The simple math of compound returns requires that investors limit downside risk while participating in positive return environments. This requires a focus on risk management, particularly on those periods where risky assets, especially equities, do poorly. Simply reducing overall risk with a focus on standard deviation results in a symmetric reduction in the upside and downside. We believe that we can create a portfolio that significantly reduces downside exposure while maintaining the majority of the upside potential.
Focus and Objectives
The strategy seeks to strategically balance the amount of risk exposure that the portfolio has to the major economic environments – non-inflationary growth, inflationary growth and recessions. This should limit the impact of surprise outcomes on the portfolio. Secondarily, the strategy allows for tactical shifts away from a perfectly risk-balanced exposure to each environment in order to emphasize those assets that are most likely to outperform cash.
Investment Process
We employ a three step investment process:
Asset Selection
The first step of the process translates the desired characteristics of the portfolio into three asset selection criteria. First, we use a correlation matrix to determine the marginal impact on diversification for each asset. The second set of criteria covers expected excess returns of risk premia for the selected markets. The third step relates to ensuring adequate liquidity, flexibility and transparency exists in the instruments and assets used to build the portfolio.
Portfolio Construction
Rather than focus on asset weights in a portfolio which can leave investors heavily dependent on the performance of one asset class, or the occurrence of one particular economic environment, we begin by examining how each asset contributes to overall portfolio risk. We build the portfolio so that an equal amount of risk comes from each asset class which produces a portfolio that is better hedged against negative economic outcomes like high inflation or deflation while still retaining the ability to participate in constructive market environments.
Active Positioning
The final step in the process is active positioning, or tactical allocation. Active positioning allows the risk weights to deviate from a strict risk-balanced structure based upon our evaluation of the assets along three factor concepts: valuation, the economic environment and price trends and reversals. Tactical overweights are applied to assets expected to outperform cash over the evaluation period and underweights are applied to assets expected to underperform cash. This process serves to adapt the portfolio to the prevailing economic environment.
