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Where were you when I needed you?


Keith Swabey, Senior Multi-Asset Product Specialist at HSBC Global Asset Management writes that despite the recovery in markets during 2019 from the terrible year of 2018, the lesson learnt was the need to (further) diversify portfolios, both by asset class and also by investment techniques.

Most wealth advisers in the UK had already implemented the latter via a variety of Diversified Growth Funds (DGFs). However, these proved to be frustrating as they mainly lost money in 2018 and had also underperformed targets over the last few years before that. This has left investors feeling frustrated that this technique or approach has let them down and are looking for a new way forward.
Given the need to maintain liquidity in portfolios, they cannot buy asset classes such as Private Equity or Infrastructure for the vast majority of their clients. Fund of hedge funds or single strategy hedge funds are possible but high fees and choppy track records make this route a hazardous one.
So where to turn for a solution? One answer that has its roots with institutional investors, but which has recently found popularity with wealth managers, is factor-based investing (or Alternative Risk Premia, ARP).  Many wealth managers already have exposure to this approach, as it meets their core needs of daily liquidity, reasonable fees and a manageable range investment firms to research. This approach uses a multi asset investment universe and the portfolio is long/short, whereas the traditional factor-based investing is long only and equity focussed.
So, what was the investor experience over the last three to five years in factor investing? 
Up to 2017, most managers produced returns of between cash +2-4 per cent with a risk profile in line or lower than expectations. However, in 2018, the majority lost money, as only about three managers produced positive returns from a peer group of 25-30.
As a result, clients have asked themselves two main questions
1)     Do I still believe in the investment approach? The answer is yes, as 2018 was the worst year since 2008 for financial assets (-9 per cent for MSCI equities and 15 per cent for Emerging Markets in USD) and the investment approach has produced stable returns over the medium term. Therefore, investors are happy to stay with it but have turned their attention to manager selection.
1)     Why was the dispersion of return so high in 2018 (+3 per cent to -12 per cent for most but the majority returned -3 to -8 per cent), as it had not been so wide earlier?
So, what should manager selection teams focus on?  
a)       Choice of premium: Especially any premium with a proven correlation to falls in traditional markets. The finger of suspicion is pointed at volatility in particular.
b)       Spread of risk: Some managers tilt portfolios towards equity, which is their historical strength. So, the question is how truly diversified is the portfolio by asset class?
c)       Instrument use: Does the portfolio take individual security risk via direct holdings or does it use indices? While there is no right or wrong answer, investors certainly need to understand the implications of this choice.
d)       Risk control: This can be interpreted differently but the use of liquid instruments (listed futures mainly and some OTCs), control of counterparty risk and minimising transaction costs by netting should all be scrutinised.
Once these questions have been answered, it often shows that investment managers are very different, as proved by the low correlations between the strategies. As a result, it also opens the possibility of having more than one manager for ARP.
In conclusion, before 2018, most manager selection teams believed that investment managers offering this investment approach were the same or very similar.
However, this has been proved not to be true and it is now clear that an in-depth analysis of the portfolio theory and practice is crucial to understand the expected return pattern. This allows investors to differentiate between the providers, which in turn will strengthen their own portfolios by providing constant return streams from ARP exposure.
Crucially, by focussing on this extra level of portfolio scrutiny, investors will be able to answer the question: Where were you when I needed you?

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