Multi-asset investing: the importance of protecting the downside.

Multi-asset investing is a hot topic. Increasingly, a wide range of investors want the dynamic allocation and effective diversification attributes that a well-managed multi-asset portfolio can provide. Savvy investors also want to ensure their multi-asset fund uses best-of-breed managers and strategies in every asset class, to generate the extra performance that is so vital in a world of low asset class returns. But fewer investors realise the importance of downside protection, and why this should be a key attribute of a multi-asset portfolio targeting consistent growth.

Downside protection consists of a range of techniques to reduce the probability and the impact of suffering losses in a portfolio. Investors can get downside protection in a number of ways. For instance, they can adopt a rules-based approach to regulating overall portfolio risk. (Russell Investments’ trading team can provide this service, using derivatives). Alternatively, they can use a range of methods, including diversifying their portfolio across a variety of defensive assets, and using derivatives to regulate their exposure to specific risk assets. (We do this in our multi-asset portfolios, often using derivative structures that have different components acting in combination, to express our insights about the different market levels that we find either attractive or extended).

Why is this key when you are investing for consistent growth?  Because big losses are hard to recover from! For example, if your portfolio suffers a 30% fall, you need a 43% rise to recover your starting level.  That’s where a multi-asset approach is so valuable.  To explain why, let’s recollect Aesop’s fable about the race between the tortoise and the hare.  In the original story, the tortoise beat the hare by being more consistent.  In our multi-asset version, we race two portfolios. One has a lower average annual arithmetic return (runs slower) but is well diversified and so exhibits lower volatility.  Let’s call this one multi-asset.  The other has a higher average arithmetic return (runs faster) but is concentrated into a single-asset class, higher volatility portfolio. Let’s call this one equities.  Although the multi-asset tortoise on average runs slower, it doesn’t trip up so badly, it just keeps on going. Because the low volatility tortoise has fewer and/or shallower setbacks to recover from, its lower average returns can compound more smoothly to achieve an equivalent geometric return to the higher volatility portfolio. (Geometric returns are how we measure portfolio performance using GIPS globally accepted standards).  The setback penalty for the higher volatility portfolio is known as ‘volatility drag’. And that’s why the multi-asset tortoise has a good chance of matching or beating the equity hare over one or more full market cycles, all other things equal.

Why is this such a big deal for our clients and prospects? Because their investing horizons are typically quite limited, and they can’t risk tripping up badly and being unable to recover the lost ground. Many of our Defined Benefit (DB) pension clients have shorter time horizons now; they have recovery plans of 7-10 years and sponsors who are reviewing their pension commitments and want to reduce the deficits as soon as possible. And in DC, individuals approaching or post-retirement can’t afford big losses either. (My colleagues Josh Cohen and Bob Collie have written extensively on this – the investment concept is called sequential risk).

But the impact of volatility on your portfolio gets more adverse once you start making cash withdrawals. (Which you do as a DC retiree or as a mature cash-negative DB Plan). Imagine what happens as a retired person if you suffer that 30% fall in your portfolio value, and then you find you have to buy a new car, or finance expensive medical treatment? You have to take cash out of your retirement plan at the worst possible time, and then even with the benefit of subsequent strong returns, you may never get back to your starting level! The impact of withdrawals on portfolio performance is known as cash-flow drag – and an increasing number of our clients and prospects need to face up to it. (My colleague Crevan Begley is writing an excellent paper on this subject). Once you start focusing on cash-flow drag, the slower but more consistent multi-asset starts to look like a much more compelling bet than the faster but more volatile equity hare.

Here’s the clincher – why that extra consistency is vital now. In DB (and in US DC too) we are approaching the point of peak assets. That’s when pension savers in aggregate have the most money on the table that they are ever going to have. A big stumble at this point could be crippling for many pension savers and DB sponsors. That’s why it’s so important for investors now to look at downside risk in a different way, to start focusing on wealth preservation in the here and now, and to get away from an exclusive focus on long-run average rates of return.

In a nutshell, that’s why downside protection is one of the key ingredients of an effective multi-asset strategy. We believe these core ingredients comprise dynamic allocation, effective diversification, best of breed in every asset class and strategy – and last but not least, downside protection.

David Millen, Director, Investment Communications


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