Beta bear trap

Investors committed to improving their expected portfolio returns need to manage the beta component, and act on “alpha” generation to tackle new market challenges and avoid a potential bear trap.
 

Opinion

Web Share

Investors committed to improving their expected portfolio returns need to manage the beta component, and act on “alpha” generation to tackle new market challenges and avoid a potential bear trap.
 

By Giordano Lombardo

Investors committed to improving their expected portfolio returns need to manage the beta component, and act on “alpha” generation to tackle new market challenges and avoid a potential bear trap.

 

The last five years have seen an increased appetite for risky assets, but with developed world equity markets now close to all-time highs and credit spreads close to historical lows, investors face the prospect of lower real returns, with limited protection. So we should ask ourselves the question, “What is the right portfolio approach for investors looking to generate higher returns in this environment?”

Historically, asset managers have turned to beta diversification in a bid to improve portfolio risk-adjusted returns. Yet all of these approaches have significant flaws. The most basic form of beta diversification, an increase in the range of investable asset classes, is rarely effective when it matters most. The synchronous falls in equities, credit and commodities during the financial crisis, powerfully demonstrated that correlations between traditional asset classes can and do change, particularly during times of extreme risk aversion.

Another example of beta diversification is provided by investing in alternative asset classes such as real estate, hedge funds or private equity. From a pure return-enhancement perspective, this option would make sense as these assets embed higher expected returns than traditional ones. However considering liquidity risks, this approach may only be suitable for genuinely long-term investors.

Other forms of beta diversification also have flaws, such as the risk parity approach. In this instance, the portfolio is built by equal marginal contribution to total risk. This aims to maximise return for each unit of risk by rebalancing the portfolio weight of each asset class to target a certain level of risk for the overall portfolio. However, in order to maintain decent levels of returns, the portfolio has to apply some leverage, which generates new and unwanted risk in itself.

Against this backdrop, the argument for making alpha rather than beta the central focus of portfolio construction is compelling. This approach emphasizes the role of portfolio construction, based on an efficient combination of multiple lowly-correlated alpha strategies, and changes the way in which the portfolio is built and visualized.

This new way of looking at portfolio construction goes beyond the traditional style based on broad classifications such as government, investment grade bonds and country of issuer. Not only does this offer purer alpha generation distinct and separate from beta, but also it helps to drive improved risk management and budgeting within the portfolio.

We believe that liquid alternative strategies that bring techniques such as long/short strategies and flexible credit to mainstream mutual funds are going to play an important role in the world of alpha-focused portfolios. For this reason, we are strengthening the culture of alpha generation through our proprietary portfolio construction and risk budgeting tools. Laying the foundations for a growing range of purer alpha strategies will be integral to the many challenges facing clients in modern markets.

 

 Giordano Lombardo is the group CIO at Pioneer Investments

Comments

More Articles

Subscribe

Subscribe to Our Newsletter and Magazine

Sign up to the portfolio institutional newsletter to receive a weekly update with our latest features, interviews, ESG content, opinion, roundtables and event invites. Institutional investors also qualify for a free-of-charge magazine subscription.

×