The dynamic response to Brexit volatility

Policy statements that set out objectives, risk tolerance and a strategic asset allocation mix remain essential. With Brexit adding to the already challenging global investment environment, long-term strategies need to be augmented with a dynamic approach, whereby asset allocation is flexed to take advantage of opportunities and adopt more aggressive or defensive positions as the need arises.

The box ‘Dynamic portfolio management’ (below) outlines some of the different approaches that asset managers may take, but for a post-Brexit portfolio we have chosen to adopt a variation of a risk-budgeting policy. Two portfolios, one giving exposure to volatile asset classes and the other with more defensive allocations, are combined in different proportions to achieve a balance between capital protection and wealth generation.

Firstly, a brief overview of the asset classes for our equally weighted risk portfolio. The reasoning for the choices below is to outpace inflation and provide a natural hedge against currency volatility. With the exception of a unit trust for exposure to the Asia Pacific region, the products chosen are exchange traded funds (ETFs) and investment trusts. The omission of US equities is because they look expensive at current prices, but the composition of this ‘risk’ portfolio could be changed as valuation metrics signal different markets, assets or investing styles look more attractive. Exposure to US equities would certainly form part of a long-term strategic allocation, but if one were buying into a market tomorrow, the US seems pricey.

Risk portfolio assets:

Mid-duration US Treasuries: United States government debt is already expensive but it’s a safe-haven asset, regardless of America’s eye-watering total debt. There may be further rate rises later in the year, but don’t expect enormous falls in bond prices. The flip-side is that yields are low, but as returns are in dollars investors will make an added gain given the weaker pound.

Fund: iShares $ Treasury bond 7-10 Year UCITs ETF (Acc) GBP (CU01)

Eurozone corporate bonds (ex-financials): Another investment that pays coupons in a foreign currency, although as Mr Bearbull pointed out in ‘It’s not the EU’, the euro still has unresolved difficulties, too. There are question marks next to the eurozone banks but many good-quality industrial companies are in a strong financial position and should prove robust in the face of Brexit fallout for eurozone economies. A higher risk-reward European play could be to invest in the eurozone’s best dividend payers, but there is a greater chance of capital loss investing in equities rather than good-quality debt.

Fund: iShares Euro corporate bond ex-financials UCITs ETF GBP (IEXF)

Gold: A timeless hedge against inflation and possible deflation, as a dollar-denominated asset gold also provides insurance against further weakening of sterling.

Fund: Source Physical Gold ETC (SGLD)

Japan equity: Although the strength of the yen can act as a drag on large-cap Japanese stocks, mid caps with higher domestic exposure offer a play on the Bank of Japan’s massive monetary stimulus and prime minister Abe’s fiscal injection and reform programme. Again, there may be a case for unhedged exposure with the weaker pound.

Fund: iShares Core MSCI Japan IMI UCITs ETF

Private equity: An asset class that historically is weakly correlated with listed equities. Growth in good prospect companies can provide a natural hedge against UK inflation.

Fund: Harbour Vest Global Private Equity (HVPE)

Defensive FTSE 100 shares: pharmaceutical, tobacco, utilities. The City of London Investment Trust is trading at a slight premium, but it holds several companies with good defensive characteristics, so makes a good proxy for demonstrative purposes. Investors may prefer to buy direct holdings in companies with strong defensive characteristics.

Fund: City of London Investment Trust (CTY)

Asia ex-Japan equity: While including developed countries such as Australia, New Zealand and South Korea, this is also a play on some of the emerging economies in the region.

Fund: First State Asia Pacific Leaders (GB0033874768)

Lower-risk portfolio

With interest rates likely to remain low and further quantitative easing a distinct possibility, the nominal return on sterling money market instruments and UK gilts is likely to remain low and, in real terms, it could turn negative. These assets should still form the basis of sterling-denominated portfolios with low chance of default, although with such vulnerability to inflation, they can hardly be described as ‘risk-free’. The primary purpose of this portfolio is nominal capital protection, so while taking on some risk in the form of longer duration bonds, it will be invested 50 per cent in money market instruments and 25 per cent each in gilts and inflation-linked gilts, using the following products.

UK Money market: three-month Libor benchmark.

Short-term Gilts: SPDR 1-5 yr Gilts (GLTS).

Index-linked Gilts: iShares £ Index-linked (INXG).

Expected risk and return

Based on four years of past data, the expected annualised return for the multi-asset risk portfolio is 9.9 per cent with an annualised standard deviation of 7.5 per cent.

The expected annualised return of the lower risk portfolio is 2.7 per cent, with a standard deviation of 2.8 per cent. This highlights the lack of a risk-free rate of return and on a risk-adjusted basis the more volatile multi-asset portfolio is better. The purpose of the lower-risk portfolio, however, is to reduce drawdown should there be a major crash in asset markets.

Combining the two portfolios:

Testing different combinations of the two portfolios gives the following risk and reward scenarios:

In terms of portfolio efficiency – getting the highest return per unit of risk – just investing in the portfolio of riskier assets is the best option. It is, however, also important to estimate what the portfolio might lose in a bad period – according to the widespread value at risk (VaR) measure, the riskier portfolio could lose over 17 per cent of its value in a severe downturn.

The 75:25 (risk to low-risk) portfolio split is less efficient in terms of its overall reward-to-risk ratio but the potential loss in a severe downturn is marginally lower. In practice, many investors will not be put off by the chance of 2 per cent worse losses in supposedly outlying cases of market turmoil. The 50:50 split, by contrast, suggests significantly lower downside and is also more risk efficient. From this analysis, there seems to be little benefit from the 75:25 portfolio, so the allocation split to choose is the 50:50, which gives a final portfolio, with the following composition:

50:50 risk and low risk portfolio

Drawbacks to consider

The problem with VaR and therefore any risk budgeting analysis based on it, is that the measure is based on the fundamentally flawed assumption that asset returns are normally distributed. When plotted on a histogram, normally distributed returns form a bell curve surrounding the mean value.

In practice, asset returns tend to be lots of small movements punctuated by much larger high-magnitude events. Thanks to investors’ cognitive bias towards fear, the largest movements often occur when panic sets in and prices drop suddenly. On a histogram these high magnitude falls give the impression of a ‘fat-tail’. A measure such as VaR ignores the reality of fat-tail distributions and therefore assigns far too low a probability to serious market falls.

Our portfolios are based on the principles of broad asset allocation, so it is hoped that we would diversify some of the risk of a 2008-09 style bear market in equities, when the MSCI World lost over half of its value. However, there is the possibility of worse drawdown than suggested by VaR and, also, that relatively significant falls could occur more frequently. With this in mind, it is sensible to go for the 50:50 portfolio rather than the 75:25 as the real drawdown risk may be much higher. In short, VaR is a useful guide between different investment options but caution needs to be exercised if opting for a more risk concentrated allocation.

Fortunately, there are better tools soon to be available. MorningStar have just announced the introduction of their new fat-tail risk distributions as part of a risk factor analysis tool. Investors Chronicle is also partnering with US firm PrairieSmarts to bring fat-tail risk analytics to bear on portfolio optimisation. We have already looked at portfolios of US-listed securities and in a few weeks we will begin applying the techniques to UK portfolios.