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Building Resilience in Multi-Asset Portfolios

In the quest for resilience during volatile times, BlackRock’s experts weigh in

An aging cycle, rising geopolitical risks and heightened market volatility all seem to threaten the ability of investors to reach their objectives. One major result is a renewed focus on the concept of portfolio resilience – always good to have, but especially important now.

Widely used these days, the term “resilience” sometimes connotes a defensive bias. BlackRock believes there’s more to resilience than that. Investors need to participate on the upside as well as to mitigate the downside. A truly resilient portfolio should be consistent, diversified, risk aware, and flexible, with the ability to effectively navigate short-term shocks while capitalizing on long-term trends.

How do you build a multi-asset portfolio that has these attributes under current market conditions? There is, of course, no one-size-fits-all answer. But considering the question from multiple perspectives can help to bring potential solutions to light. To that end, II asked two BlackRock experts – Phil Green, Head of Global Tactical Asset Allocation, and Phil Hodges, Head of Research for Factor-Based Strategies – for their thoughts on building resilience for the long term.

How are you looking to build resilience in today’s market environment?

Phil Hodges: We believe the economy is starting to slow, and that the easy money of the equity bull market is largely off the table. As a result, we think that now is the time to start diversifying portfolios into exposures that can do well in different market environments.

Adding interest rate risk or inflation risk to a portfolio that is heavily exposed to equities – and thus to economic growth risk – can be a good place to start. Within an equity portfolio, investors may want to consider tilting toward quality or low-volatility stocks, or both. These moves can help investors build resilience, while still targeting the returns they need.

What steps are required to construct a resilient, factor-based portfolio?

Hodges: Step one is to determine what actually drives the returns of different asset classes. We’ve found that six macroeconomic factors – economic growth, real rates, inflation, credit, emerging markets, and liquidity – explain more than 90% of the returns across asset classes.

Step two is to balance risk across these fundamental drivers of return. Because many different asset classes are exposed to the same common sources of risk and return, we believe that it’s much more effective to diversify your exposure to factors than to asset classes.

Step three is to be very aware of the risks of market extremes and to provide downside mitigation during periods of economic stress. This is a crucial component of building resilience into a factor-based strategy. There are some environments in which even well-diversified portfolios are subject to severe drawdowns, so you need a process in place that allows you to act nimbly and decisively in adverse environments to try to mitigate losses.

How does the multi-asset, factor-based strategy you're describing differ from a traditional risk parity approach?

Hodges: Over the course of many years, a variety of multi-asset investment approaches have come to be grouped under the term risk parity. Recent market conditions have impelled many investors to look more carefully at the similarities and differences among these strategies. We think that our approach stands apart in two ways. One is that we balance factors, not asset classes. Factors are the fundamental building blocks that drive risk and return across asset classes, so it makes much more intuitive economic sense to balance factor exposures.

Number two is that we don't actually believe that parity is optimal. Parity works if all risks are equal, but we think that different risk exposures lead to different long-term return outcomes. We take an active approach to seeking the appropriate balance among the risks in a portfolio. Different risks also have different tail characteristics, and allocating with an awareness of those characteristics can play a key role in improving a portfolio’s resilience. The bottom line is that we believe in balance, not in parity.

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How are you looking to build resilience in today’s market environment?

Phil Green: To build more resilience, we start by analyzing the macro environment, including the outlooks for economic growth, inflation, fiscal policy, and monetary policy. We then draw insights from that analysis and look to see whether or not those insights are priced into asset classes, including equities, bonds, currencies and commodities.

For example, we might determine that the global economy is accelerating from an already high level. If that insight is already priced in across asset classes, then we won’t make any changes to our portfolio. But if one or more asset classes are not reflecting that insight, we’ll increase our position in the asset class that appears to be the most mispriced, while also factoring in sentiment, crowdedness and possible asymmetrical payoffs.

What’s different about this approach is that we’re starting with insights and then looking for the best asset class in which to express those insights, rather than just building a portfolio asset class by asset class. What often happens when you take an asset class approach to investing is that your exposures within equities, bonds and currencies are all correlated, because they’re all based on the same insights. We think it’s very important to start with a broad, diverse set of insights and then look for asset classes that are attractively priced according to those insights, and we believe this approach can help to build better-diversified, more resilient portfolios.

A lot of investors think we’re nearing the end of the current cycle: Do you agree?

I think there is a general consensus that we’re in the latter stages of the cycle, but that’s not entirely clear to us. For several years, many investors have believed that we’re late in the cycle, but the cycle seems to continue.

We think the cycle has further to run, and a big reason for that has to do with monetary policy.  Policymakers can have significant impact on market and credit cycles, and we think that the Fed’s new, more patient posture—as well as the patience we’re seeing from other major central banks—will allow this cycle to carry on further than some participants appreciate. That said, we are hyper-vigilant about tracking changes that could indicate a turn in the cycle, so we’re constantly monitoring a multitude of economic indicators, in addition to tracking valuations.

It seems clear that markets have entered a more volatile stage. How does that affect your strategy?

Green: We actually welcome higher-volatility environments. Increased volatility gives tactical asset allocation (TAA) strategies – and other macro strategies – increased opportunities to capitalize on changing market prices. As TAA investors, we’re looking at two types of volatility. First is the obvious one of price volatility across stocks, bonds, currencies and other asset classes. But we’re also interested in the volatility of the fundamental variables that I mentioned earlier –things like growth, inflation, central bank policies and other macroeconomic indicators.

One of things that can drive opportunities for us is the relationship between price volatility and what I’d call fundamental volatility. In the environment we’re in now, the volatility of prices is quite a bit higher than the volatility of the fundamentals that we are tracking, and we see that as an excellent climate for us to attempt to add value and build resilience for our clients.

We don’t believe that we’re going back to the low-volatility, high-return environment that characterized much of the post-crisis period when central bank policies effectively amplified the returns and reduced the volatility of most asset classes. So, when volatility presents opportunity, we think that it’s critical for institutions to have the flexibility to adjust their strategic asset allocations.

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