With ever-evolving financial markets we have seen increased liquidity, leverage and sophistication but also higher asset volatility and correlations.
Cross-asset investors are questioning the efficacy of traditional approaches, having witnessed the failure of risk models over the 2008 crisis.
Asset class diversification, the basic tenet of cross-asset investing, did not work because the risk factors embedded in traditional asset classes turned out to be highly correlated, and provided no shelter in turbulent markets. Investors are now realising that in order to deliver a truly diversified, risk-controlled portfolio, it is necessary to diversify the risk factors themselves – and this means looking outside the traditional asset class toolkit.
Diversification is an often-used, but much-misunderstood term. Examining the risk of a typical balanced portfolio, one can see that contribution to total portfolio risk from bonds is minimal and that it is equity variance that dominates portfolio risk.
For the average balanced portfolio, overall returns will still depend on the vagaries of the equity market. More sophisticated investors have intuitively countered this problem by diversifying the typical multi-asset portfolio into corporate and emerging market bonds as well as further-flung equity markets. Yet still, at its core, the portfolio has exposure to only three broad risk factors, namely equity, interest rates and credit quality. With negative and rising real yields on government bonds currently pushing investors to further overweight equity and credit – two highly correlated risk factors – the risk-mitigating qualities of such a portfolio is in question as the bull market matures.
Some investors have taken a different approach, moving away from traditional assets into ‘alternatives’. However, the term is nondescript with the alternatives spectrum encompassing everything from property and infrastructure funds at one extreme to opaque hedge funds at the other. This amalgamation of alternative assets into one ‘asset class’ is unhelpful in the quest for risk factor diversification, especially considering the terrible, and correlated, returns from property and some hedge funds over the crisis.
However, a closer look at the alternatives space shows that the ‘asset class’ can be decomposed into two broad camps – those asset classes that are ‘illiquid’, with investments that are typically associated directly with the physical world – property, infrastructure etc – contrasted with those alternative asset classes that are ‘systematic’, with investments linked to liquid trading strategies in financial instruments.
Access to alternatives of both types has been a problem in the past, with liquidity, fund structure and cost of the available vehicles all proving prohibitive. Yet it need not be: risk factor-based investing has shone a light on structures such as hedge funds, to expose not only how returns are generated, but also that elements of these returns are systematic, and therefore replicable in low-cost, liquid format.
Just as long-only equity fund returns are decomposed into style risk exposures as well as broad market (beta) and stock selection skill (alpha), so too have hedge fund returns been dissected. While many hedge funds give access to the returns of truly skilful managers, much of the industry’s returns can be explained in ‘systematic’ terminology.
