Hermes Investment Management, the £29.8 billion manager focused on delivering superior, sustainable, risk adjusted returns to its clients – responsibly, has today published the paper Portfolio construction methodologies: Looking beyond the good, the bad and the ugly by Tommaso Mancuso, Head of Hermes Multi Strategy. The paper argues that when devising multi asset portfolios, no single methodology – risk parity, fixed weight or momentum – is wholly superior across market scenarios. Mancuso argues that as with any asset, the performance of different asset bundling methodologies depends on one or a few factors and is therefore subject to biases and cyclicality.
Tommaso Mancuso, Head of Multi Asset, Hermes Investment Management says: “The one key attribute that we believe all asset bundling methodologies should share is simplicity. Simple approaches tend to be more robust over time while complex and optimised processes usually inexorably fade away. Perhaps more importantly, it is easier to stick with a simple process during turbulent times. At Hermes we see significant value in diversifying risk across different portfolio construction methodologies.
“Although we do not employ risk parity in our multi asset strategy, we believe it is a well-founded approach to portfolio construction. Still, it is only one of several well-founded approaches, alongside fixed weights and mean-variance optimisation. Our view is that none of these methodologies is wholly superior across market scenarios. We believe that investors’ natural reaction to poor results, which often sees one portfolio construction method being swapped for another, is the main risk underpinning the use of a single portfolio construction methodology."
Mancuso divides the three main methodologies into the ‘good, the bad and the ugly’.
Risk parity – ‘the good’
The financial crisis has substantially raised investors’ interest in risk-driven methodologies, with risk parity seemingly the most popular among them. The main argument for adopting a risk-driven methodology is the fact that fixed-weight methodologies may suffer from excessive concentrations of risk. During the financial crisis, it became clear that a 60:40 equity-bond split in notional terms translates into something closer to a 90-10% split in risk terms.
Moreover, the loose monetary policies implemented by central banks since the crisis have inflated asset prices across the markets. In such a scenario, the best asset bundling methodology is the one that offers the broadest and most efficient exposure to risk factors. Risk parity provides just that.
Fixed weights – ‘the bad’
For the most part, the increased interest in risk-driven methodologies has come at the expense of a fixed-weight approach. Several institutional investors have abandoned the prevalent fixed weight approach, often in favour of risk-driven approaches.
Among all its limitations, a fixed weight approach presents a unique advantage. It is the only approach that offers an unwavering value bias in that the rebalancing activity is always going to be contrarian with respect to the market moves that have occurred between one rebalancing date and the other.
Momentum – ‘the ugly’
Momentum as an asset bundling methodology is mostly used in the context of trend-following strategies. In its purest form, it leads to a collection of long/short trades across a universe of assets based on a trend signal. The portfolio is then purely based on a return-driven philosophy, often with little consideration for diversification and correlation other than sizing positions based on risk budgeting. Trend-following portfolios are generally model driven. The discipline of a systematic approach is required given that the hit ratio and pay-off profile goes against the natural biases of most investors.
According to Mancuso, experience and observation tell him that portfolio construction methodologies generally go into or out of fashion because of three reasons: “First, ‘negative surprise’ – when an in-vogue methodology is affected by an uncomfortable level of poor performance. Second is ‘herd mentality’, consensus among the investor community that the current methodology is broken and that there is a clear alternative, and third ‘empirical evidence: new knowledge, typically limited to the last 10-20 years, supports the case for switching approaches.
“We generally reject the notion that investors in the past were less thoughtful or less rational than today’s investors. The main difference between now and the past is a continuously larger historical data set and ever greater computational power”, said Mancuso.
Despite all of this, there is little evidence that investors are becoming more accurate at forecasting economic indicators, asset returns, or anticipating turbulent markets and crisis points (the financial crisis being a recent reminder of that). In fact, it is possibly the case that the ever greater computational power may generate a false sense of security and incentivise the need to adopt the newest asset bundling methodology.
The stronger the understanding of the economic rationale behind a methodology, the easier it is to formulate expectations as to what constitutes a positive or negative market environment. This insight reduces the scope for surprises. Being able to hold onto an investment methodology throughout the cycle dramatically increases the likelihood of reaping the rewards it is designed to deliver.
Mancuso continues: “The first step to selecting an asset-bundling methodology is to establish the key objectives for a mandate. In most cases, this is comprised of return and risk objective. The second step is to establish the scope of portfolio construction methodology. Such scope should be set based on the level of confidence with regards to estimating or forecasting risk and returns.”
There are various ways in which investors can combine the different methodologies in one portfolio. For the most part, they can be classified as either a top down approach or a parallel approach. Some investors may prefer to identify one methodology as core and one or more others as non-core.
In the context of a multi-asset portfolio, the top-down asset allocation is likely to be the main driver of returns. However, the differences in returns when comparing portfolio construction methodologies are likely to be smaller than those when comparing the same portfolio methodology applied to a different asset mix.
In fact, the large majority of the returns comes from the assets themselves. In other words, being exposed to the right mix of assets remains the major factor determining success. The chosen portfolio construction methodology should smooth the journey. Diversifying the portfolio construction methodologies helps ensure that the value generated by the asset selection does not get eroded by an out-of-sync bundling methodology.
Mancuso concludes: “Asset selection should be largely discretionary and free from any preconceived asset class bucketing. It employs a factor-based investing approach applied to alternative and traditional factors so long as they are subject to the specific criteria. Keep it simple and adopt a gradual approach to making changes.”