Conventional wisdom and investment practice over the last 20 years have disproportionately focused on asset class returns and risk profiles. A sense of urgency is now needed to build more effective risk management solutions, argued Jan Straatman, Global CIO of Lombard Odier, at the CFA Institute Fifth Annual European Investment Conference held in Prague, 18–19 October 2012. Given that the range of modern asset classes has apparently failed to deliver the desired diversification effects promised by optimisers and mathematical techniques, Straatman believes that risk management at the portfolio level has been found to be negligent.
Straatman developed his premise by first explaining four “problems” the modern fund manager faces:
- Although there has been a proliferation of new asset classes in the last two decades, the globalisation of the capital markets through company expansion and orchestrated multinational monetary policy has reduced the diversification impact across asset allocation.
- The pedestrian returns of the last five years suggest a reset of expected long-term asset class returns, which paints a grim future. If we are building portfolios based on asset class return history, we will struggle to meet our return objectives and liability commitments.
- Equities, the engine of portfolio returns over the last century, seem to be in a prolonged and stagnant range reminiscent of the post-Great Depression or oil crisis periods.
- Fixed income, the great white knight of the recent past on the back of a secular decline in interest rates, can’t possibly be expected to continue its stellar run.
Straatman likened the result of this fixation on asset classes to a farmer who “diversifies” through a variation of crop types and livestock yet finds his yield decimated by a five sigma flood event. “Strategy diversification” versus “asset class diversification” would have seen the farmer planting some of his crops on higher ground. This mindset suggests that a shift towards portfolio building through a combination of uncorrelated strategies is the key to sustained and stable future risk-adjusted performance.
For Straatman, the fund manager who will be successful over the next 5 to 10 years will have to be acutely aware of the exposures he is buying — the real, uncorrelated, and idiosyncratic elements that transcend our traditional asset categories. Careful study of the sensitivities of prospective strategies to liquidity, sovereign, credit, interest rate, equity market, geopolitical regime, event, and style risk will be critical. Using this multidimensional approach allows for the construction of a truly diversified portfolio. By starting with risk exposures instead of asset classes, this more integrated approach will result in a much more robust and predictable behaviour of return and volatility.
