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In the wake of the financial crisis of 2008 and 2009, investors and advisors have been seeking alternatives to classic portfolio construction―solutions that help them achieve their outcomes rather than tracking an index. As many investors painfully remember, in many portfolios developed prior to 2008—a lot of which incorporated well-diversified, non-correlated asset classes—the array of investments were found to be moving in concert, and most unfortunately, in the wrong direction. Since that time, new asset classes have emerged—particularly in the alternatives space—to help shore up portfolio diversification1 and long-term stability. While we applaud these enhancements, at Franklin Templeton Solutions, we believe there is a further step to take to address the underlying issues in traditional portfolio construction. Instead of simply adding new diversifiers to traditional asset allocation, we believe a more fundamental question needs to be answered. Why did traditional portfolio allocation fail in the first case?
The answer to that question comes from a better understanding of the composition of various asset classes, and specifically the risk factors embedded in each. For instance, in a typical bond fund, there are a number of distinct risk factors: interest rate risk, credit risk and yield curve risk—the risk that the short end of the yield curve will outperform the long end. In normal markets, interest rate risk tends to dominate the bond fund return, providing useful diversification from small equity-market moves. Yet in stressed markets, credit risk can dominate as the market questions the issuer’s ability to pay back the loan. As with equities, the credit component of a bond is linked to the earnings power of the company, and when that is questioned, corporate bonds can follow equities lower. Rather than mitigating volatility, the credit risk embedded in many fixed income portfolios pushed correlations with equities higher, and instead of dampening the downturn, the traditional asset classes simply reinforced each other.
For the investor, this leaves a dilemma: While non-correlated assets generally work well to diversify a traditionally constructed portfolio in less volatile markets, we believe they’ve failed to generate the intended cushion in more extreme market conditions—when arguably they are needed most.
The question for investors then is how to address these various market risks. Can these risk factors be isolated from and managed out of the portfolio when desired? We believe the answer is yes. A number of new financial instruments have been created to do just this—identify and provide access to specific market risk elements. Hedge funds2 have become particularly adept at picking certain risk factors within traditional asset classes and packaging them as alpha. We believe these so-called “alpha-generating3 strategies” are actually no such thing. Instead, they undertake a cherry-picking of specific factors inherently embedded in an asset class, and isolate that factor with the intention of delivering the desired effect on performance. Many have charged their clients handsomely for access to these exposures, also known as systemic or alternative beta.4
The Franklin Templeton Solutions team believes that a carefully considered multi-asset strategy can give investors access to the potential of systemic beta within a traditional open-ended investment company (OEIC) at a fraction of the cost of most hedge fund vehicles.
A New Approach to Portfolio Construction
Our strategies focus first on a desired outcome or client goal. Rather than tying ourselves to indexes (which we believe do not operate to meet investors’ goals), we align our portfolio to a return objective. For example, we may seek to outperform the return an investor could realise on a fixed cash deposit by 3%. To achieve this “cash + 3%” goal on a consistent basis, we build a portfolio that incorporates four styles of investments:
- Growth: Strategies that aim to find opportunities that are deemed to have good growth potential
- Defensive: Strategies that aim to protect investors against significant losses from major market downturns
- Stable: Strategies that aim to offer consistently higher returns than money markets while taking on modestly higher amounts of risk
- Opportunistic: Strategies, either growth or defensive, that aim to capitalise on market dislocations or valuations that occur over short-term time horizons
The starting point for the positioning of our portfolios is the development of broad macroeconomic, forward-looking themes which ultimately drive portfolio construction. However, the actual construction of our portfolios is fundamentally based on diversifying the risk factors, not the asset classes, and we believe that using risk factors rather than asset classes is the most precise means to gain exposure to our macro themes. That means segregating and isolating individual risk factors within asset classes and finding ways to invest (or de-invest) in them separately.
Getting exposure to these embedded risk factors can involve the use of more sophisticated financial tools such as derivatives, which is why they were traditionally the preserve of hedge funds. But we believe that a truly multi-asset strategy needs to look at an expansion of the toolkit to include such elements.
Practically, how does this impact our portfolios? Let’s take as an example the potential slowing of the Chinese economy. We believe this is a true risk and will likely impact certain asset classes. A traditional portfolio approach might be to underweight an emerging markets allocation as many of these markets trade heavily with China. But, such an approach muddles the risk that a slowing China has on these economies with the benefits some of those markets can achieve through an expanding US economy.
Alternatively, we can look at more specific components of the market that we believe will be more directly impacted by the slowdown in China. In this instance, one element of the market we believe directly impacted by a slowing in China’s growth rate is the demand for commodities, and more specifically, copper. Chile and Brazil are both big exporters of commodities to China. While Chile exports mainly copper, Brazil’s exports are more diversified. Brazil has also been raising interest rates, taking its medicine in an attempt to combat its inflation crisis, while Chile, in response to a fall in the price of copper, has been pushing for growth, trying to stimulate its economy even though inflation has been ticking up. So in these two South American countries, there have been very different interest rate policies in response to the same macro shock: one raised interest rates; one lowered rates.
That gives us occasion to consider some very particular trades that address the theme of slowing growth in China that are distinct and more isolated than achieved through traditional asset allocation.
We believe the resulting portfolio built in such a manner can provide a better diversification profile versus a traditional bond/equity mix, and is better suited to deliver to our intended goal.
The comments, opinions and analyses are the personal views expressed by the investment manager and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice and it is not intended as a complete analysis of every material fact regarding any country, region, market or investment.
Data from third-party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information, and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional advisor for further information on availability of products and services in your jurisdiction.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to these same factors. Bond prices generally move in the opposite direction of interest rates. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value.
Investments in derivatives involve costs and create economic leverage, which may result in significant volatility and cause losses that significantly exceed the initial investment. Short sales involve the risk that losses may exceed the original amount invested. Liquidity risk exists when securities have become more difficult to sell at the price they have been valued.