Markets don't stand still. Should portfolios?
There are two schools of thought, both of which are explored in academia with extensive evidence to support their respective cases.
One is that tactical changes to asset allocation don't make a material difference to portfolio risk and return. The other is that tactical changes to asset allocation can make a material difference to portfolio risk and return. How can these two seemingly contradictory statements both hold true?
The answer is time. In the long run, say for time horizons over 20 years, tactical adjustments don't make a material difference. In the short to medium term, say for time horizons under 10 years, tactical adjustments do make a material difference. And the shorter the timeframe, the more impact tactical adjustments can have.
This is illustrated by what we call the volatility funnel. The volatility and variability of returns of a fixed asset allocation over the short run are higher than they are over the long run. Given the wider potential range of returns in the short run, it makes more sense to be adaptive within that time frame.
By adapting the asset allocation to short-run risk return and correlation conditions, it is possible to narrow the variability of returns. This means obtaining a similar level of returns for an asset allocation compared to a static/fixed-weight counterpart, but improved risk-adjusted returns.
To be clear, an adaptive approach is not the same as market timing where you are trying to time market low and highs. That is notoriously difficult and often counterproductive. An adaptive approach is about being proactive in terms of risk management. This is because while returns are unknown, volatility is relatively consistent.
Being alert to known risks, and clear on-risk budgeting, is key to multi-asset portfolio management. Without it you are simply flying blind.
How does an adaptive approach work in practice? We see three main layers.
First is adapting the overall level of portfolio risk relative to a strategic neutral. This can be done by adapting the overall equity allocation. Because equity volatility is structurally higher than bond and cash volatility, its contribution to portfolio risk is higher than its headline asset allocation. Dialling the overall equity allocation up or down therefore has a material impact on a portfolio’s overall risk position.
Second is adapting the risk exposure within the equity allocation. Traditionally, equity allocations consider countries or regions. But an adaptive approach (which could also be termed an active approach) might also consider sector positioning or factor exposures too. Sectors group equity by business type (for example energy, technology or utilities). Factors group equity by persistent return-driving characteristics (for example value, size or quality).
Portfolio managers can adapt the sector allocation based on the current or expected economic cycle or adapt the factor positioning based on the current or expected market regime. The behaviour of different sectors and different factors in different stages of the market cycle is an area of extensive research in academia, meaning there are precedents to draw from.
