A Proposed Solution..
January 11, 2022
As the title implies, this is now the last in a short series of posts that addresses four important and inter-related problems with Wealth Management and by extension Asset Management and in this conclusion offers a Solution.
In previous posts we have identified what we see as four inter-related problems for Asset Management and, by extension, Wealth Management. To reprise, the Wealth Management Industry faces a problem that its flagship product, the balanced fund, is struggling to fulfil its purpose, largely reflecting existential problems with its underlying components.
1) After a decade of QE and ultra-low nominal, let alone real, yields, bonds now face rising inflation and a tightening cycle, making it difficult to see where positive returns of any sort can come from. They are now a trading instrument and/or a tool of monetary policy, they are no longer a credible long term investment.
2) Over the same period, Benchmark Equity Indices have been so distorted by passive, momentum driven, inflows that the traditional, market cap weighted, indices suffer from undue focus on a tiny number of stocks, most of which are exposed to the same industries, introducing new, but largely unacknowledged, risks in terms of stock risk/concentration and lack of diversification. As such they too are no longer fit for purpose for long term investors.
3) Ironically, at the same time as passive benchmarks have re-introduced hidden idiosyncratic risk to passive investors, the innovations brought in to help deal with skewed equity benchmarks, thousands of ‘smart beta’ indices and passive ETFs to track them, have heavily reduced the ability of active investors to generate Alpha from taking idiosyncratic risk with concentrated stock portfolios as, increasingly, short to medium term stock price performance has more to do with the liquidity and membership of assorted smart beta and thematic baskets than with the stock fundamentals. This increases the short term volatility of actively managed equity funds in a balanced portfolio.
Thus with neither bonds nor passive equities able to meet their traditional role and concentrated active equity portfolios showing increased volatility the industry has adopted a number of ‘fixes’ involving private capital markets to reduce volatility and leveraged products to try and enhance return. None of which to our mind is satisfactory. Better to go back and start again.
‘Building back Beta’
Against this background therefore, we offer a solution, hopefully taking advantage of the developments in economies and markets to use them to to our advantage, rather than struggle with trying to adapt old solutions to new and current problems. However, to do so, we need to rebuild the framework to achieve our goals of diversification, downside protection and the ability to achieve positive real, risk adjusted returns. Thus we propose to:
- Replace Bonds in the Balanced Portfolio with a number of genuinely diversified Equity ‘Smart Beta’ Indices. Here we would select a balance of five Global Indices, each exposed to acknowledged sources of ‘Factor’ return – Value, Quality, Momentum, Size and Minimum Volatility.
- In place of the traditional Equity component, we select a number of Equity Themes, mostly with a long term growth Bias. These would include, Robotics and Automation, Digitisation, Digital Security, Digital Health, Emerging Market Consumers, Clean Energy, FinTech and Gold.
- The two components are then rebalanced quarterly in the traditional manner, but the weightings of the sub-components of each are managed through a Dynamic Asset Allocation process. This utilises a systematic risk-return framework to try and only be exposed to the sub-components while they are ‘working’ and to avoid them when they are not. Crucial to this is the ability to hold up to 100% in cash. In this way we can avoid individual thematics falling out of favour and, when necessary, avoid broader Beta market drawdowns (like 2020).
Practical Implementation. – Fund of ETFs
The advantage of this approach is that there already exist large, liquid, ETFs to implement the strategy through a Fund of Funds approach, or in this case a Fund of Exchange Traded ETFs. It also makes it ‘easy’ to back test the strategy, we have already done so on the component parts – running them as both Model Portfolios and managed accounts over the previous two years, such that the ‘Performance’ of a quarterly rebalancing of these components can be shown to look as follows.
A new approach for Core Balanced Funds, Combining Global Factors and Thematics with a Dynamic Asset Allocation approach
We can also calculate the other characteristics of the Portfolio and compare them with assorted benchmarks, in this case a standard Balanced Fund return of 60:40 Equities to bonds. For clarity, this approach also outperforms the Global Equity Benchmark over the same period, but given the point we are making is related to the 60:40 fund, we see this as the more appropriate comparison.
The importance of Asset Allocation.
Multiple studies have shown that the biggest source of long term returns is asset allocation, being in the asset that is out-performing, but just as important, if not more important, not being in the one that is under-performing. Sometimes this can be true for a matter of a few quarters, sometimes it can last years – think being in Japan in the late 1980s was all that mattered and not being in was what mattered for most of the 1990s. Beating the benchmark was not the most important thing when it was the benchmark doing most of the work. Being in the right benchmark was.
However, while these are multi-year trends, our approach to asset allocation is a more dynamic one, based around a risk return framework and is probabilistic in nature. All investment is basically a balance between momentum and mean reversion; will an asset continue going in the current direction? Or will it mean revert? If so, what would that mean reversion imply for the price? Thus we can build a framework assessing the probabilities of those scenarios using prices, volumes, earnings estimates and other variables and weight our exposures accordingly. If the sub-components of our Factor, or Theme strategies all have the same positive (low) risk, we can weight them equally. However, if a component sees its risk rising then we can reweight some of our exposure to the ‘lower risk’ components according to a systematic structure. This approach can also be shown to add value over and above a simple equal weighted basket of the same components, including, but not limited to, the ability to hold cash. However, we stress that this is not a short term trading strategy and all our backtests are based on a weekly rebalancing of underlying ETFs at closing NAV. We are not seeking to generate excess return from short term trading ‘skill’. We do, however, believe that the ability to rebalance within the usual quarterly or even annual ‘review’ time frame is crucial – for by the time the end client has decided to, say, shift from quality to value, or to decrease exposure to clean energy, the upside return has almost always already gone.
In effect, we are aiming to get smarter with Beta
Importantly we choose not to be more than double weight in any individual component, if all other components are ranking highest risk, then the residual will be in cash. This means that, on occasion, the whole portfolio may be in cash, but this is part of the downside protection. Equally the discipline of the systematic approach means that the portfolio starts to reinvest as the risk level reduces, offsetting the emotional response that most individual investors feel after a sell off. The advantage of of this ‘Behavioural Finance’ driven approach to investing shows up clearly not only in the longer term backtests, but also in real time performance over the 2020 crisis period, when signals to exit in early February were matched by signals to re-engage in April, highlighting the importance of capital preservation from this type of approach and using the flexibility of cash as a better source of downside protection than holding bonds would provide.
A key point to note then is that we are not looking to use hidden sources of risk in order to generate return, we are not using leveraged products, nor are we using illiquid instruments in order to capture a liquidity risk premium. The post Covid performance shown here has three key components; first, while not getting out right at the top, the system did move to cash in February 2020, when, it should be remembered, Bonds sold off as well as Equities, obviating the notion of inverse correlation. Second, it started to move back into equities in April 2020 and, while the buy and hold investor saw a sharp reverse in both bonds and equities thanks to Fed intervention in March, for most active or semi active investors, this was a time when they were taking risk off the table, rather than putting it on. This was particularly important for the third aspect of the return, the steady increase in exposure to longer duration, thematic, equities in the second half of 2020 as the risk-off de-rating in H1 2020 was reversed. Here again many active investors delayed re-entering this area until early 2021, by which time most of the re-rating was over. Indeed, 2020 saw the ‘Equity’ part of this strategy – the thematic equity baskets – up 52%, but this year they largely traded sideways overall, while the ‘Bond’ component, the Global Factor element was up 16% in 2021 after 21% in 2020. Global Bonds by comparison were up 9% in 2020 but down 4.7% to a $ based investor in 2021.
In our series of posts we have sought to address one of the key considerations for Wealth managers and by extension the Asset Management industry overall, what to provide as a ‘Core’ component of a Portfolio in a world where not only are bonds no longer offering any of things they are supposed to, i.e. low volatility, uncorrelated returns, downside protection and, last but very much not least, a source of income, but also where benchmark equities are offering what amount to narrow and highly concentrated exposure to a small number of mega Cap stocks. With rising prices and governments not unhappy to see the real value of their obligations decline, it is difficult to see how this will change for bonds in the near future, while the practice of chasing benchmarks like the S&P that are now the most concentrated for 50 years is creating a dangerous amount of concentration and momentum risk in what are supposed to be low risk tracking funds.
Our approach is to focus on risk, in so far as being transparent as to which risk we are taking in order to generate a return. The traditional approach focuses almost exclusively on volatility and correlation and in seeking to limit these it ‘allows’ for other risks to be taken to generate returns. Alterative sources of income, essentially coming from Corporates via dividends or credit or property such as REITs can help with the lack of bond yield, but they need to be assessed for company specific risk – a bad credit may be better than a bad equity in the same corporate entity, but that is not the only, or indeed, the correct point of comparison. An Evergrande Bond may outperform Evergrande Equity, but there is no need to be in either. Equally, leverage as a source of return, be it in the underlying corporate structure itself, or in the ‘asset’ offering the return needs to be recognised not only as a source of potential return, but also of potential fragility. Private markets too, may appear to offer a low risk in terms of volatility, but that comes at the expense of illiquidity and, often, leverage. The big benchmark indices offer concentration risk in the biggest stocks, largely eliminating the benefits of diversification, while country specific benchmarks can offer very skewed economic exposure to one or two sectors and a dangerous degree of momentum – which as we know from the GFC can give the false impression of low volatility until it suddenly switches to negative momentum.
We believe that one approach is to replace Bonds with a basket of Global Equity Factor indices to achieve diversification, with the ability to rotate not only into winners and out of losers but also, where necessary, into cash. From an underlying investor viewpoint this ability to switch between factors such as Value, or Size and others such as Quality or min Volatility within a quarterly time frame, while not a trading fund, allows for timeliness based around risk assessment. For the ‘Equity’ component, the same ‘buy and hold but risk-manage’ approach leads us to look at Global Thematics, rather than traditional country or sector benchmarks or even stock specific approaches. (Remember this is for the ‘core’ part of the client portfolio, the more active themes and rotations can still sit in the ‘satellite’ part.) Largely focused on growth, a basket of themes can offer differentiation in terms of duration (some have higher near term cash flows, others almost entirely in the future) as well as some hopefully low or even inverse correlation for downside protection (the key rationale behind the emerging market consumer or gold for example.) The dynamic asset allocation process helps us be exposed to the themes when they are performing – either through recovery or momentum, but to rotate out and ‘rest’ when they become over-extended. As with factors, the process enables us to be flexible without being short term traders.
We recognise that the system may continue to ‘require’ investors to hold fixed income in some form due to capital or risk requirements, but we also believe it is now the time to rethink the Core 60:40 offering and that this proposal can help underlying investors return to the basics of risk and return in a simple, affordable and scalable manner.