In search of portfolio resilience

In an uncertain environment, many investors are looking for ways to make their portfolios more resilient. We examine the challenge from different vantage points and offer strategies for the long term.

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

More than defense

An aging cycle, rising geopolitical risks and heightened market volatility all seem to threaten the ability of investors to reach their objectives. One major result is a renewed focus on the concept of portfolio resilience—always good to have, but especially important now.

Widely used these days, the term “resilience” sometimes connotes a defensive bias. We think there’s more to resilience than that. Investors need to participate on the upside as well as to mitigate the downside. We believe that a truly resilient portfolio should be:

• Consistent: Deliver steady risk-return performance across market cycles

• Diversified: Maintain exposure to multiple uncorrelated sources of return

• Risk-aware: Able to manage risk and mitigate volatility

• Flexible: Capable of capitalizing on shifting market opportunities

How does one build a portfolio that has these attributes under current market conditions? There is, of course, no one-size-fits-all answer. But considering the question from multiple perspectives can help bring potential solutions to light. To that end, we’ve asked four senior investors from our multi-asset and fixed income platforms to share different approaches to a common goal: building truly resilient portfolios that can navigate short-term shocks while capitalizing on long-term trends to optimize risk-adjusted returns across market cycles.

Our Q&A participants are:

• Philip Hodges, Head of Research for Factor-Based Strategies
• Philip Green, Head of Global Tactical Asset Allocation
• Rick Rieder, Chief Investment Officer and Co-Head of Global Fixed Income
• James Keenan, Chief Investment Officer and Global Co-Head of Credit

Use factors to build more diversified portfolios

Q: How are you looking to build resilience in today’s market environment?

A: We believe the economy is starting to slow, and that the easy money of the equity bull market is largely off the table. So we think that now is the time to start diversifying portfolios into exposures that can do well in different market environments.

Adding interest rate risk or inflation risk to a portfolio that is heavily exposed to equities—and thus to economic growth risk—can be a good place to start. Within an equity portfolio, investors may want to consider tilting toward quality or low-volatility stocks, or both. These moves can help investors build resilience, while still targeting the returns they need.

Q: What steps are required to construct a resilient, factor-based portfolio?

A: Step one is to determine what actually drives the returns of different asset classes. We’ve found that six macroeconomic factors—economic growth, real rates, inflation, credit, emerging markets and liquidity—explain more than 90% of the returns across asset classes.

Step two is to balance risk across these fundamental drivers of return. Because many different asset classes are exposed to the same common sources of risk and return, we believe that it’s much more effective to diversify your exposure to factors than to asset classes.

Step three is to be very aware of the risks of market extremes and to provide downside mitigation during periods of economic stress. This is a crucial component of building resilience into a factor-based strategy. There are some environments in which even well-diversified portfolios are subject to severe drawdowns, so you need a process in place that allows you to act nimbly and decisively in adverse environments to try to mitigate losses.

Q: How does the multi-asset, factor-based strategy you're describing differ from a traditional risk parity approach?

A: Over the course of many years, a variety of multi-asset investment approaches have come to be grouped under the term risk parity. Recent market conditions have impelled many investors to look more carefully at the similarities and differences among these strategies. We think that our approach stands apart in two ways. One is that we balance factors, not asset classes. Factors are the fundamental building blocks that drive risk and return across asset classes, so it makes much more intuitive economic sense to balance factor exposures.

Number two is that we don't actually believe that parity is optimal. Parity works if all risks are equal, but we think that different risk exposures lead to different long-term return outcomes. We take an active approach to seeking the appropriate balance among the risks in a portfolio. Different risks also have different tail characteristics, and allocating with an awareness of those characteristics can play a key role in improving a portfolio’s resilience. The bottom line is that we believe in balance, not in parity.

Q: Are more investors using factors to help with portfolio construction?

A: We’re definitely seeing an increase, and we’re trying to make the process more transparent and easier to navigate. To that end, we’ve created two tools—Aladdin Factor Workbench and Factor Discovery—that can help investors understand the factor exposures in their portfolios. Once they have that information, they can get a better idea of how well their portfolios actually line up with their investment objectives. Often, a factor analysis reveals that portfolios aren’t as diversified as investors think, and that there may be a disconnect between their exposures and their objectives.

When investors identify a disconnect, they have several options to get their portfolios better aligned with their objectives. At the extreme, we’ve seen some institutions completely switch their approach to strategic asset allocation, such that they allocate to factors rather than to asset classes. While this clearly isn’t going to be possible for all investors, it does represent the purest expression of the factor approach. But even a small allocation to a multi-asset factor-based strategy—or simple, factor-aware changes to an existing asset allocation—can improve the resilience of many portfolios.

Adapt to changing market conditions

Q: How are you looking to build resilience in today’s market environment?

A: To build more resilience, we start by analyzing the macro environment, including the outlooks for economic growth, inflation, fiscal policy and monetary policy. We then draw insights from that analysis and look to see whether or not those insights are priced into asset classes, including equities, bonds, currencies and commodities.

For example, we might determine that the global economy is accelerating from an already high level. If that insight is already priced in across asset classes, then we won’t make any changes to our portfolio. But if one or more asset classes are not reflecting that insight, we’ll increase our position in the asset class that appears to be the most mispriced, while also factoring in sentiment, crowdedness and possible asymmetrical payoffs.

What’s different about this approach is that we’re starting with insights and then looking for the best asset class in which to express those insights, rather than just building a portfolio asset class by asset class. What often happens when you take an asset class approach to investing is that your exposures within equities, bonds and currencies are all correlated, because they’re all based on the same insights.

We think it’s very important to start with a broad, diverse set of insights and then look for asset classes that are attractively priced according to those insights, and we believe this approach can help to build better-diversified, more resilient portfolios.

Q: A lot of investors think we’re nearing the end of the current cycle: Do you agree?

A: I think there is a general consensus that we’re in the latter stages of the cycle, but that’s not entirely clear to us. For several years, many investors have believed that we’re late in the cycle, but the cycle seems to continue.

We think the cycle has further to run, and a big reason for that has to do with monetary policy.  Policymakers can have significant impact on market and credit cycles, and we think that the Fed’s new, more patient posture—as well as the patience we’re seeing from other major central banks—will allow this cycle to carry on further than some participants appreciate. That said, we are hyper-vigilant about tracking changes that could indicate a turn in the cycle, so we’re constantly monitoring a multitude of economic indicators, in addition to tracking valuations.

Q: It seems clear that markets have entered a more volatile stage. How does that affect your strategy?

A: We actually welcome higher-volatility environments. Increased volatility gives tactical asset allocation (TAA) strategies—and other macro strategies—increased opportunities to capitalize on changing market prices. As TAA investors, we’re looking at two types of volatility. First is the obvious one of price volatility across stocks, bonds, currencies and other asset classes. But we’re also interested in the volatility of the fundamental variables that I mentioned earlier—things like growth, inflation, central bank policies and other macroeconomic indicators.

One of things that can drive opportunities for us is the relationship between price volatility and what I’d call fundamental volatility. In the environment we’re in now, the volatility of prices is quite a bit higher than the volatility of the fundamentals that we are tracking, and we see that as an excellent climate for us to attempt to add value and build resilience for our clients.

We don’t believe that we’re going back to the low-volatility, high-return environment that characterized much of the post-crisis period when central bank policies effectively amplified the returns and reduced the volatility of most asset classes. So when volatility presents opportunity, we think that it’s critical for institutions to have the flexibility to adjust their strategic asset allocations.

Take an unconstrained approach to fixed income

Q: How do you build a resilient fixed income portfolio in today’s environment?

A: We’re really focused on what I call efficient portfolio construction. We run some very sophisticated analytics to assess things like beta risk, volatility and dispersion, with an eye toward understanding how all of the assets in a portfolio are interrelated.

One very important theme that arises from this analysis is the renewed role that Treasuries can play as a hedge in a portfolio. In this environment, we think interest rates are likely to remain range-bound for the near term, which means investors can once again use duration as a hedge to build more durable portfolios. At the same time, we’re faced with a slower global growth dynamic, so we think it’s important to be cautious around credit risk. We have a high-quality bias across our allocation to credit that we rely upon to source durable income. In areas like high-yield, we are very selective and favor idiosyncratic opportunities rather than broad index exposure.

Q: How do you approach risk management in your portfolios?

A: We believe in casting an extremely broad net in search of returns and in taking a cautious, deliberate, and flexible approach to both investment selection and risk management. We avoid concentrated bets and instead seek out the many and diverse sources of alpha that markets offer. In our experience, targeting a wide array of incremental return opportunities, without being tied to a benchmark, can help keep volatility low while enabling investors to seek returns across different market environments and cycles.

We also spend a lot of time looking at marginal contribution of risk. We want to understand how every individual asset and every sector that we’re considering adding to a portfolio would impact the risk of the overall portfolio. If you can understand that, we think you have a much better chance of building a stable, resilient portfolio that doesn’t experience massive up and down swings, even when markets come under pressure.

Our goal is not necessarily to have the best performance in up markets, but we definitely want to avoid having the worst performance in down markets. We want to create consistent returns for our clients, and the portfolio construction and risk management strategies that I just described really form the backbone of our approach.

Q: Which market or macro risks are you most concerned about?

A: There are two things that come to mind. The first is China—I think a lot of people underestimate how important China has become to the global economy and, by extension, to global financial markets. When you look at China’s contribution to global growth, its importance to commodities markets, the amount of debt on its books—these are all variables that can have a tremendous impact on market outcomes. To be clear, I don’t think China is headed for an imminent hard landing, but I do think that investors need to monitor the situation there very closely if they want to build resilient portfolios.

The second risk is what I call short-volatility liquidity. There are many more ways to take a short position in volatility than there were in the past, and a lot of investors piled into various short volatility trades over the past several years of relative market calm. But when markets come under stress, the liquidity in a lot of these trades can evaporate. So I think you need to be really careful about how you manage your liquidity, how you diversify your portfolio, and how those decisions will impact your performance in unstable environments.

Add exposure to additional sources of risk and return

Q: Credit is often viewed as a risky asset class. How can an allocation contribute to the resilience of an investor’s overall portfolio?

A: We view credit as a strategic asset in a broadly diversified portfolio. Credit exists in the space between equity risk and traditional fixed income. Equity returns are based on expectations of future earnings, whereas sub-investment grade credit returns are based on the likelihood of default. Both returns factor in earnings expectations, but because credit is senior to equity in the capital structure, an allocation to credit may reduce the volatility and drawdown risk associated with an equity portfolio.

From the perspective of a bond investor, adding credit to a fixed income portfolio can introduce diversifying sources of risk and return. For example, an allocation to credit can be used to reduce duration and make the overall portfolio less susceptible to changes in interest rates.

Q: How should investors be thinking about allocating to credit given where we are in the cycle?

A: I think you need to start with a historical perspective. For many decades, we were in a boom-and-bust environment that culminated in the global financial crisis. During that era, it was critical to move to a much more defensive position as we got later in the cycle in order to invest after the dislocation or the pullback.

We’re always going to have credit cycles, but we think that an important shift occurred after the financial crisis. In the last ten years, we’ve seen assets and leverage move from the household sector and the banking sector onto government and central bank balance sheets. When we think about that structural change, we believe that the end-of-cycle tail risks and liquidity-shock risks are lower than they have been historically.  We think the cycles are probably going to be more frequent and milder to both the upside and the downside.

So if we’re no longer living in a boom-and-bust world, but we are living in a world of low growth, low returns and low inflation, we believe there is a strong case to be made for a long-term allocation to credit.

Q: How are you looking to build resilience in your portfolios in the current environment?

A: We believe in looking across the full spectrum of credit opportunities. Credit is an asset class that has become more accessible to investors over the past decade as the market has grown and bank financing has shrunk.  This larger investable universe allows you to build resilience through diversity across industries, geographies and liquidities.

At this late stage of the credit cycle, we look for companies with stable cash flows in non-cyclical industries, and in our liquid portfolios we have a higher-quality bias. We also take advantage of the growth of credit markets in Europe and Asia to gain exposure across different stages of the economic cycle. And by giving up some liquidity, we see opportunities to pick up additional yield for comparable credit quality in the private market.

We think the global monetary-policy environment will extend the current credit cycle, and the risk of recession has come down from last year. This is a supportive environment for credit. Nevertheless, we’re still underweight companies in cyclical industries and those with already slow earnings that we think would suffer the most if economic growth slows.

Q: You mentioned private assets. What role can they play in a credit portfolio?

A: If you believe that we’re going to be in a low-growth, low-return environment for some time—and we do—then I think you have to ask yourself how you’re going to meet your long-term return objectives. Trying to achieve reasonable return targets in this environment requires taking on some additional exposures, in our view.

When you move into private markets assets like direct lending, opportunistic credit or dislocation strategies, you may be able to harness an illiquidity premium or a complexity premium, on top of the spread premium that you’re getting in public markets. This can obviously improve your long-term return profile, but it can also improve the resiliency of your portfolio via exposure to these diversifying sources of return.

Back to top