Ever since the global financial crisis, many investors have been anxious over the possibility that any surge in volatility may presage a 2008-style equity market plunge. Seven years into the current equity bull market, many investors still carry psychological scars from those traumatic days and have derisked their portfolios by reducing equity exposure. Meanwhile, though, they still must seek to grow their assets to meet rising liabilities and costs. While managing long-term volatility and tail risk may seem to conflict with simultaneously seeking equity-like returns, we believe it is possible to successfully do both.
Some investors employ multiasset strategies to curb volatility. These strategies manage total portfolio risk, rather than active risk, and offer greater flexibility than traditional approaches, including the ability to short. They aim to smooth out the stock market's bumps, but they may not deliver the returns required to meet investors' objectives. Before choosing strategies that seek, above all, to lower volatility, we believe that endowments and foundations, plan sponsors and even individual investors facing retirement funding challenges should consider whether the 4% to 5% returns typically delivered by absolute-return strategies can satisfy their long-term requirements, or whether a larger allocation to growth assets is worth considering.
No one wants to repeat the experience of 2008 or the similarly severe equity market declines that took place in 2001, 1998 and 1989. But those traumatic experiences should not overshadow the fact that over the long term, the average equity drawdown for any calendar year has been 14.6% from peak to trough.
We believe strategies can be designed to deliver returns slightly below the 8% historical average for equities while restricting drawdowns to no higher than the long-term average. The key is to identify attractive multiasset investments and specifically target a volatility range, rather than simply accepting the fluctuations inherent in investment approaches that use traditional benchmarks. These traditional approaches do not typically protect significant capital during periods of heightened volatility and are particularly exposed to downside tail risk in times of unforeseen events. A comparison of the performance of traditional benchmark-centric strategies with more flexible multiasset approaches in the immediate aftermath of the U.K. referendum on leaving the European Union illustrates this point effectively.
By focusing instead on shorter-term measures of volatility and dynamically adjusting equity exposure in response to changing conditions, we believe we can create a smoother long-term return profile. The objective of this approach is to offer investors a dynamic asset allocation based on attractive investment opportunities that can be adjusted to reflect the market risk environment from a strongly growth-oriented environment to a more defensive one.
Without doubt, implementing this dynamic approach requires resolve, and investors must be willing to re-risk their portfolios and reallocate to growth-like assets at times when volatility is declining. This approach requires timely decision-making and execution by plan sponsors. It also requires a symmetrical and disciplined volatility management approach to eliminate potential missteps caused by emotional decision-making in the heat of a market crisis.
Naysayers may argue that this approach prevents investors from correctly picking the absolute market bottom when re-risking. But that's not what this dynamic approach is about. Rather, it's about dynamically managing exposures in an effort to provide higher returns than typical absolute-return strategies can, while minimizing drawdowns in order to improve cumulative returns over time.
While investors can create these types of strategies on their own, it's not easy or without risk. Many institutional investors face staffing limitations and resource constraints, not to mention governance challenges and risk-averse investment committees.
Taking a dynamic approach may offer a way to avoid the opportunity costs associated with strategies that target low absolute returns. If you believe that cash will remain close to zero over the next few years, an absolute-return strategy that aims to deliver a return of cash plus 4%, assuming the strategies achieve their target, may deliver a return that hovers around 4% before fees. Investors should ask whether this is sufficient for the risk-seeking parts of their portfolios.