Much of the debate about risk in the managed solutions space has boiled down to ‘risk-rated’ versus ‘risk-targeted’ portfolios but, Schroders’ multi-manager head Marcus Brookes tells Julian Marr, there is another consideration
Advice on levels of risk in managing investment portfolios
From volatility, tracking error, standard deviation and the Sharpe ratio to alpha, beta, delta and lambda, a great deal of brainpower – not to mention a fair chunk of the Greek alphabet – has gone into framing how investors might best look at risk. In the managed solutions arena, the last couple of years have seen much of the debate boil down to ‘risk-rated’ versus ‘risk-targeted’ portfolios and yet, believes Schroders’ multi-manager head Marcus Brookes, investors and their advisers may find it more helpful to think in terms of ‘risk-adjusted’.
To help make his point, Brookes runs through three common risk measures and the pros and cons of mainstream ways of implementing them. Starting with volatility, which lies at the heart of any risk-targeted approach, he says: “Clearly this does need to be borne in mind when you are running client portfolios and advisers can also feel reassured the client’s risk profile will always fit into the correct ‘box’, which helps from a regulatory standpoint.
“When a market does turn, the fund manager you want is the full believer – and that is probably someone who has been languishing in the fourth quartile.”
“However, take a look at the S&P 500 index, for example, and you will see volatility falls as the market goes up while rises in volatility tend to be associated with a market decline. So, if you are trying to keep the volatility of your client’s portfolio constant over time, there is every chance that, as volatility goes down, you are adding risk to your client’s portfolio – at a time when the market is going up.
“Equally, as markets fall, you then have to start selling assets – in other words, you have ended up buying high and selling low, which is obviously the wrong way round.” Brookes accepts risk-targeted portfolios do not always follow this pattern but argues investors and their advisers nevertheless need to bear in mind such solutions can lead them to behave counter-intuitively.
The second risk measure under the Brookes microscope is tracking error, where the popular solution remains passive investing. “The benefit of this solution is the low probability of falling well short of your benchmark because you are not really taking much risk against it,” he says. “However, for us, the compromise is guaranteed underperformance in both rising and falling markets – typically by the annual management fee being charged by the index-tracking product.”
Ahead of the third measure, Brookes apologises for having yet to come up with a snappy title. “We have been calling it ‘permanent loss of capital’ because that is what we believe clients are trying to avoid,” he continues. “Investors do not see themselves as a ‘4’ or a ‘5’, say, but as people who want to retire or meet a particular liability at some point in the future and would like their manager to grow their assets in a sensible way.
“The way we look to go about that is not only to try and provide a lower-volatility outcome but also to target an appropriate return. So, rather than just targeting risk itself, this means having a flexible approach to investing and targeting risk-adjusted returns. The benefit of such an approach is the potential to outperform throughout the cycle with low volatility – although the compromise is contrarian investing does require patience.”
As an example of how this approach can work, Brookes looks back to the summer of 2011 when concerns about the stability of the eurozone saw a 5% rise over the first seven months of the year quickly reverse into a 15% fall. “That was a 20% drawdown in total and, if you had tracked the index, you would have seen all of that,” he says. “Even if you had taken the volatility approach, you would probably still have seen a large part of that drop.
“As it happens, because of its flexibility, the mixed asset sector as a whole did quite well in that declining environment but what is now the Schroder MM Diversity portfolio did even better. That is because, if you are not trying to look like the index and if you can be a bit more contrarian, then you can produce returns that look different themselves.”
Key touchstones of the Schroder multi-manager team’s approach to achieving superior investment results include asymmetry – in other words, aiming to participate in gains when the market rises to a greater extent than they participate in losses when it falls – and compounding. “Managing downside risk is crucial to compounding returns over the longer term,” adds Brookes.
The team’s ongoing desire to be different extends across both asset allocation and fund selection. “Again, if you look like the index, you will probably produce index-like returns – and pretty dull ones at that,” says Brookes. “Being contrarian does of course mean you need to be patient – just because something is cheap, it does not mean it is going to appreciate tomorrow and the fact that something is overpriced certainly does not mean it will fall right away.”
Some of the team’s most successful purchases were made at times when many other investors would not have dreamed of buying in – for example, Fidelity Special Situations at the start of 2012, GLG Japan Core Alpha in the middle of that year and Artemis European Growth in early 2013. “We thought there was a European recovery coming,” Brookes elaborates on the Artemis fund. “You did not want to own it in a recession but if you felt a recovery was coming, then there was a chance the fund would do very well – and so it has done.
“It has been the same story with Legg Mason Capital Management Opportunity. Manager Bill Miller had a dreadful time when he was caught with a portfolio of consumer stocks that did poorly during what was a pretty nasty recession in the US. But as the recovery came in, he did really well.”
At this point, Brookes offers a word of warning about funds that outperform their peers in a falling market. “Often the reason one fund manager is outperforming when their asset class is getting cheaper is they do not actually believe in that asset class,” he explains. “They are being defensive and that is why they are outperforming. Whereas, when a market does turn, the fund manager you want is the full believer – and that is probably someone who has been languishing in the fourth quartile.”
So how does Brookes see the outlook for the remainder of 2014? “There are a few threats beneath the surface but we see quantitative easing as the biggest,” he replies. “Everybody knows the US Federal Reserve is tapering but I do think investors’ understanding of its impact on financial markets is still pretty sketchy.”
Brookes suggests it is helpful to think of quantitative easing as a fountain, with the $4.5bn or so of ‘new’ money created by the Fed flowing from the top and down into a series of tiers – the different asset classes. The money flows first into high-grade government debt and then, when that tier is filled up, it spills over into lower-grade government debt and mortgages, then into investment-grade corporate bonds and lower-risk equities and so on.
“Each time, prices are bid up and the natural buyers for a particular asset class get displaced and move down to the next tier,” continues Brookes. “Eventually the money ends up in high-yield corporate bonds, low-grade emerging market government bonds and high-beta equities – and maybe now some investors are considering wine funds or whatever – but the money has been driven down. Now the Fed feels able to reduce the level of what is flowing in at the top so the money is now trickling down at a much less powerful rate.”
To Brookes’s way of thinking, this is a recipe for falling prices although he is quick to add he is not calling a bear market. “I just think anything that looks expensive is about to have a ‘moment’,” he explains. “Things that look overvalued can stay overvalued just as long as everything stays in place – and what is not staying in place is this trickle-down effect of QE.”
Areas Brookes has been regarding with unease for some time now include US equities. “If you look at the price-earnings ratio of the US market, you could convince yourself it still looks reasonable value,” he says. “But if you look at the cyclically-adjusted Schiller price-earnings ratio, it looks pretty expensive – and, if you use price-revenues ratios instead, the S&P 500 is around where it was in 2000, which was a time of craziness in terms of valuation.”
Brookes is also far from keen on fixed income – having little time, for example, for those who argue corporate bonds are less risky than they used to be because companies have built up the cash on their balance sheets. “Research from Deutsche Bank shows the proportion of US companies’ cash holdings relative to corporate debt is the lowest it has been for 15 years,” he points out. “Again, I am not saying there will be massive defaults in the market – I just think any concept of these things as less risky than they were is just wrong.”
Faced with such a troubling environment, Brookes’s instinct, as ever, is to do something different from the pack. “We have entered a final, difficult part of the economic cycle,” he says. “At this point, we would normally be thinking about buying some very well-positioned hedge funds but even these are looking pretty bullish so instead currencies could be one way to play any sort of dislocation.
“Equity valuations are high and government and corporate debt are both looking expensive – indeed, our current total of three is the lowest number of bond funds we have ever held – and in lieu of all that we are willing to hold a large amount of cash. In the Diversity fund, for example, the cash level is now way over 30%. That is pretty contrarian – even by our standards – but we feel it is time to take some risk off the table.”