Potential sources of return can be split into broad categories. For example, they could vary between the following categories: • Fixed income: alpha and beta
• Equity: mainly beta • Real assets: alpha and beta • Total return strategies: mainly alpha
Approximately 50% of a portfolio’s returns might be derived from asset allocation and the remainder from investment selection, although these proportions could vary over time. When conditions are conducive for beta to perform, one might expect a strategy to run more directional risk and beta would be likely to contribute more than half of portfolio returns. Conversely, when conditions are more challenging (and beta is less attractive), there may be more opportunities for the portfolio to generate returns from alpha. Managing investment risk across such a portfolio requires thinking in multiple dimensions:
• At a portfolio level to ensure appropriate levels of diversification.
• At an asset class level, specifically, being mindful of drawdown risk when running directional exposure.
• At an individual position or strategy level to ensure that risk is not overly concentrated and that downside in the event of extreme moves is within tolerance levels.
When managing directional risk, some form of downside protection is sensible for assets with material downside potential. When it comes to managing individual positions and strategies, and also overall portfolio risk, incorporating strategies that involve non-directional sources of return can help deliver a better distribution of returns.
Managing directional risk
The most volatile elements within a multi-asset portfolio dominate the portfolio’s risk/return characteristics. It is reasonable to anticipate that asset class exposures are likely to be an important contributor to aggregate portfolio risk, and the most volatile assets (equities and commodities) are likely to be at the top of that list. Biases towards these asset classes can be driven by a fundamental understanding of how they are influenced by macroeconomic factors, such as monetary policy, fiscal policy, growth and inflation. Looking at a range of valuation indicators in the context of an assessment of the macroeconomic environment, alongside proprietary indicators of market positioning, is one way of forming a view on their likely performance. But how much exposure is finally incorporated into a portfolio should also be guided by risk considerations.
A specific asset class approach could be deployed to limit downside. This can be illustrated with regard to equity exposure. As Chart 1 shows, equity returns can be attractive – but the ‘left hand tail’ (the risk of an extreme negative outcome) is large. The same is true of a number of other risk assets.
chart 1: global equities distribution of returns: watch the ‘left hand tail’
Global equities
% of time occured since 2004
30 25 20 15 10 5 0 <-30 -30 to-25 to -20 -25-20 to -1 5 -15 to -1 0 -10 to -5-5 to 0 0 to 5 to 105 10 to 1515 to 2020 to 2525 to 20>30 12-month return %
Source: Insight as of December 31, 2014.
For illustrative purposes only. This is not intended to be taken as investment advice.
Risk MAnAgEMEnT wiThin
A MulTi-AssET sTRATEgy
January 2015
OnE AppROACh TOwARds MulTi-AssET invEsTing invOlvEs blEnding ThE ACTivE MAnAgEMEnT OF
diRECTiOnAl Risk ACROss A RAngE OF AssET ClAssEs wiTh nOn-diRECTiOnAl sOuRCEs OF RETuRn.
This dOCuMEnT shOuld nOT bE REpROduCEd in Any FORM wiThOuT pRiOR wRiTTEn AppROvAl.chart 2: simple put protection
Change in underlying equity index (%)
P&L at expiry (%) 40 35 30 25 20 0 10 15 -10-5 5 -50 -40 -30 -20 -10 0 10 20 30 40 50
10% OTM put option Put protection benefit
Put protection cost
chart 4: dynamic approach to risk budgeting for cyclical assets
Return (%)
Probability density function
45 40 35 30 25 20 10 15 0 5 -10 -5 0 5 10
P&L falls, risk tolerance decreases
P&L rises, risk tolerance increases
Period 1 (cumulative return= 0%) Period 2 (cumulative return= 2.5%) Period 3 (cumulative return= -2.5%)
chart 3: simple put protection: possible benefits versus costs
<-30 -30 to -2 5 -25 to -20-20 to -15-15 to -10-10 to -5-5 to 0 0 to 5 to 105 10 to 1515 to 2020 to 2525 to 20 >30 Global equities 12-month return%
% of time occured since 2004
30 25 20 15 10 5 0
Global equities + put option 10% OTM
chart 5: dynamic risk management versus simple put protection
<-30
-30 to -25-25 to -20 to-20-15 to -10 -15 -10 to -5-5 to 0
0 to 5 to 105 10 to 1515 to 2020 to 2525 to 20 >30 %
Dynamic risk management of equity exposure (DRM)
% 30 25 20 15 10 5 0
Global equities + put option 10% OTM
Source: Insight as of December 31, 2014.
For illustrative purposes only. This is not intended to be taken as investment advice. Improving the distribution of those returns, reducing the ‘fat tail’
at the left is obviously attractive.
There are many ways of providing downside protection. One simple approach, shown in Chart 2, is to use a put protection strategy with the aim of limiting downside beyond a
pre-determined level. Chart 3 illustrates the potential impact of employing this strategy. It can be effective, but can come with a cost in terms of return generation.
More dynamic approaches to downside protection can improve meaningfully on simple put protection. One example is synthetic option replication, a variant discussed here that helps to increase the probability of a portfolio achieving an outcome and seeks to reduce the probability of significant drawdowns, even in deep bear markets. The principles which guide the process are: • scale initial investment in individual positions in accordance
with conviction and tolerance for downside performance (by reference to historic and expected volatility).
• dynamically manage the position size in accordance with changes in conviction and the performance of the investment. If the investment loses money, then the dynamic asset
allocation framework will guide towards reducing the exposure, looking to contain the risk of further downside. If the position makes money, the portfolio manager may have the scope to increase the position size because it has moved further away from the tolerated loss level set when the position was initiated. Isolating the risk management process within this approach, the charts below show how this may improve on the more simplistic option-based strategy.
Chart 4 illustrates the principle behind this approach to dynamic risk management. Chart 5 shows that the resulting distribution could offer better downside protection and greater upside participation than the previous example.
chart 6: Us 30 year vs 5 year treasuries
Sep 14 Dec 14
Dec 13 Mar 14 Jun 14
Sep 13 Jun 13 130 125 120 115 110 105 100 Price target
US 30 year vs 5 year Breakeven
Stop Loss review
chart 8 : option strategy – put spread collar: benefiting from a market fall P&L (% ) 0.15 0.10 0.50 0.00 -0.05 -0.10 -0.15 9500 10000 10500 11000 11500 12000 Index level P&L at expiration Linear P&L
Initial Current
chart 7: euro vs Us dollar
Price target 1.15 1.20 1.25 1.30 1.35 1.40
Euro vs US dollar Breakeven Stop Loss review
Sep 14 Dec 14 Dec 13 Mar 14 Jun 14
Sep 13 Jun 13
chart 9 : option strategy – call spread collar: capturing a market rise with an element of downside protection
P&L at expiration (% ) 0.40 0.20 0.00 -0.20 -0.40 1400 1450 1500 1550 1600 1650 1700 1740 1800 Index level Initial Current Linear P&L P&L at expiration
Managing individUal positions and
strategies
This dynamic approach to risk management can work for some investible assets, but not all. There are asset classes without a ‘fat left hand tail’ or ones which exhibit mean reverting characteristics. Alternative approaches to risk management are more appropriate for assets that fall within these categories and also for strategies that are designed to generate returns through alpha and have a limited requirement for beta management. One example is ‘relative value’ positions that aim to capture the difference between two similar assets, where a long position is held in the investment believed to offer a better relative return and an offsetting short position in the one which is expected to underperform. The volatility (historic and expected) of the relative position must be taken into consideration when identifying the potential profit target, as well as the acceptable tolerance for loss. This approach aims to ensure the monitoring of position
performance against pre-determined expectations. The simplicity
and rigour of this approach applies once a profit target has been reached – if the fundamental rationale remains valid, one could continue running positions while also ‘locking in’ profits and re-setting higher stop-review levels to account for this, as can be seen in Charts 6 and 7 below.
Other strategies require alternative approaches to risk
management, for example, derivative strategies where economic exposures can move in a non-linear fashion.
By combining put and call options, an investor can seek to be precise about the trading ranges viewed as likely across a variety of asset classes (see, for example, Charts 8 and 9). Different strategies can also isolate the particular characteristics viewed as desirable: directional views, volatility, carry, time value decay and skew can all be expressed using combinations of strikes and expiries.
when structuring an options trade, the position can be sized for a profit target, while also setting a stop-review level that reflects an acceptable level of downside risk.
chart 10: illustrative profile of a diversified multi-asset strategy % 9 8 7 6 5 4 3 2 1 0 Eme rg ing marke t equity European equity US equity UK equity Japanese equity
Asian equity Government
bonds Investment grade Eme rg ing marke t bonds High yield
Infrastructure Real estat
e
Commodities
Dividends
Absolute return
funds
Relative value Range boun
d strategies Breakout strategies Diversification benefits Por tfolio volatilit y
Equity market strategies Fixed income strategies Real assests Total return strategies Result
chart 11: Building a better distribution of returns
<-30 -30 to -25-25 to -2 0 -20 to -15-15 to -1 0 -10 to -5-5 to 0 0 to 5 to 105 10 to 1515 to 2020 to 25 25 to 20 >30 12-month return %
% of time occured since 2004
30 25 20 15 10 5 0
DRM with active asset allocation and alpha strategies Dynamic risk management of equity exposure (DRM)
chart 12: the desired outcome: a better distribution of returns
<-30 -30 to -25-25 to -20-20 to -15-15 to -1 0 -10 to -5-5 to 0 0 to 5 to 105 10 to 1515 to 2020 to 2525 to 20>30 12-month return %
DRM with active asset allocation and alpha strategies
% of time occured since 2004
30 25 20 15 10 5 0 Global equities
Source: Insight as of December 31, 2014.
For illustrative purposes only. This is not intended to be taken as investment advice.
Managing overall portfolio risk
Multi-asset portfolios aim to deliver returns by investing across a range of asset classes and strategies. This enables them to generate returns in different market conditions. Some investments may work better (or, indeed, worse) in different environments; a strategy that has a broad mandate and the flexibility to take advantage of such opportunities can enhance its return potential.
A multi-asset opportunity set can also be used to diversify risk. When managing a multi-asset portfolio, it is crucial to understand the potential risks that are embedded within that portfolio and to seek to ensure that it is sufficiently diversified. This sometimes involves thinking beyond historic statistical relationships: inter-relationships and correlations can change over time. It is important to have not only an accurate picture of overall portfolio risk (measured by volatility, value-at-risk (vaR) and other appropriate risk metrics), but also to appreciate the
decomposition of risk among portfolio positions. If risk were inappropriately skewed, portfolio adjustments would need to be made to secure more balanced risk distribution. This could then ensure that the portfolio had sufficient diversification from a fundamental perspective.
In Chart 10, the potential benefits of diversification are illustrated by showing the contribution to risk of the various strategies deployed within a diversified multi-asset portfolio and then comparing the aggregation of these individual positions with the realised volatility of the overall portfolio. The difference between the two gives a sense of the possible benefits that can be derived from a diversified multi-asset approach to return generation. This kind of multi-faceted approach to risk management seeks to provide confidence that a broad opportunity set can be used with the aim of further improving the distribution of portfolio returns. Chart 11 shows the return profile of a 100% equity portfolio adjusted to incorporate the dynamic risk management strategy described above. The distribution achieved by an actively managed multi-asset portfolio is then overlaid on this return profile. Chart 12 illustrates the same distribution, but compared with global equities. it shows precisely how combining a wider opportunity set (including non-directional strategies), with an active asset allocation overlay may improve on the distribution of returns.
iMportant disclosUres:
past performance is not a guide to future performance. The value of investments and any income from them will fluctuate and is not guaranteed (this may partly be due to exchange rate changes) and investors may not get back the amount invested. Transactions in foreign securities may be executed and settled in local markets. Performance comparisons will be affected by changes in interest rates. Investment returns fluctuate due to changes in market conditions. investment involves risk, including the possible loss of principal. no assurance can be given that the performance objectives of a given strategy will be achieved. The information contained herein is for your reference only and is being provided in response to your specific request and has been obtained from sources believed to be reliable; however, no representation is made regarding its accuracy or completeness. This document must not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or otherwise not permitted. This document should not be duplicated, amended, or forwarded to a third party without consent from insight. This is a marketing document intended for professional clients only and should not be made available to or relied upon by retail clients.
investment advisory services in north America are provided through four different sEC-registered investment advisers using the brand insight investment: Cutwater Asset Management Corp. (CAMC), Cutwater investor services Corp. (CisC), pareto new york llC (pny) and pareto investment Management limited (piMl). The north American investment advisers are associated with a broader group of global investment managers that also (individually and collectively) use the corporate brand insight investment and may be referred to as “insight”, “insight group” or “insight investment”. The investment adviser offering these advisory services is pareto investment Management limited (piMl), an investment adviser registered with the securities and Exchange Commission (sEC), under the investment Advisers Act of 1940, as amended. Registration with the sEC does not imply a certain level of skill or training. you may request, without charge, additional information about insight. Moreover, specific information relating to insight’s strategies, including investment advisory fees, may be obtained from piMl’s Form Adv part 2A, which is available without charge upon request. This document is distributed in the united states by piMl. piMl is one of the subsidiaries of insight investment Management limited (iiMl), a uk company, and the strategies outlined in this document may be offered outside the United States and implemented by another affiliate of IIML (the ‘Affiliate’). performance presented is that of the Affiliate and should not be viewed as the performance of piMl. The performance of the Affiliate is being presented to show the historical performance of the portfolio management team responsible for managing the strategy. The track records presented include all accounts managed by the Affiliate with substantially similar investment objectives, policies and strategies for which the Strategy management teams were
responsible. The strategy portfolio management teams may concurrently manage portfolios at the Affiliate and piMl under dual employment arrangements. The advisory services and investment products advised by Affiliate are not offered in the u.s. and are not available to u.s. persons. Advisory services referenced herein are available only through piMl. piMl and the Affiliate constitute the gips firm insight investment, which claims compliance with gips. Unless otherwise stated, the source of information is Insight. Any forecasts or opinions are Insight’s own at the date of this document (or as otherwise specified) and may change. Material in this publication is for general information only and is not advice, investment advice, or the recommendation of any purchase or sale of any security. Insight makes no implied or expressed recommendations concerning the manner in which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives and should not be construed to be an assurance that any particular security in a strategy will remain in any fund, account, or strategy, or that a previously held security will not be repurchased. It should not be assumed that any of the security transactions or holdings referenced herein have been or will prove to be profitable or that future investment decisions will be profitable or will equal or exceed the past investment performance of the securities listed. Telephone calls may be recorded.
Insight does not provide tax or legal advice to its clients and all investors are strongly urged to consult their tax and legal advisors regarding any potential strategy or investment. pareto investment Management limited is a uk limited company registered in England and wales with the Company no. 03169281. its registered office is The bank of new york Mellon Centre, 160 Queen victoria street, london, EC4v 4lA, united kingdom. pareto investment Management limited is authorised and regulated by the Financial Conduct Authority (FCA) with FRn 416024 in the united kingdom and is registered with the securities and Exchange Commission (sEC) in the united states as an investment adviser; the Ontario securities Commission (OsC), Alberta securities Commission (AsC), british Columbia securities Commission (bCsC), Manitoba securities Commission (MsC), nova scotia securities Commission (nssC), Authorities des Marches Financiers and saskatchewan Financial services Commission (sFsC) in Canada, the Financial services Agency in Japan; the Commodity Futures Trading Commission (CFTC) as a Commodity pool Operator and a Commodity Trading Advisor and is a member of the national Futures Authority (nFA). pareto Australia pty limited is regulated by the Australian securities & investments Commission (AsiC) with AFsl 230541. pareto new york llC (pny) is registered as an investment adviser with the sEC and with the CFTC as a Commodity Trading Advisor and is a member of the nFA. pny markets all of insight’s strategies and provides client servicing for its north American clients. pny does not recommend any investment or provide advice in the course of marketing insight strategies. pny is not independent of insight and pny’s interests are generally aligned with those of insight. insight is a group of wholly owned subsidiaries of The bank of new york Mellon Corporation. bny Mellon is the corporate brand of The bank of new york Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. Products and services may be provided under various brand names and in various countries by subsidiaries, affiliates and joint ventures of The bank of new york Mellon Corporation where authorized and regulated as required within each jurisdiction. unless you are notified to the contrary, the products and services mentioned are not insured by the FdiC (or by any governmental entity) and are not guaranteed by or obligations of The bank of new york Mellon Corporation or any of its affiliates. The bank of new york Corporation assumes no responsibility for the accuracy or completeness of the above data and
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