David Crawford, co-Head of Institutional & Wholesale Distribution UK at Nordea Asset Management
Being different can be rewarding, but it brings its own set of challenges.
We approach Multi-Asset investing differently compared to our competitors as we focus on academically researched Risk Premia with diversification through the understanding of cashflow and performance behaviour during rising and falling markets. In our portfolio construction process, we consider tail volatility, risk budgeting and purposefully aim for market neutral returns over time. So we think we are different; our performance over the long-run and in significant equity market sell-offs supports that. You would think the biggest challenge we have is explaining our approach to Risk Premia, but surprisingly it is not. It is explaining our beta and correlation characteristics.
Why invest in a Risk Focused portfolio?
For Defined Benefit Schemes, our Alpha Multi-Asset Solutions are used within the “Growth” portfolio as an equity replacement as well as a diversifying investment alongside traditional assets. For Defined Contribution Schemes, the same solutions are used across the investment lifecycle with larger percentage allocations in the “Balanced” (middle) and “Consolidation” (end) blocks. The objective here is to offer growth and protection.
For other Professional Investors, these strategies are used to reduce reliance on equities as the main source of return. Boiling it down, all client groups have the same objective: protect in periods of unexpected volatility and deliver returns in excess of cash; therefore it’s not too surprising that the same multi-asset solutions are used across many client types.
Our Alpha Multi-Asset Solutions are designed to mitigate downside risk and provide “resilience” in tough market conditions, while delivering returns independent of the market cycle in more favourable times. In short: an all-weather, macro-economic immune solution.
Asset Class or Risk Allocation?
In the UK, a majority of multi-asset solutions use traditional asset classes and apply a traditional asset allocation approach. This means that portfolio risk is determined by the asset allocation which, in periods such as the one we are in, leads to variability in portfolio risk. This also assumes that diversification can be achieved by investing in “different” asset classes, which has demonstrated some, but not much, protection. The big challenges are either in the asset allocation calls, market timing, or the most difficult of all – relying on “naïve” diversification, which is the presumption that these “different” asset classes will offer protection in crisis and not drag on performance in “good” times.
Our Alpha Multi-Asset Solutions employ a “risk first” approach. This means that we start with a target risk level for the strategy which incorporates tail-volatility—our asset allocation is actually a “Risk Premia Allocation”. This allows us to be more surgical in investing into the Risk Premia which removes unrewarding or unwanted risk.
Measuring Performance, Correlation and Beta… What’s the problem?
The problem is with the numbers. Or more specifically, the mathematical calculation of the relationship between our returns and the overall markets – formally known as beta and correlation. Our Alpha Multi-Asset Solutions have dynamic beta and correlation. However, this may not be apparent when using traditional beta and correlation calculations, because the traditional calculations are slow to capture change and are, in effect, averages.
Our Alpha Multi Asset Solutions aim to be market neutral over time. However, using traditional calculations, we have a non-zero correlation and beta to both equities and interest rates. Shock horror… Here’s the misconception with our beta and correlation: we deliver positive performance in the same periods that equities and government bonds perform. Take global equity market: the MSCI World has delivered a positive monthly performance approximately two-thirds of the time for the last 10 years; we have also delivered positive performance in those periods, hence the symptomatic positive correlation and beta.
What if we separate market performance into up and down markets? This is getting us closer to understanding how the strategy, on average, performs in up and down markets, and starts to reveal our asymmetric return behaviour. I’ve always called this “positive conditional correlation or beta” as I am sure that this was the formal term I was taught for ‘when the markets go up you want to have a high(er) beta, but when they go down you want a low(er) beta’.
Formal naming aside, our Multi-Asset strategies are designed to have this asymmetric beta (or return) behaviour. In fact, our Alpha Multi-Asset solutions have historically, on average, delivered a positive return in down markets. For a more responsive correlation and beta observation, one could also use shorter-term rolling calculations. Interestingly, over this recent period of market volatility, as already happened in the past, our Alpha Multi-Asset solutions have exhibited negative correlation and beta to global equities.
So what’s next?
For investors in traditional assets, perhaps this crisis will provide the opportunity to review current investments and discover an answer to one of the next big challenges that remains: how to find diversification in this current low yield environment. (see Finding diversification in a low-yield environment) For investors in Nordea’s Multi-Asset Solutions, times like these are a useful reminder of why a differentiated approach to multi-asset investing and putting Risk at the forefront of asset allocation can have a useful role to play in your portfolio.