Multi-asset: a new era for diversified investments

Most investors have a requirement for both regular income and capital growth. Is it your view that the best recipe for these outcomes is mixing different asset classes together?

By mixing different asset classes, you can have different sources of income – from equities you can obtain dividends, from bonds you can receive coupons. Often these asset classes exhibit low or negative correlation between them, and by diversifying your portfolio you can optimise your risk return profile, increasing the expected return for the same level of risk, or decreasing the risk for the same level of expected return. 

Compared to the old buy-and-hold balanced portfolios, multi-asset funds need to have a much more dynamic, reactive tactical asset allocation, in order to improve the expected return in the short term, catch investment opportunities and reduce exposure when the market is facing sharp drawdown. This is what the current multi-asset funds can offer. 

As a consequence of the two shellshocks of 2001 and 2008, risk management has become a cornerstone in multi-asset funds and is probably one of the main improvements in this space.

In terms of devices and financial instruments, are there new tools you can use today that were not available 20 years ago?

Options are not new, but are used much more today compared to in the past. Thanks to their convex profile, options enable you to quickly gain exposure to a rising asset class or to reduce exposure to a declining one. 

Also, put options enable you to protect the portfolio against drawdowns. Finally, selling options is a way to harvest income through the premium. 

How do global and regional economic cycles affect the performance of multi-asset class portfolios?

The economic cycle determines the price and affects the valuation of each asset class, because it impacts economic variables and investors’ expectations of these variables.

In each stage of the economic cycle, there is always one asset class that is outperforming the others. In a recession, for instance, interest rates, inflation and growth are lower, and central banks are more accommodative. This is a favourable environment for bonds. In an expansion phase, growth, inflation and also interest rates are higher and central banks are generally hawkish. This is a positive environment for equities. 

But we have to distinguish between the short and long-term. By definition, a cycle is a short to medium-term cycle, which lasts less than 10 years. It determines which asset class outperforms at each stage, but does not affect long-term secular trends. The cycle can tell you that, right now, bonds will underperform equities, but does not affect the fact that we are in a long-term, structural trend of declining interest rates, which means bonds could perform well, although probably less well than equities. 

Bonds are still a valid instrument for diversification in a multi-asset portfolio. I do not think the bond market will collapse. 

But we are living through very unpredictable political times at the moment; we have a US President who nobody knows what he will do from day to day and also the ramifications of Brexit. Do you feel markets will operate independently of these political changes or are you painting scenarios for the politics to directly influence these cycles?  

Any hit to economic growth will negatively impact the cycle. If Donald Trump delivers a fiscal boost, it will be positive for the economy, but if he fails to deliver it or if he starts a trade war with China, for instance, or with Russia, and implements protectionist policies, clearly that will be detrimental for global growth. 

Higher taxes on borders for imported goods will introduce inflation into the US economy. Lower growth and recession could come much earlier than expected in the US. It is the same problem in Europe, due to Brexit and upcoming elections in France and Germany. We are still in a quite low growth environment, with low interest rates, which gives [central banks] limited room for manoeuvre to avoid a recession.

Is the main decision you make as a portfolio manager that of strategic asset allocation? And what factors would lead you to review it?

The strategic asset allocation defines your long-term view, your neutral positioning. When you design your strategic asset allocation, you are designing your risk profile; the risk profile you want to deliver to investors. But it is tactical asset allocation, and any overlay you add in your portfolio, which can really differentiate your multi-asset fund from competitors’. 

We are assessing and reviewing the risk profile of each asset class at least on a yearly basis. If an asset class is suffering during a short period of time, this is not a sufficient reason to take it out of the strategic asset allocation. You reduce exposure to it through tactical asset allocation. 

But if the risk profile of an asset class, or the correlation of this asset class with others within the portfolio, changes dramatically, that is a good reason to review the strategic asset allocation. For instance, if high yield bonds would prove to be less sensitive to growth and more sensitive to interest rates, with lower yields, I would consider reducing their weight in my portfolio, because they would no longer offer the risk profile I am looking for.

What kind of role does macro level research and trend following analysis play in those tactical decisions?

The macro analysis allows analysing the economic environment and determining in which phase of the economic cycle we stand – based on growth analysis, risk premium analysis and central bank policies – and which asset class will best perform in the coming weeks or months. It enables you to be proactive, to modulate your strategic asset allocation, based on your short-term views of the macro environment. 

However, if you do not choose the right timing, you will not make money. That is why we complement the macro analysis with the trend following analysis. The latter is climbing momentum, the former is much more contrarian.

And how do volatility control devices work within the multi-asset portfolio?

Volatility control is an efficient way to avoid sharp drawdowns and maintain a constant risk profile for the investor. A security will have a very different risk profile over the years. With the volatility control in the fund, we make an arbitrage between risky assets and cash in order to keep the fund volatility below the 6 per cent level.

In your particular strategy  you are targeting a 4 per cent return. There is a history of financial services firms guaranteeing such returns, which were not always kept. Why should your promise be any different?

When I designed this strategy, one of my first concerns was to make sure to be able to distribute at least 4 per cent income, which in the current low yield environment is quite difficult to achieve, if you only invest in equities and bonds. 

That is why we complement this source of income with option premium, which offers a buffer to income generation and does not oblige you to invest in high development yield stocks or high coupon bonds only, which would give you an undesired bias. It is reasonable to think that the portfolio will not lose more than twice the maximum volatility level.

Since the financial crisis there have been several episodes of all assets being totally correlated, all falling at exactly the same time. What is to prevent this happening with the assets that you have in your portfolio?

Most of the time equities and bonds are negatively correlated, but at some point they could re-correlate. This is often the case when central banks influence the market. It was the case in May 2013 for instance, when Fed chairman Ben Bernanke announced tapering, and all asset classes went down at the same time. You reduce your risk exposure by switching to cash, in order to protect the portfolio. 

But the periods when all asset classes go down at the same time, because central banks are more hawkish than expected, are transitory. Often equity markets recover and perform well in the following months. Investors understand that if the Fed is more hawkish, it is because the economy is strong enough to withstand a higher interest environment. That is what happened in the summer of 2013, which was very positive for equities.  

I am convinced that a well-diversified multi-asset fund, which offers a flexible tactical asset allocation in a risk controlled framework, while delivering a 4 per cent income carrier, is a good instrument. It meets exactly the need of private investors as core investment within their portfolios.