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Why Now is the Time for Smart Diversification

It’s an opportune time to reassess traditional asset allocation strategies.

Portfolio Managers Marco Aiolfi, PhD, Yesim Tokat-Acikel, PhD, and Lorne Johnson, PhD, from QMA’s Global Multi-Asset Solutions team, spoke with Institutional Investor about their approach to “smart” diversification, and why it is necessary in our current market environment.

Q:  What is “smart” diversification?

Lorne Johnson: First let me explain how it differs from traditional asset allocation. A traditional balanced portfolio generally allocates 60% to equities and 40% to bonds. This type of strategy invests across regions and the risk spectrum in order to achieve diversification. But it allocates portfolio risk almost entirely to equities. So it is not, in fact, well diversified.

To avoid such high concentration in equity risk, some managers suggest a risk parity approach. In this scenario, investors allocate their assets on a risk basis, rather than on the basis of long-only dollars. Achieving a risk profile similar to the 60/40 portfolio entails the use of leverage.  

The market environment has been fertile for risk parity strategies over the last several years, and they have performed fairly well. Going forward, however, we are starting from rich equity valuations and low bond yields. In this challenging return environment, we believe that there is a smarter way to diversify portfolios.

Q:  Why do we need smart diversification?

Yesim Tokat-Acikel: Smart diversification helps to move portfolios away from traditional sources of risk.  Smart investors use absolute return strategies to diversify this way. These strategies invest across the capital markets. They go long where there are attractive opportunities, and short unattractive opportunities. This is a much more direct way of diversifying a portfolio.

Q: What types of absolute return strategies are there?

Marco Aiolfi: There are several types of absolute return strategies. One example is a relative value, or market-neutral strategy. Relative value strategies invest in highly liquid instruments. They select assets across a variety of asset classes, including equities, bonds, currency and commodities, in both developed and emerging markets.

Directional absolute return is another type of strategy. Directional strategies are designed to be market neutral across a full market cycle, typically 3 to 5 years. At different points in time, however, they may go long or short across various asset classes. Both relative value and directional strategies can also be combined into a capital-efficient portfolio with attractive risk-return payouts and minimal correlation to traditional asset classes.

Q:  What sources of return do absolute return strategies seek?

Yesim Tokat-Acikel: Systematic absolute return strategies generally seek two sources of return. The first is behavioral mispricing – opportunities where companies are not priced according to their intrinsic value, but rather by investors’ over- or underreaction to the market. The second source of return that absolute return strategies seek to benefit from is economic risk taken on by the portfolio. Such risk, currency carry for example, is generally not shared across the capital markets. Absolute return strategies benefit from these diversified sources of return, as they shift portfolio risk away from traditional asset classes into more market-neutral territory.

Q:  What else should investors know about absolute return strategies?

Marco Aiolfi: Risk budgeting is critical. Investors need to allocate a targeted amount of risk to absolute return strategies. Traditional asset classes, however, have volatility baked into them. For example, there is natural, repeatable volatility associated with both equities and bonds.

Risk budgeting is an active investment decision. Investors should consider their skill, leverage, and breadth in making such decisions. All else being equal, we believe that investors should allocate more of the portfolio’s risk budget toward strategies in which s/he has more skill; toward strategies that are more efficient (requiring less leverage); and toward those with higher breadth. Then such strategies will complement their investments in traditional asset classes, while they mitigate risk in a targeted range over a full market cycle.

QMA began managing multi-asset portfolios for institutional investors in 1975. Today, we manage systematic quantitative equity and global multi-asset strategies as part of PGIM, the global investment management businesses of Prudential Financial, Inc. Our time-tested processes, based on academic, economic and behavioral foundations, serve a global client base with $122 billion in assets under management as of 3/31/2019.

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