Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
A new investment order, but don’t throw the baby out with the bathwater
“Post-GFC, there were many asset managers who claimed we were in a new paradigm,” says Wai Lee (picture at top), global head of research for Allspring’s Systematic Edge team. “But my attitude is that we should really kick our own tires. And my conclusion was that there was no new paradigm; we were all just working under the mean variance paradigm with different tweaks to the inputs.”
“Sometimes it’s easier for us to jump to the new paradigm, thinking that we have to discover something new. But I’ve found that if we just tweak it, fine-tune it, it remains relevant. My stance is that we should be humble students of the market.”
Lee spoke to ISN about the conclusions of his paper Perspectives: Multi-Asset Portfolios in the New Order, to be published in a forthcoming multi-asset special issue of the Journal of Portfolio Management. The paper was partly inspired by a position paper from the Future Fund titled The New Investment Order as well as a generalised anxiety among investment managers that the techniques that worked in a low-rate/geopolitically stable world no longer will, a sentiment generally expressed as: is traditional portfolio construction dead?
Lee’s answer is no (or rather, probably not); traditional portfolio construction just needs to be tweaked.
“Do we really have to throw away traditional portfolio construction in the face of inflation?” Lee says. “My answer is that it’s too soon. If you look at inflation, to what extent are its recent heights structural or transitory? Maybe the Fed was too optimistic, but when I used some published techniques to estimate inflation we saw that most of the volatility is transitory, and the structural is very stable.”
“My goal isn’t to convince everyone that that’s the reality, but depending on your view of how much is structural and how much is transitory, you can tweak your strategic asset allocation in response to the structural shift, and leave the rest to tactical (asset allocation). You can be a lot more tactical on inflation in the near-term.”
In one example from the paper, Lee notes that the conventional approach of building portfolios using capital market assumptions or capital budgets requires “binding constraints” to ensure that the portfolio looks ‘sensible’; the set of constraints determines the allocations. But using a risk-budgeting approach instead – starting with a set of desired risk allocations and portfolio target risk – becomes “an interesting alternative portfolio construction contender”. The risk-budgeting approach has also been useful for accommodating climate-aware asset allocation by adjusting risk budgets in line with assessments of climate resilience of assets.
“The conventional approach is less flexible… Instead of thinking about whether we should allocate a per centage of assets, we think about what risk budget we should assign to different fundamental factors, like inflation, interest rates and economic growth,” Lee says. “If our starting point is risk allocation to inflation, it’s much easier for us to say “structural inflation is up, we can adjust the allocation to inflation higher in our starting point”. That’s a much more pragmatic and direct way of responding to the new challenge.”
These aren’t new ideas, Lee says, but they’re helpful to keep in mind when everybody seems to want to abandon the methods that have served them well since the dawn of modern portfolio theory, often without any solid idea of what should replace them.
“Before I throw away my toolbox, I want to look through it and see what else is relevant and available,” Lee says. “Maybe I can combine them into something that could potentially be useful going forward. When I look at the challenges of inflation, climate change, geopolitical tension, I don’t think I jump to the conclusion that conventional portfolio construction is dead; there are opportunities for us to tweak the inputs, and maybe the toolbox can remain relevant.”
For constructing multi-asset portfolios in the new order, Lee uses the metaphor of a professional boxer, trained to take unavoidable hits and get back up after being knocked down. They know what the weakest part of their bodies is and where the risk of losing the match concentrates. And because they can’t predict where the next attack will come from, they build a neutral stance mixing a combination of defensive skills rather than using a single technique that works all the time against all attacks.
“As a boxing match can only be won with scores from successful offences, boxers understand that staying in a defensive stance all the time cannot achieve the goal of winning,” Lee writes in the paper. “Each time they launch offences, they deviate from neutral to take tracking error risks that are confidence weighted, calculated risks. They are teachers of resilience.”
