Clarify the goal
Clearly defining and understanding the investment goal is critical for accurate reporting on performance because it implicitly provides key information about time horizon, risk tolerance or other factors that should steer the way to set up the performance attribution.
“Hopefully you’ve crafted a benchmark that properly reflects the goals that the client has, [so] that when we’re achieving or beating that benchmark, it essentially can be inferred that we’re also achieving that goal,” Hubrich said. “So the link between goal and performance attribution really happens at the very beginning, when you translate the client-specific goal into a portfolio mandate expressed through benchmark indexes, time horizons and fees, etc.”
For example, an absolute-return strategy might include a goal of beating a cash benchmark return by a specific amount over a certain period of time. “In that case, the first question is, ‘Did you?’” Hubrich said. “The only thing that makes it a little less simple than it sounds is that if investor goals are informed by risk considerations, the risk that was taken to achieve the return also becomes very important.” For example, the same level of performance is more or less attractive if less or more risk had to be taken to achieve it, respectively.
As another example, he said some multi-asset portfolios have mission-driven goals, such as to hedge inflation. “Then, over time the question you want to ask in addition to performance is, ‘Did this strategy correlate with inflation surprises the way you were hoping it would?’”
Of course, over the last 10 years deflation has been a bigger issue than inflation spikes. In this case, “you should not be surprised that that strategy looks like it’s underperforming,” Hubrich said. “It was your goal to hedge inflation. That’s one more example [of] why establishing a clear understanding at the beginning is so important.”
Negotiating expectations
Hubrich emphasized that “that’s why an upfront discussion with clients is so important, because that’s where the expectation setting happens. Once you’ve said go and you’re on that path, it gets really hard to then renegotiate what expectations should be.”
In addition to the outcome expectations and the time horizon, the frequency of reporting on multi-asset strategy performance is important, and it’s another component that institutional investors need to understand upfront.
“When you do performance attribution, you’re trying to accomplish two things,” Hubrich said. “The first is an accounting of what happened, and that’s OK to do on a pretty regular basis. If I’m on [an investment] board, I may want to know what happened with some regularity. Otherwise I might be remiss in my monitoring obligations.
“The second purpose of attribution is to assess the quality of the investment decisions that were made. And as we all know, skill accrues with time. And so the way I think of that is, if you’ve hired a manager for a certain investment strategy and you think that strategy can deliver a certain Sharpe ratio, unless that Sharpe ratio is really high, you may need a pretty long time, measured in years, to statistically determine whether or not the strategy is working, just because it takes time for the mean ― or the skill ― to start driving the cumulative return, as opposed to the volatility [seeming to drive return] along the way.”
When designing the multi-asset strategy, a complete understanding of goals, risk and time frame is critical, and understanding the risk management component should be a top priority because it’s elemental to building the portfolio.
“For a buyer of an investment process, the fewer official constraints a portfolio has, the more important my understanding of the risk management,” he said. “If I want managers who would go anywhere and have no constraints, I really need to understand their investment processes and their risk management.”
Hubrich explained that risk considerations are a major component of building multi-asset portfolios because, compared to the individual asset class universe, multi-assets present investors with a very heterogeneous set of investment opportunities ― things that are really difficult to compare at face value.
“Looking at multi-asset through a risk lens, which is the volatility level and correlation, or how they relate to each other, becomes the great equalizer. It becomes the thread running through your portfolio that enables you to put together a coherent, mutually consistent set of risk positions. Risk is the only way to look at things on an equal footing.”
Predicting changes in risk
What’s more, risk isn’t static. It changes over time — and that can be predictable.
“The way the market went the last month in terms of direction tells you practically nothing about the way it’s going to go tomorrow,” Hubrich said. “But if you look at the realized daily volatility over monthly periods and find that, for example, the realized volatility in October was high, does that on a relative basis indicate higher volatility in November? The answer is, generally, yes. In a statistical sense, risk is actually forecastable. Not with perfect confidence — nothing is! — but with much greater confidence than returns.
“We can forecast the risk and we can forecast the way it changes, and so we use that in our portfolio management,” he said. “If you’re managing multi-asset and you don’t talk about risk, something is off. Risk should inform your portfolio construction.” •
