Multi-Asset Strategies

In an era of fast-moving financial markets, investors can sometimes wonder how to keep up. Five years after the financial crisis, investment managers have adopted a wide variety of responses to help their clients cope. One of the solutions that has drawn rapidly rising asset flows in recent years is multi-asset investing strategies.

As the name suggests, these portfolios range across asset classes in search of more consistent returns with lower volatility and risk. Within this broad definition, different firms have developed different approaches. They vary across investment time horizon. Some focus on macro factors; others on fundamentals.

For investors, these strategies present some questions in portfolio construction terms. Can a multi-asset strategy take the place of an allocation to equities, for instance, or is it generally considered as part of an alternatives bucket? To answer this and other questions, P&I brought together three expert money managers to explain the benefits of portfolios that invest in all sorts of asset classes and across geographies.

Nicolas Gaussel: The definition is simple. The key rationale for running a multi-asset strategy is to take advantage of the power of diversification. To get that effect and the extra return benefits, you must invest in a variety of asset classes, not just one. By diversifying, you can get the same return with less risk or, if you are ready to leverage, more return with the same risk.

Michael Kelly: The definition has evolved somewhat. Multi-asset used to be the vehicle that delivered a strategic mix and thus a relative return outcome driven by markets. Today, multi-asset strategies seek an absolute return – a solution to markets. The risk/return parameters have changed and the eligible universe of asset classes has widened. Multiple sources of assets and multiple sources of alpha contribute to a smoother ride, which is a key goal in an absolute return solution.

Tam McVie: We view multi-asset investing as unconstrained investing within a strong risk framework. We describe ourselves as being risk aware or risk informed. We're certainly very concerned and interested in liquidity and the scalability of our investment positions. We also don't tie ourselves to any traditional benchmark; we're seeking an absolute return and as such have a cash benchmark.

Michael Kelly: Investors today are looking for an updated approach to give them a different outcome should they go through another very challenging time like the global financial crisis. Before the crisis, investors were happy to take a long-term strategic approach that involved a willingness and ability to look beyond the peaks and valleys in the market. When the markets are going up, that's very easy to do.

But come 2000 to 2006, that approach started fraying around the edges and investors began to question whether it was still suitable for the world we lived in. The financial crisis shattered the illusion that investors could look beyond the valleys. Since then they've been looking for more opportunistic approaches to where the returns are and updated approaches to risk control. There have been many different answers.

We think you need to look beyond diversification. The strategic approach to investing – the one followed by most before the financial crisis – involved setting a long-term strategic asset allocation and supplementing this with a small degree of short-term tactical, market-timing approaches. This relies first and foremost on a religion that diversification is the only form of risk protection you need. While this is undoubtedly a very useful and important form of rotection over the long term, during the valleys – when markets go down – diversification benefits almost completely disappear.

Tam McVie: You do get a lot of different reasons as to why people utilize a strategy like multi-asset investing, but we see that the majority of our investors are looking for a differentiated return stream, one that is consistent and behaves differently from the traditional asset allocation framework.

Nicolas Gaussel: There are some structural reasons why multi-asset investing is attractive. It allows you to diversify the risk and enhance the return available from investing in each individual market. This diversification allows you to weather the bad times of a specific market. To make it really effective, you need to size your investments so that they are comparable in terms of risks. You also need asset classes to move as autonomously as possible, which is the case when markets are focused on fundamentals. This has been the case since mid-2012 fuelling good returns for those strategies.

Tam McVie: Ours is a macro-led strategy. We identify 25 to 35 longer-term macro-driven ideas. We want the strategy to be highly liquid and highly scalable. Importantly, we look for longer-term ideas because we think many market participants are very focused on the short-term and that creates inefficiencies over the longer term that we can take advantage of. We think we have a better chance of getting our views right over the longer term.

We insist that all of our positions have a positive return expectation on a forward-looking basis. The individual positions could be as straightforward as just owning U.S. equities. Or it could involve views on currencies or implied volatility of different markets. It can also include relative value positions between different markets. So each position must justify itself in isolation, but when you aggregate these positions into a portfolio, it becomes highly robust. We construct a portfolio that is capable of performing well not only when what you expect to happen in the world happens, but also when it doesn't. We acknowledge that we don't know what is going to happen, so we build a portfolio that can perform well under a range of different circumstances – and provides more opportunity to protect against downside risk and tail events.

Michael Kelly: Our particular multi-asset solution is intermediate-term orientated. It's fundamentally driven and instead of taking a very long-term strategic approach to return, it takes a dynamic approach to risk and return. It recognizes that the outlook for fundamentals and thus the risk/return opportunity set is always slowly evolving. So we too evolve dynamically.

The reason that we take an intermediate-term approach is that our research shows that markets and fundamentals are almost divorced in the short-term. The same research shows that markets do begin to connect quite nicely with fundamentals over nine to 18 months. We are a fundamental firm at heart, so we connect the two through a process we call Capital Market Line modeling, which is the effort to judge the return and risk potential of each asset class over the next five years. What comes out of this effort is the ability to seek and accomplish total return, instead of relative return. We are looking for returns consistent with CPI plus five percent over five years.

Nicolas Gaussel: We aim to give investors access to the largest possible opportunities provided by liquid financial markets. We aim to invest broadly across the world to complement what many investors probably do locally. We aim to produce consistent returns by ensuring that the risk of a single asset class does not dominate the portfolio.

A key element of rational multi-asset investing is to understand that it is infinitely difficult to predict which asset class will perform best in the next year. Our risk-based approach to multi-asset investing means a balanced distribution of the risk sources across these opportunities, in order to deliver stable absolute returns. In our multi-asset portfolio, we do not engage in security picking. Instead, we focus on tactically seizing market opportunities. The rotation of performance contributions illustrates the benefits of this approach.

Michael Kelly: To us, it's vital because if you want to deliver high total return and move away from a bumpy relative return world and smooth the ride, you need to recognize that in the intermediate term, risk itself changes. In an evolving, changing world, we think you need to be dynamic, which does not mean short-term and tactical because those approaches don't have a high probability of success as they are insensitive to fundamentals. We believe fundamentals are more predictable than those measures used in making tactical decisions.

Nicolas Gaussel: We agree on the need to be dynamic because the risk opportunities of each asset class vary over time. If you look at correlations, they can change dramatically over time. So at one point in time, European equities can mitigate the risk of Japanese equities, while at some other point in time, these two can be highly correlated.

You have to make a choice as to whether the risk – and the performance – of the portfolio should vary over time or not. Most investors want to stabilize the risk and the performance, so then you have to adapt to changing conditions. In our flagship Lyxor absolute return multi-asset strategy, the series of returns is very stable. This is achieved with a very different level of diversity in terms of asset allocation in each year, which enables the fund to benefit from the complete economic cycle.

We are very dynamic, we follow three steps to construct our portfolios on a weekly basis. First, on a weekly basis, we look at our neutral positioning, and how we view the risk of each asset class and its correlation. In this way we size up the relative risks of investing in each asset class. Second, we consider our own views on macroeconomic and price signals. For example, in January and February 2013, we felt the risk of a hike in interest rates was high, so we trimmed our bond exposure. Finally, we look at the portfolio overall and adjust it to maintain a stable amount of money at risk so as to seek absolute performance while limiting the risk of negative returns.

Tam McVie: We may be longer-term investors, but we still think it is very important to be dynamic. For us, this isn't about high frequency. But things do move quickly occasionally and you have to be able to react. There have been times when we have moved quickly, usually taking profit rather than taking positions off for risk reasons.

You have to think about the changing environment. So for example thinking about duration. The prospect of what you can earn from the U.S.10-year is very different than it was four years ago, two years ago and even arguably a year ago. You have to think about forward-looking return opportunities. It's about not being rigid in your thinking.

So do we know what's going to happen over the next couple of months with U.S. Treasuries? Not really. But I think it's a reasonable assumption to think that in three years, the U.S. 10-year is going to be yielding more than it is today. So on a forward-looking basis, we don't think you're going to make money holding the U.S. 10-year and we're also not sure that it will provide the same diversification going forward. So now you need to think about whether it will be possible to make money on a relative basis. Today we are positioned long European bonds while at the same time being short a combination of U.S. and Japanese bonds.

Michael Kelly: Let me start by defining risk-based because our definition differs from some of the more popular definitions, like the definition of risk parity. Many take the view that returns are unknowable (which is a passive approach to returns) while at the same time claiming risk is knowable and quantifiable because it mean reverts. They believe in merely managing risk and assuming the returns will be there.

Over time this approach will not be successful in our view. We believe risk and return should be equal partners; they are two sides of the same coin. By implementing our forward-looking fundamental process, which focused on where returns are being created and risks are rising, we mitigated the downside for portfolios quite admirably during the crisis. We view ourselves as risk-based, yet not driven solely by risk. Importantly, we are not attempting to rediscover

risk post-crisis.

Tam McVie: Yes. We allocate to positions based on risk. We use risk models and historical data to be risk-informed in combination with our qualitative skill and judgment about how the market is behaving real time and over the next few years.

Nicolas Gaussel: There is a temptation when interest rates are low to consider that they can only increase, which is really wrong. The Japanese example shows this. To date, even the European example shows that interest rates can go down and the U.S. is maintaining interest rates at a low level.

Low interest rate environments with limited carry will fuel high valuations of equities. Equities look expensive, but the question is, are they really expensive given the very low rate environment? Our computations of equity premium show that they are not so low as compared to long-term averages. If earnings per share keep appreciating, there will still be room for equity appreciation.

We don't see rising volatility at the moment. In fact, our indicators of risk are plummeting and we see low risk pricing in the market. Our view is that this is a good opportunity to put more money at risk because risk is low. But you have to be prepared to be dynamic, because changes can happen quickly.

Tam McVie: I agree with Nicolas in that volatility is particularly low currently. It's low, but of course at some point volatility will rise. But from our perspective, changes in the environment don't always change the way that we position our portfolio in the sense that we are always trying to be highly robust.

We seek to deliver a return target of cash plus 5% on a rolling three-year period with the least amount of volatility, so that's regardless of the environment. One observation about the current environment is that especially as multi-year investors, you have to be more thoughtful about how a negative carry is eating away at your return.

Michael Kelly: Today our Capital Market Line is positively sloped yet at low levels, foreshadowing low nominal returns with rising volatility over the next few years. We believe challenging times lie ahead. Fortunately, in dragging down the Capital Market Line, one asset class at a time, we have seen quite an uneven market cycle.

We think it is important to move away from owning a little bit of everything in a capitalization-weighted way. We think that over-diversification in today's world will lead to a very mediocre return. But if one has a process and an aptitude to be more dynamic, selective and opportunistic in the asset classes you embrace, we believe you can still achieve high single-digit returns with a well-diversified multi-asset class approach in the years ahead.

Michael Kelly: We do believe that the point of the economic cycle is important. It's also equally important to see the shape of the business cycle ahead and how it is priced by the market. We think the biggest risk lies in the 'risk-free' curves around the world, with the Japanese Government Bond curve being the most dangerous asset class ahead. Historically these curves have been risk-free. Going forward we think many will act like very risky assets. The German Bund market and even the U.S. Treasury market are other examples of what is not attractive.

In a QE world, most asset classes are priced on the rich side. Some are a little rich; others are extremely rich. The risk-free curves are the richest of the rich. That means that the degree to which equities, for example, will give a superior return to risk-free bonds is almost normal. This is true overall for other growth assets, like real estate and private equity. Yet the key is dispersion within and across asset classes, which is unusually wide today. Mid-market private equity is still attractive whereas large deals are not. Opportunistic real estate is attractive whereas core real estate is not. So you have to be opportunistic and selective. We also like Japanese, European, Indian and Mexican equities, many emerging market debt markets as well as bank loans, some private debt, timber, and the U.S. dollar.

Tam McVie: Volatility is the cheapest asset class around, so if it's an asset class you can access, it's cheap. You still need to be very thoughtful about how you implement that view because there's a negative carry in being long volatility.

If we go through our positions currently, we're long implied volatility on a pretty broad range of different equity markets. We think it's cheap enough for us to make money in the normal course of events, but should we have a risk-off shock, these positions should do incredibly well. We've also got some relative value positions because we see some dispersion between the volatility on Asian stock markets compared to the U.K. and the U.S. We own some U.S. equity beta, but have been implementing using call options for some time. On a multi-year timeframe, we see a lot of opportunity in currencies. We're short the euro and have been for a long time. We're short the yen. Some macro-traders are bored with Japan and have moved on. We still see an opportunity for depreciation.

Nicolas Gaussel: We would advise that investors should be thinking about investing in equities. They have an acceptable level of risk. The valuations of equity premiums for the U.S., European, U.K., Japanese as well as emerging market equities are in the same range. As a result, the risk reward equation tends to favor developed market equities rather than emerging market equities.

Credit markets have converged and tightened, though we still can see some opportunities, notably in specific hedge fund strategies around structured credit. However, there isn't much room in our multi-asset process to access them.

Nicolas Gaussel: It can sometimes be difficult for some investors to incorporate these strategies into their portfolios because it goes against the governance structure, which outlines an asset allocation. Many pension plans and other long-term investors get around this by putting the multi-asset allocation into a separate absolute return bucket. Multi-asset strategies provide a very efficient way to achieve absolute returns in a scalable, transparent and liquid manner.

Many investors have a distinct domestic bias. If you are a Japanese pension plan you are often more comfortable investing in Japanese equities, and perhaps Korean or Hong Kong equities. Other markets may seem remote. Multi-asset strategies can be a way to gain a broader international exposure to complement their domestic holdings.

Tam McVie: Many investors, when we introduced our first multi-asset strategy, used it as part of a de-risking program. Our first client was actually our own closed defined benefit pension plan.

Our multi-asset portfolios are used in a broad range of different investment programs. By delivering a similar return to equities over the very long term with considerably less volatility, investors can achieve more diversification and also improve their overall risk return result.

Michael Kelly: We see investors heading towards outcome-based investing. With more opportunistic views of return and a more nuanced approach to risk all over the world, we are fortunate that our approach can play a role here. In Australia and much of Asia, defined contribution schemes are mandatory, so they are growing at a very rapid pace. Some of the biggest and brightest superannuation funds are using three to five different managers for dynamic asset allocation as idea generators that will help them morph the remainder of the fund to less of a relative return orientation and more of a total return, outcome orientation. The result is an overall new and better mix.

These investors aren't putting a massive amount of assets into these strategies. They are looking for managers with very different approaches where they can borrow elements from those approaches and stretch them across the rest of the portfolio.

In the U.S., corporate pension plans that have spent the last five to seven years perfecting the liability driven side of their investing programs are now just beginning to move away from tight-ranged, old-fashioned strategic asset allocation. They are implementing more opportunistic approaches to the other side of the program – the return-seeking side – and multi-asset products have a role here as a new and growing allocation for that return-seeking side.

A lot of investors are wandering outside their countries for the first time, and as Nicolas said, these strategies offer a way to access unfamiliar markets. The big pension plans in Latin America – Mexico and Chile for instance – are growing rapidly and have too much liquidity to invest at home. Global multi-asset strategies are attractive to them. In many retail markets, the only opportunity set has been various equity and fixed income funds. Multi-asset products are being offered here as a new liquid alternative that has the potential to offer a broader, smoother ride.