Many institutional investors are searching for adequate risk premiums, as this is something most bond markets no longer offer. A strategic asset allocation that includes a significant proportion of risky asset classes such as equities makes it possible to achieve typical institutional return targets, even in today’s market environment. However, this sort of strategic orientation can only be recommended in combination with intelligent risk management. And intelligent risk management is synonymous with strategic yield management.
Current challenges for risk and return management
The risks on the capital markets have not disappeared – they were just on their summer holidays. This is the conclusion one reaches when looking at the performance of the VSTOXX (Graph 01) risk barometer in 2014 and 2015. While the implied volatility for equities in the Eurozone was still less than 15% last summer, it rose to twice that figure in autumn and at the beginning of this year.
Even a cursory fundamental analysis confirms that strong and sometimes diametrically opposed forces are at work in the main markets: in macroeconomic terms, the growth and recovery trend in Europe has been anaemic thus far. Whether this will be enough to limit the political risks resulting from the massive gains by radical parties with a clear anti-Euro agenda (in addition to Syriza, mainly Podemos in Spain), remains an open question. Starting in March, the ECB’s massive bond purchase programme announced on 22 January will pour over a trillion Euros of central bank money into the bond markets, where returns on German government bonds with maturities of up to five years and beyond already had negative yields at the end of February. US equities, in contrast, are profiting from very solid economic growth, but valuation levels are sky-high: based on our preferred valuation measure – the cyclically-adjusted price-earnings ratio – the value of the US equity market is currently about 58% above its long-term average. Our expectations of a divergence in central bank policies by the Fed, the ECB and the Bank of Japan in 2015 has the potential to reinforce the already visible distortions in the currency and bond markets. Geopolitical hotspots, especially the situation in Ukraine, may flare up into major fires.
The simplest risk management strategy – avoiding risks – is no solution given that in many cases money market and government bond interest rates are in negative territory: at the beginning of February, bonds with a value of USD 3.6 trillion, or 16% of the JP Morgan Global Government Bond Index, had negative yields. The fact is, the greatest risk is avoiding risk entirely. Institutional investors, who had traditionally used low-risk bonds as their anchor investment, will not be able to sustainably meet their medium-term yield targets with this portfolio structure. The strategic challenge in the coming years is therefore to take advantage of the risk premiums on equities and other risky asset classes for investments, while simultaneously protecting the usually modest risk budgets.
Strategic return and risk management
Given the market environment described above, return and risk management should be of particular importance to investors. Our 4-point plan (Graph 02), which we presented in Update 2013 Edition IV, takes a holistic view of the sources of income, and the risk-reducing components in a portfolio context. In order to harmonise the earnings targets, risk budgets and other constraints, such as liquidity requirements, the strategic asset allocation (SAA) and the allocation of alpha sources must be given a tactical orientation, and make use of sensible risk management which sustainably supports, rather than hampers, the generation of long-term returns.
Broad diversification of the strategic asset allocation reduces portfolio risk, and thus makes the first significant contribution in the context of risk management. However, in order to ensure compliance with a defined risk budget with a high level of confidence, beta risks should also be controlled dynamically over time, especially if there needs to be a higher allocation of risky investments in the portfolio to achieve the required rates of return. This dynamic element of the investment concept (dynamic asset allocation, DAA), which is usually implemented in the form of a derivative overlay, is already standard at many nstitutional investors, and uses the defined SAA to reallocate assets to provide the desired asymmetry of the results. (Graph 03)
This means that losses due to the dynamic allocation are generally reduced, while the return potential in positive market phases is retained. This sort of asymmetry cannot be achieved via purely forecast-based tactical approaches to asset allocation (TAA); a systematic dynamic strategy (DAA) is also required to reduce unfavourable investment results or downside risks independently of short-term return forecasts.
Dynamic asset allocation
The Dynamic Risk Management Solution of Allianz Global Investors was developed in order to effectively generate the desired asymmetric return profile. This approach addresses, among other things, the weaknesses of well-known portfolio insurance strategies (such as constant proportion portfolio insurance, CPPI). CPPI offers protection in bear markets, but often does not permit attractive participation in a market recovery. CPPI strategies act purely pro-cyclically, which creates value in clear trends, but lacks correction mechanisms in market exaggerations. The pro-cyclicality of such simple risk management approaches results from fully linking the allocation decision to the available risk budget. However, as capital markets have scientifically proven trends, and a tendency to revert to the mean after positive and negative exaggerations (mean reversion), the dynamic allocation strategy should take these properties into account.
For this reason our proprietary strategy combines pro- and anti-cyclical allocation components at both portfolio and asset class level.
- The pro-cyclical component gives the portfolio a more opportunity-oriented focus when more risk budget is available, and reduces the risks when the risk budget is low. This involves an increase in the weighting of the risky asset classes in the event of a positive performance, and a reduction in their weighting in the event of a negative performance.
- The countercyclical component takes effect in more extreme market movements. It thus ensures re-entry into the market after a rapid drop in prices, and at the same time it means that at least some gains can be taken when prices rise sharply.
- These pro- and anti-cyclical elements also act at the level of the individual asset classes, so our risk and return management also takes into account the “special economic cycles” of individual markets (e.g. emerging markets, commodities).
The conditions in each case are individually coordinated in detail when this strategy is defined. This includes customising the strategic asset allocation, including the permissible allocation bandwidths, as well as the mandate-specific return and risk objectives.
The following composites document the sustainable success of our investment approach. These include firstly the Dynamic Composite Risk Management (since April 2008, exclusively overlay mandates) and secondly the Dynamic Multi Asset Plus Composite (since February 2005, exclusively underlying mandates) (Graph 04). Since both types of mandate follow the same basic process for active asset allocation and risk management, we see both composites as representative of the risk/return profile of our dynamic investment approach.
The Dynamic Risk Management Composite initially consisted of very defensive portfolios, with the result that only a moderate amount of risk reduction was required in comparison to the already very low-risk benchmark. The mandates of the Dynamic Multi Asset Plus Composite date back to 2005, and on aggregate have significantly higher weightings of risky asset classes in the benchmark. The risk protection offered by our approach can thus be more clearly seen in these mandates in 2008. Apart from the hedging effect in weak markets, in both composites the SAA yield was achieved without high hedging costs in positive market phases. (Graph 05)
The asymmetry can thus be clearly seen in the return profile, i. e. the significant reduction in downside risks in the composite, as well as the improvement in average returns.
“The current market environment presents institutional investors with major challenges, and more than ever requires the very conscious and active management of risks.”
The current market environment presents institutional investors with major challenges, and more than ever requires the very conscious and active management of risks. For this reason, we advise institutional investors to analyse all components of their investment concept, and to review them to ensure that they are a good fit.
In our opinion, the importance of dynamic allocation management has increased noticeably, as it allows the active management of allocations in the overlay through different market phases, and between the adjustment dates of the respective strategic asset allocation. Our many years of experience in the dynamic management of a variety of international risk management mandates for a wide range of different customer requirements shows that the desired long‑term asymmetric return profile can, in fact, be achieved. We are also convinced that, in the current market environment, the added value provided by systematic dynamism in the portfolio is an indispensable component of institutional investors’ future-proof investment concepts.