Exploiting economic conditions to pursue growth with less risk

The ideal for most investors is a portfolio that generates growth without exposing them to the threat of painful losses. A good way of reducing risk is being able to deploy assets in a way that best addresses the prevailing economic environment. But investors first need to identify the environment and then be able to adapt to it.

4 January 2016

Changing macroeconomic conditions and market valuations regularly create uncertainty for investors. Depending on the individual’s perspective, these can provide risk or opportunity. Those who want to focus on opportunity should, we think, look to a new class of strategies known as risk-controlled growth, or RCG. In this article, we describe a framework for defining RCG strategies that have become popular with both institutional and private investors.

An RCG strategy should be based on the investment outcomes it is designed to achieve – an “outcome-oriented” approach. For the purposes of this article we will assume our expected return goal is cash + 4%, and that we would like to avoid an annual loss (or “drawdown”) of 15% or more (with 90% confidence). However, other goals or outcomes can also be addressed within the framework we will outline in this article. Figure 1 shows our chosen outcomes defined in terms of risk and return, with the “acceptable” portfolios indicated as the shaded region. The horizontal boundary marks the expected return criterion. The diagonal boundary shows the drawdown criterion.

We have plotted an efficient frontier showing the possible portfolios based on typical long-term assumptions for risk premiums and asset class returns. We are looking for a portfolio that is both feasible – likely to produce a given return (without leverage) for a certain level of risk – and acceptable – lies within our dual criteria for risk and return.

Our first (static) solution portfolio lies on a very short section of the efficient frontier that falls within the shaded region. This portfolio has an allocation of (roughly) 70% to global equity, 9% to credit, 10% to inflation-sensitive assets (for example, commodities), and 12% to “strategies” (a blend of portfolios designed to exploit value, size, carry and momentum investment approaches). A more traditional 60% equities/40% bonds portfolio would also lie right on the efficient frontier, but it is not admissible as it would fail to achieve the minimum required returns.

At first sight, our first solution portfolio appears to provide an answer, but it barely meets our desired outcomes over the long term. In truth, a real investor never experiences such an idealised long-term equilibrium state because their investments are always subject to a range of shorter-term conditions, some helpful and some very harmful.

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