Recently, our Head of Multi-Asset Investing, Daniel Seiler, shared his views with more than 200 institutional investors from Australia and the UK at various events for private and public pension funds. During these events, the audiences were asked what annual return target they expect from a multi-asset strategy. The majority of respondents (33%) indicated an expected return target equal to the inflation rate (CPI) plus 4%, whilst 29% stated CPI plus 3%.
Assuming a realistic long-term Sharpe ratio of 0.6, a portfolio has to take risk within a target volatility range of 5-7% to be able to achieve a return of CPI plus 3-4% – a struggle for many multi-asset portfolios, given the current environment of low interest rates. The remedy? Applying a flexible investment approach, we believe, one that allows leverage and dynamically manages investments in risk premia.
Another question discussed at the events was the main reason for using a multi-asset strategy. 74% of the respondents think it is diversification.
"Diversification is the only free lunch" reads Harry Markowitz’s famous statement. The US economist and originator of the modern portfolio theory was right. However, there are different ways to diversify a portfolio. From our standpoint, achieving excess returns requires a diversification focus, preferably on liquid risk premia investments with solid economic foundations and long-term tailwinds. As there are not many of these, the portfolio stays simple instead of complex. We are convinced that exposure to five risk premia is enough to build robust portfolios: the traditional risk premia in equities and government bonds, as well as the alternative risk premia in commodities (market-neutral), volatility, and currencies (market-neutral). The graph below shows that over the past 18 years simple portfolios focusing on those five risk premia provided the same results as complex portfolios involving partially illiquid investments across all asset classes.
Since the future market environment will probably be characterized by low interest rates and phases calling for caution, achieving a return of CPI plus 3-4% requires dynamic management of portfolio exposure in line with market movements. For this reason, we also tactically allocate exposure to the five risk premia. This we do with the help of quantitative models and risk management that has a tight grip on correlations. We are convinced that only a systematic approach, which avoids any emotional decisions, can generate stable, repeatable excess returns in the long term.