actions have also boosted corporate credit markets. Finally, the rise of passive investment has exacerbated momentum and size factors in equity markets.

While these themes have boosted public markets, all underlying asset classes are now exposed to a very similar set of risks. Government bonds have low nominal and real rate buffers should inflation or rates rise quickly. Corporate credit may not have sufficient coupon to offset capital losses if bond spreads widen. Finally, equity index returns are increasingly driven by the largest listed companies.

As a result, correlations between asset classes are high during market corrections, making portfolio diversification less effective. (See figure 1.)

Figure 1: Asset classes correct together in volatile markets

At Columbia Threadneedle Investments, we believe that this challenging environment calls for differentiated and innovative approaches to alpha delivery and beta diversification.

Innovative approaches to alpha

Turning first to alpha delivery, we think there are several useful tools, depending on the investor’s goals, such as the three below:

1) Equity portfolios with ‘extended’ potential for alpha generation
Extended alpha strategies combine a traditional long-only portfolio with a short portfolio. The short positions enable the fund manager to increase holdings in high conviction stocks while maintaining a net equity market exposure of 100%. In this way, the fund manager ‘extends’ the potential for alpha generation. Typically, a global extended alpha portfolio might have leverage of 30% and short positions of 30%, giving a net exposure of 100%.

2) Income portfolios diversified across asset classes
Multi-asset income strategies target specific long-term returns on capital, balanced with attractive and sustainable levels of income. Portfolios are typically diversified across multi-asset, equity income, fixed income and property. These strategies aim to give investors greater certainty about their level of income, with strict control over volatility.

3) Risk parity portfolios with greater flexibility
While traditional risk parity is proven and effective, we believe that it can be improved. By adapting to take more, or less, risk depending on market conditions, we think risk parity can deliver higher risk-adjusted returns. This can be achieved using uncomplicated bond and equity market measures, which classify the current market state and map that state to a risk allocation portfolio. With the low interest rate environment that has favoured risk parity products widely expected to end in the foreseeable future, this approach adapts risk parity’s principles to the new environment.

While alpha is scarce, when captured successfully it is a strong tool for diversification from beta with a powerful compounding effect on total returns.

However, to capture manager skill or ‘true alpha’ investors need to address several questions. Does the manager have an investment process that harnesses skill in a repeatable fashion? Do the portfolio exposures have sufficient active share or deviation from the reference benchmark to maximise alpha generation? Does the manager have the freedom to short the beta to manage overall portfolio risk or to extend the risk budget allocated to a long exposure? Does the manager have a mandate to specifically target or limit volatility or drawdown?

Dynamic methods of diversifying risk

Successfully building robust or shock-resilient portfolios that deliver desired outcomes will also increasingly depend on embedding true risk diversification in a structural way that recognizes:

1) The mix of beta in asset allocation is a powerful factor in generating long-term returns.
2) Asset class returns vary over time. There is no static optimal asset allocation; instead the mix should adapt to different market regimes.
3) Traditional capital allocations result in a high concentration of risk assets, so portfolios need to be organized in a way that spreads risk and volatility.

Ultimately investors want to try and improve their risk return trade off in a sustainable way. (See Figure 2.)

Building portfolios using the sorts of approaches described above gives significant flexibility to deliver a range of client outcomes for both wealth accumulation and income generation. Using this type of solution as the core of a total portfolio allows significant tactical flexibility and customization for specific client requirements.

There is also a growing opportunity for investors to split out the underlying drivers of returns in individual securities markets and to focus on them alone (see Figure 3). Multi-asset portfolios can be constructed using lower cost exposures to capture traditional and non-traditional betas and factors in a precise way.

Viewing the risk spectrum with greater care

Today’s strongly interlinked investment landscape, with high correlation between asset classes in falling markets, requires investors to choose where they operate on the risk spectrum with greater care.

For their part, investment managers must build robust solutions with dynamic methods for managing risk, whether within a single beta or on a cross asset class approach.



Important Information:
For investment professionals only, not to be relied upon by private investors.

This material in this publication is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments to anyone in any jurisdiction in which such offer is not authorised, or to provide investment advice or services. Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. The research and analysis included in this publication have been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. The mention of any specific shares or bonds should not be taken as a recommendation to deal. This document includes forward looking statements, including projections of future economic and financial conditions. None of Columbia Threadneedle Investments, its directors, officers or employees make any representation, warranty, guarantee, or other assurance that any of these forward looking statements will prove to be accurate. This document may not be reproduced in any form or passed on to any third party without the express written permission of Columbia Threadneedle Investments. This document is not investment, legal, tax, or accounting advice. Investors should consult with their own professional advisors for advice on any investment, legal, tax, or accounting issues relating an investment with Columbia Threadneedle Investments.

Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: 201101559W.

Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission (“SFC”) to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No. 1173058.

Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.

This is a sponsored article from Columbia Threadneedle Investments.

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