Alternative Investment

Portfolio construction needs hedging and diversification, say strategists 

Paul Docherty (left), David Elms, Andrew Thomas and Graeme Mather

Hedging and diversification are critical for portfolios now, but investors must not confuse diversification as a hedging tool, say super fund and asset management strategists.

Strategists must manage beta risk due to the potential for more muted returns in response to combined high equity valuations and the impact of inflation on fixed income markets on conventional credit said Janus Henderson head of diversified alternatives and portfolio manager David Elms.

“The portfolios we run are designed to have low beta but that doesn’t mean that we don’t have the second order impact of beta risk,’’ Elms told a panel session at Investment Magazine’s Absolute Returns Conference in Sydney in September.

“When beta assets sell off in equities or bonds, particularly bonds because bonds are typically set up to be a solution to risk in a portfolio and right now they’re an amplifier to risk in a portfolio, this is an important parameter likely to herald regime change in a portfolio.”

He said there were no silver bullets or universal solvents for risk. “Trend is your friend, it works well historically in an inflationary environment and I would say at best we are in a transitional environment, arguably we are at the start of an inflationary environment. I (also) like global macro and volatility option-based hedging,’’ Elms said.

“Hedging is critical even in a market-neutral portfolio where you’re essentially hedging alpha because of the very significant uncertainty and potentially long term flat to negative returns from conventional assets.”

Protecting downside risks

Spirit Super general manager strategy and risk Dr Paul Docherty said the fund had to think about other ways to protect downside risk because conventional hedging was penalised under the Your Future Your Super performance test.

“The one difficulty is that if we want to look at some of the conventional ways to protect ourselves against downside risk, it comes with an expected return drag and we’re faced with a regulatory regime that penalises us for expected return drag because of the Your Future Your Super, there’s no scope to have compensation for that downside risk,’’ Docherty said.

Docherty said the fund looked at diversifying across economic exposures, asking what the economic drivers of returns across sub asset classes, to add complexity into portfolios.

“Derivative-based hedging is something we’ve done over time … it’s more of a tactical overlay,’’ he said.

“We’ve looked at a rebalancing process…and ways we can overlay a trend-based approach to rebalancing which helps to add complexity when we rebalance back after drawdowns or after particular asset classes have rallied.

“The third thing… looking to allocate to non-traditional exposures where the risks are not concentrated in some of those traditional key economic risks,’’ Docherty said.

These included insurance-linked securities and catastrophe bonds.

“Those risks of loss are not correlated with the risks of loss across the rest of our portfolio. So, unless we get unlucky and there’s significant weather events at the same time as a significant drawdown, we should hope that those losses are not correlated,” he said.

REST head of investment strategy Andrew Thomas said the fund was tackling the downside through asset risk management with asset classes.

“When we think about portfolio construction, we aggregate the asset classes into eight mega asset classes and they’re broadly aligned to Your Future Your Super definitions of those asset classes,’’ he said.

“Where we do take a lot of active risk is within the asset classes [themselves]. For example, we’re moving duration around on fixed income, credit allocations, looking at exposures within equities, to drivers of inflation.”

“More broadly … we are looking at exposures to property, infrastructure, agriculture within the portfolio as well. That provides the robustness for the portfolio.”

Thomas said he did not “want to throw out a broad blanket” and say just allocating to those asset classes will lead to great stability in inflation hedging because you need to look at the individual assets within those asset classes.

“We just had a significant tightening in financial conditions and historically that doesn’t play too well to property, but if you’ve got assets within them with great demand and supply dynamics then they do provide some good offsets in these periods of increasing inflation and volatility.”

Diversification not a hedge

Meanwhile diversification was critical but should not be mistaken as a hedging tool, said Janus Henderson’s David Elms.

“The thing about diversification as we see it is it works perfectly well in every single environment except when you need it to work,’’ Elms said.

“Diversification doesn’t really work in a synchronised sell off and it gets worse in a panic like 2008 or the first quarter of 2020 with Covid.

He said the first way to get diversification is to recognise your role in a portfolio for the client, for example delivering an alternative returns stream without contaminating it with beta.

“Don’t mistake diversification for a hedge. It doesn’t necessarily protect you against downside,’’ Elms said.

“The first way to get diversification is to eliminate the beta exposures that cause a lot of alternative assets to become correlated. For some private equity and private debt have the beta exposures of the equity and debt that underlie it.

“Then look for innovative structures … where the return streams are orthogonal to traditional assets.”

 

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