‘Risk’ and solving for real world problems

On Wednesday 24th September, we took part in the Titan Square Mile Investment Conference, an event packed with insightful discussions, expert moderation, and a forward-looking agenda that explored the challenges and opportunities shaping the investment landscape.

James Mee, Co-Head of Multi-Asset Strategy at W1M, joined the panel “Multi-Asset: A True Diversifier?”, contributing to a thoughtful debate on the evolving role of multi-asset investing in today’s markets.

Following the conference, Titan Square Mile released their e-magazine, featuring articles from all event sponsors, expanding on the key topics discussed throughout the day. In the e-magazine, James Mee contributes his perspective in “‘Risk’ and Solving for Real-World Problems”, an article that delves deeper into the themes explored during the panel discussion.

Read his article below, and find the full Titan Square Mile e-magazine at the bottom of the page.

The next evolution of multi-asset investing

Since Markowitz' 'Modern Portfolio Theory' in 1952, diversification has been hailed as "the only free lunch" in investing - "free" because, so the theory goes, we can reduce risk (defined as "volatility") while maintaining the same returns. And by adding not just to the number of positions, but also new asset classes, surely this brings volatility down further. Ergo: 'multi-asset = lower risk'.  But is multi-asset a true diversifier?

There is some merit to the argument. We need only look at the Sharpe Ratio of a 60/40 portfolio over the past 30 years for empirical proof that multi-asset improves risk-adjusted returns.

However, the past is not a reliable guide to the future.

Three things to bear in mind: (1) the secular decline in interest rates is over - bonds simply cannot generate the same returns over the next 30 years as they did in the 30 years to 2022; (2) consistently negative stock/bond correlation is not a given: prior to circa 1998, the relationship was consistently positive; and (3) this 'diversified' portfolio still faced periods of acute and major volatility.

Global Yields

Source: Bloomberg

If we take our principal assumption (our 'base case') that the next 30 years will look quite different from the last, (1) lower return expectations for bonds nudges us to look for similar return streams elsewhere (alternatives); (2) the correlation breakdown points us towards other negatively or lowly-uncorrelated assets; and (3) the spouts of volatility turn our eye to portfolio hedging strategies. We are doing all three.

A traditional 60/40 portfolio is not offering the 'natural' diversification it once did

Source: Bloomberg, Waverton

We might also add a fourth ‘thing to bear in mind’: starting valuations and margins. Many of the structural trends which supported bonds also underpinned equity markets, thus the end of these secular trends may pose problems to both bonds and equities – at the same time. . . The solution to this (in addition to investing in non-traditional asset classes) must be “know what you own” – investing directly in companies with simple and clear theses, and tracking corporate performance.

Taking aim at "risk"

Strip the question, back to what it is really about (risk), and delve a little deeper into what exactly "risk" is, and we might consider the ‘multi-asset as a diversifier’ question another way.

So what? we hear you ask; what's this got to do with multi-asset and diversification? Well, everything.

It gets to why we diversify. If we diversify to limit volatility, we run the risk of building inherently fragile portfolios: optimised to maximise risk(volatility)-adjusted returns, founded on an assumption that the future will look a lot like the past. And even if it works, so what? We don't say that to be facetious; we ask the question in good faith - if the portfolio achieves its goal of low volatility but fails to keep up with inflation, is that a good outcome for the investor?

If we rather focus on (1) not underperforming inflation and (2) avoiding permanent capital loss, all of a sudden we are solving for real world outcomes. We are not pushed towards the industry's version of perfection (optimisation), which doesn’t exist, and we can construct portfolios which are truly diversifying – “robust” in Antifragile terms. Critically, they also pass the 'so what?' test.

We fundamentally believe in (1) looking beyond traditional asset classes and (2) investing directly when building truly diversified portfolios. Real assets will contribute to capital growth and inflation protection, hedging will mitigate that 1-in-100 event (which will happen – probably more often than every 100 years) and knowing what we own is the best risk management tool in the box.

Click here to view the full e-magazine