Faced with elevated market volatility and sharp drawdowns in portfolio value, a natural reaction among investors is to turn away from higher risk asset classes and head for the safe harbour of cash and government bonds. However, while this de-risking strategy may ease fears and limit losses in the short- term, it could jeopardise returns over time. Not only is perfectly timing markets a near-impossible thing to do, but investing more in cash means giving up significant yield. As such, when facing bouts of volatility, we think investors should take a deep breath and focus on three themes. First, to the extent possible, ignore the short- term noise. Second, maintain a long-term investment strategy that avoids assessing each asset class in isolation. And third, when one and two won’t suffice, look at de-risking solutions that offer diversification and potentially a positive yield.

How do investors typically de-risk portfolios?

In response to the market sell-off this year, many investors reduced risk to try and protect themselves from further drawdowns. Some did this by shifting within asset classes, for example by rotating from lower to higher quality equities, while others did this across asset classes, by increasing their allocations to cash and government bonds.

Yet, to illustrate the difficulty in marketing timing, consider a portfolio split 60/40 between equities and bonds. An investor who de-risked by switching out of equities into cash and government bonds at the beginning of the year would have avoided the drawdown in equity markets that occurred through mid-February. However, as of the end of July, the overall return for the investor would be lower than for someone who maintained a 60/40 allocation, due to the de-risked portfolio having lower yielding assets and missing out on the recovery in riskier assets.

What are more effective ways to de-risk?

Instead of adopting the typical de-risking approach, we think investors should consider the following strategies.

Moving higher in the capital structure: For investors willing to take a holistic approach, moving up in the capital structure by reducing equity exposure and increasing allocations to corporate bonds may provide an efficient solution. This strategy reduces the potential for capital loss as initial losses are absorbed by equity holders, and can provide a positive yield. It also has the potential to reduce a portfolio’s overall volatility as bonds have historically demonstrated low correlation with equities.

It is important to note, however, that while bonds can provide stable returns, capital appreciation potential, and diversification, investing in bonds still contains risks. Specifically, investors will be exposed to interest rate risk and spread risk, both of which can result in a capital loss if a company defaults or if the bonds are not held to maturity.

Allocating to absolute return oriented strategies: Absolute return strategies take many forms, and while such strategies often share a cash or Libor benchmark, they can be very different in approach. Non-traditional bond, equity market neutral, and multi-asset strategies, for example, all fall under this category. Most have an objective of seeking positive returns, or attractive risk-adjusted returns, with limited downside across market environments, using a combination of active management and trading expertise. Their role is not to replace traditional asset classes but rather to enhance the overall risk/reward of a portfolio.

Given the variety of approaches, strategy and manager selection are critical in successfully allocating to an absolute return strategy, which can vary significantly in risk characteristics and performance objectives. Furthermore, as manager discretion increases, so does the potential for over and under performance.

Incorporating alternative investment strategies: Incorporating alternatives is another option for those looking to diversify risks. Like absolute-return approaches, the alternatives space encompasses a wide variety of strategies, typically sharing a low-to-negative correlation to a traditional portfolio of equities and bonds. An example of a widely used alternative is managed futures, which has the potential to generate positive returns, while displaying low correlation to risk assets. However, as with other approaches, alternatives are not risk-free and downside risks should be evaluated in a broad portfolio context.

What is the impact of these strategies on a typical asset allocation?

To weigh the costs and benefits of the above strategies, we took a typical 60/40 portfolio split between equities and bonds, and examined the impact of moving 20% from equities into one of the three de-risking strategies described above. The results of this are summarised in Figures 2 and 3.


Moving higher in capital structure: In this scenario we reduced the allocation to global equities and substituted it with investment grade credit, using the Barclays Global Credit Aggregate index. The result of this was a significant reduction in overall portfolio risk, with a moderate reduction in return expectations. Downside risk significantly decreased, as shown by the portfolio VaR falling from 14.4% to 9.3%.

Allocating to absolute return oriented strategies: In this scenario we reduced the allocation to global equities and substituted it for PIMCO’s Global Libor Plus strategy. This is an absolute return strategy that targets Libor +2%, while maintaining a low volatility of approximately 2%-4%. This approach significantly reduced overall portfolio risk, and could be an effective solution for cash plus investors.

ŽIncorporating alternative investment strategies: In this scenario we reduced the allocation to global equities and substituted it for PIMCO’s Trends Managed Futures strategy. This strategy is designed to identify market trends – asset classes or sectors going up or down – and invest in them to provide diversified sources of return with a low or negative correlation to equities. Adopting this strategy reduced overall portfolio volatility and enhanced estimated returns.

As can be seen from the figures, all three approaches reduced risk compared to the 60/40 starting point. Importantly, all three strategies enhanced risk-adjusted returns.

What is the expected performance in a market down turn?

As well as looking at overall portfolio risk, we examined the performance of the portfolios in a sharp market down turn. To do this we stress tested each allocation for a 25% drop in equity markets, using historical relationships to analyse the impact on other risk factors.

As shown in Figure 3, adopting one of the three de-risking approaches reduces the portfolio drawdown and is almost as effective, and in one case is more effective, than cash. In contrast to an allocation to cash, which is likely to generate zero to negative returns in the current environment, these de-risking solutions are also expected to deliver positive returns over the long term in normal markets.

Looking ahead, we think markets will be prone to higher levels of volatility, as the global economy looks “Stable But Not Secure”. Although investors can’t control how and when these bouts of volatility will occur, they can control how they react. While shifting to cash may be a natural reaction, it is not always the most effective option. Instead, investors who have a well thought out asset allocation should look to weather periods of volatility. For those who prefer a smoother ride, there are de-risking options, such as those detailed in this paper, that can lower overall portfolio risk without relying on market timing or giving up significant yield.


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Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The use of leverage may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause a portfolio to be more volatile than if the portfolio had not been leveraged. PIMCO strategies utilize derivatives which may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Diversification does not ensure against loss.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

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