Post-crisis portfolio construction:
Asset allocation in a new era of risk
“Investors have been suffering The global financial crisis changed perceptions about the balance between investment
from diversification deficit risk and return. Investors who sustained losses in the 2007–2009 bear market are likely
disorder. What they thought was to have a new appreciation for portfolio risk management. But they are faced with a
diversified has become very paradox. While long-term history shows that stocks have provided higher returns than
highly correlated because of the other investments, recent history demonstrated that they can also devastate portfolio
global integration of the finan-
values over the short term.
cial markets. Assets we thought
were uncorrelated have started In the past, investors attempted to resolve this dilemma in two ways: with exposure to
to move together, so we have to high-quality fixed-income and through broad portfolio diversification. But these two
be much more thoughtful strategies may no longer be as viable as they once were.
about asset allocation.”
1) High-quality fixed-income may offer relatively stable returns, but with interest rates
– Dr. Andrew W. Lo, founder
and portfolio manager, at historic lows, it will not likely generate a sufficient return.
AlphaSimplex Group 2) Effective diversification assumes that historical performance relationships between
asset classes remain stable – but they don’t, especially in periods of financial crisis.
That’s why asset allocation models need to be adapted to a new era of risk.
Not For Use With The Public • June 2010
the evolution of asset allocation
Asset allocation has evolved over the past Figure 1: Headwinds for traditional assets
30 years. It began with the idea of using
stock and bond mutual funds to create
diversified portfolios. Throughout the Historical yield on 10-year U.S. Treasury bond 1954−2009
1980s and 1990s, diversification and 20
Returns: May 1954 – Aug. 1981 Returns: Sept. 1981 – Dec. 2009
asset allocation were promoted as a way Stocks: 10% (5% inflation-adjusted returns) Stocks: 11% (8% inflation-adjusted returns)
to optimize returns and lower investment Bonds: 4% (-1% inflation-adjusted returns) Bonds: 9% (6% inflation-adjusted returns)
risk. But with market trends so broadly 15 50/50 Mix: 0.28 Sharpe Ratio 50/50 Mix: 0.36 Sharpe Ratio
positive, they were never really tested on
the downside. During the extended bull
market of the 1990s, the primary goal of 10
asset allocation was generally to ensure
exposure to the best-performing asset
classes rather than to protect against
a potential market decline.
In post-2008 portfolio construction,
that dynamic may be reversed. Today, 0
managing risk may be considered a higher Jan-55 Jan-60 Jan-65 Jan-70 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10
priority than chasing market-beating
returns. But historically low interest rates Source: St. Louis Federal Reserve Bank, Morningstar
can make allocations to cash and high- Returns reflect reinvestment of capital gains and dividends, if any. Indices are unmanaged and do not incur fees.
quality fixed-income very unappealing It is not possible to invest in an index. Stocks are represented by the S&P 500 Index. Bonds are represented by
– and 2008 demonstrated the peril of the Ibbotson Associates U.S. Long Term Government Index. For illustrative purposes only. The information is not
intended to be a recommendation to purchase or sell a security. Past performance is no guarantee of future results.
relying solely on assets with historically
low correlation for risk management. So
what are investors to do?
The new foundation for successful asset maturity, including interest payments and Why? Because with yields so low, if stock
allocation may be a portfolio that relies appreciation/depreciation.) In this scenario, market conditions are normal or better,
on specific risk management strategies, the yield-to-maturity returns are likely to be the allocation to high-quality bonds
rather than on diversification across asset in the range of investors’ long-term return should do nothing but dilute long-
classes. This may allow for adequate needs under most circumstances. And in term returns to portfolios that also have
levels of return under normal to favorable scenarios where riskier assets like equities exposure to risk assets like equities. On a
market conditions, but would potentially have losses, these high-quality assets benefit hold-to-maturity basis, based on historical
limit losses when market conditions from a flight to quality and can generate performance, intermediate maturity
are poor. returns in excess of their yield-to-maturity. high-quality bonds should earn 3% to
5% annualized, with periods of time
High-quality fixed-income As a result, investors with balanced
when they significantly underperform as
exposure to stocks and high-quality bonds
losing its appeal were generally spared the disaster that
interest rates rise.1
Back when yields on high-quality fixed- befell equity-centric investors over the Finally, as Figure 1 shows, the Sharpe
income securities were high, as they ten years ended 2009.1 But the flight to Ratio (risk-adjusted return) of a standard
were from the 1970s to the 1990s, risk quality during the 2008 financial crisis is 50/50 mix of stocks and bonds when
management was a fairly straightforward partly responsible for the low rates offered rates were rising was lower than the
exercise (see Figure 1). If investors can by cash and high-quality bonds today. risk-adjusted return of the same portfolio
get yields-to-maturity of high single digits In fact, based on historical performance, when rates were falling.2
or better from government securities or current rates are so low that significant
very high-quality corporate bonds, there exposure to high-quality bonds is no In order for today’s investors to continue
is minimal opportunity cost to allocating to receive strong risk-adjusted returns
longer a source of risk management, but
to these assets. (Yield-to-maturity is from traditional asset allocation, interest
rather a de facto bet that the next crisis
the annual return on a bond held to rates would need to continue to decline
should happen relatively soon.
while equity markets produce historically
Source: Morningstar, Natixis Investment Strategy Group
Stocks are represented by S&P 500 Index and bonds are represented by the Ibbotson Associates U.S. Long Term Government Index.
2 ASSET AlloCATIoN IN A NEW ErA oF rISK Not For Use With The Public • June 2010
normal long-term rates of return. A acknowledges the need to take increased Historically, stocks have averaged
declining rate scenario is similar to the market volatility and global risk factors 12-month returns of approximately 12%
economic environment experienced in into account to improve the odds of with a standard deviation of 22%.4 At first
Japan over the past two decades, which meeting investor goals. glance, that risk-return tradeoff doesn’t
has not been a recipe for robust equity seem very alarming. But when you look
market returns. Adapting allocations to a little deeper, the risk inherent in equities
market volatility comes into sharper focus:
What about diversification? • The maximum 12-month loss for
With today’s higher volatility levels,
Historically, diversification has lowered equities has been nearly 70%.4
relying on stocks alone to create attractive
risk because different types of assets
levels of return may be less likely to lead • Standard deviation (22%) nearly
respond differently to changing market
to success than in the past. Not only is double the average return of 12%
conditions, a concept otherwise known
equity volatility currently high relative to implies a significant possibility of
as low correlation. But in today’s global
historical levels, it may remain so. Analysis negative returns.4
marketplace, assets that have historically
of historical data shows that spikes in
complemented one another may be more Similarly, the maximum 12-month
volatility have consistently left a higher
likely to move in synch, reducing the drawdown on long-term U.S. government
baseline in their wake. These “aftershocks”
benefits of traditional diversification. bonds has been over 21% – a considerable
have continued for several years, with
As Figure 2 demonstrates, in times of crisis volatility levels 25% higher on average loss for what is commonly considered a
– just when investors are most in need of than pre-spike levels.3 “risk-free” investment. So while historical
risk management – the correlation of “risky” data shows that it is highly unlikely for
Heightened volatility without downside significant negative returns to occur
assets such as stocks and bonds tends to
risk management may increase the simultaneously in both stocks and
increase. This phenomenon may make risk
potential for loss. Investors unwilling to high-quality bonds, 2008 taught us the
management through diversification less
tolerate the uncertainty and potential risk importance of expecting the unexpected.4
effective in extreme environments.
to their investment balances are seeking
Post-crisis portfolio construction new ways to limit overall risk but still
recognizes that historical trends maintain a reasonable opportunity
cannot predict future correlations, and for return.
Figure 2: In periods of crisis, risk management through diversification may lose its effectiveness
Correlation to large-cap U.S. stocks 1998−2007 compared to 2008
Small-cap International Emerging markets Investment-grade High yield Convertible Hedge
stocks stocks stocks U.S. bonds bonds bonds funds
Source: Natixis Investment Strategies Group 1998–2008. Large-cap U.S. stocks represented by S&P 500 Index, small-cap stocks represented by Russell 2000, international
stocks represented by MSCI EAFE Index, emerging markets represented by MSCI EM Index, investment-grade U.S. bonds represented by Barclays Capital Aggregate Bond Index,
high yield U.S. bonds represented by Barclays Capital High Yield Corporate Bond Index, convertible bonds represented by Merrill Lynch Convertible Bond Index, and hedge funds
represented by Credit Suisse/Tremont Hedge Fund Index.
Natixis Investment Strategies Group
MPI Stylus 1926–2009
Not For Use With The Public • June 2010 ASSET AlloCATIoN IN A NEW ErA oF rISK 3
rethinking the core
Conventional wisdom on the purpose Components of the new The evolution of asset allocation
of core portfolio holdings has been to
core include: 1980 to present
harness the long-term risk-adjusted
return potential of a traditional mix of 1. GloBAl EQUITY EX-U.S. – Equity exposure 1980s
assets such as large-company stocks and to developed and emerging markets
high-quality bonds. The goal of asset
2. GloBAl FIXED-INComE – A portfolio Reduce risk by investing in diversified
allocation has been to strike a strategic
allocated across geographies to gain access portfolios, not individual stocks or bonds
long-term balance between these two low-
to-negative-correlation asset classes that to different yield curves, as well as across Key points:
optimizes their risk-adjusted return. the quality spectrum, to pursue yield • Equity and fixed-income pooled funds
and total return potential were a cost-effective way to help
But in the post-crisis world there are investors diversify their holdings
three key factors in play: 3. rISK-mANAGED AlTErNATIvES – • Age, risk tolerance and specific
Global exposure to currencies and investment goals helped shape
• Historically high volatility recommended allocations
commodities as well as traditional asset
classes, with the ability to take long and
• Historically low interest rates
short positions, and managed with tight Late 1980s – 2000
• Renewed awareness of the potential for risk controls to potentially limit volatility Guiding principle:
historical correlations to break down and the possibility of extreme loss Lower pooled fund risk by diversifying
across the style box
In this environment traditional core 4. HEDGED U.S. EQUITY – A traditional Key points:
holdings – especially long stocks – may U.S. large-cap portfolio that maintains • Investors encouraged to diversify
just be too volatile. And the low rates on exposure to the growth potential of holdings across equity and fixed-income
high-quality fixed-income securities make equities while limiting the variability of style boxes
it likely that their long-term returns are returns and adding protection on the • Maintain exposure to all equity categories,
downside because no one could predict the next
insufficient to provide strong risk-adjusted
returns even when accompanied by stocks.
This new core portfolio can provide
Post-crisis core portfolios may benefit global exposure to stocks and bonds, 2000 – 2008
from some revisions to traditional asset risk-managed exposure to non-correlated
allocation. Each potential component of asset classes and hedged exposure to U.S.
Core that combines traditional assets,
the new core includes an enhancement equities. Satellite investments that seek diversified with satellite investments to
that may offer greater risk management to add alpha should continue to play seek higher returns
better suited to today’s environment. an important role in complementing Key points:
core holdings, but they too may reflect a • Establish core portfolio of inexpensive
greater concern for risk and diversification passive or low tracking error investments
beyond traditional asset classes. • Seek alpha with satellite holdings
Limit overall volatility to optimize risk-
Derivatives, primarily futures and forward contracts, generally have implied leverage (a small amount • Unhedged equity exposure may be
of money to make an investment of greater value). Because of this, extensive use of derivatives may too volatile
magnify any gains or losses on those investments as well as certain risks. Stock markets, particularly • Interest rates on high-quality bonds
foreign stock markets, are volatile and can decline significantly in response to adverse economic,
issuer, political or regulatory changes. Exchange rate risk between the U.S. dollar and foreign curren-
may be too low
cies may cause the value of investments to decline. Exposure to commodity markets may result in • Managing risk may be more important
greater volatility than investments in traditional securities. Interest rate increases can cause the price than reaching for return
of debt securities to decrease and will affect the value of investments in income-producing securities.
4 ASSET AlloCATIoN IN A NEW ErA oF rISK Not For Use With The Public • June 2010
Post-crisis asset allocation with the new core
Global equity ex-U.S. Alternatives Hedged U.S. equity
Exposure to world equity markets is Alternatives can be broadly defined as Owning a large number of stocks may
essential to proper diversification, but investment strategies that aren’t limited to help diversify away stock-specific risk, but
many global equity strategies tend to long-only stocks and bonds. Alternative in strong bear markets equities as a group
overweight U.S. holdings. An allocation strategies can diversify traditional tend to respond similarly to economic
to non-U.S. global equity – including portfolio holdings because many of risk factors. Certain types of strategies,
emerging markets – ensures exposure their techniques, such as shorting and particularly hedging strategies, seek to
to more world economies and reduces hedging, produce non-correlated returns. constrain the deviation of returns and
dependence on large-cap companies. In addition, they often provide exposure reduce loss during unanticipated negative
to new or different asset classes, such as events and crises.
Global fixed-income commodities and currencies.
Adding hedged equity as a core holding
High-quality bonds have traditionally
This combination of sophisticated maintains exposure to the appreciation
been recommended as a core allocation
techniques and non-traditional asset potential of equities while limiting the
because they are historically less volatile
classes has the potential to deliver strong volatility of returns. Hedged equity funds
than stocks and have historically had low
risk-adjusted returns and significantly generally pursue returns similar to stocks,
correlation with equity returns.5 They
improve the overall risk-return efficiency but seek to maintain a lower volatility
also generate a regular income stream,
of asset allocation programs. Institutions profile.
which may help cushion overall returns.
and hedge funds have relied on the
But an effectively diversified fixed-income A hedged equity strategy may provide
non-correlation and risk management
core may need exposure to international greater stability to the core allocation
properties of alternative investments for
securities, interest rates and yield curves. under volatile market scenarios, although
years. However, the experience of 2008
showed us that alternative strategies must it should underperform in strong bull
In addition to diversification across
be offered with strong risk controls, markets.
geographic regions, a global fixed-income
core allocation may benefit from the transparency and liquidity if they are • If stocks go up, hedged equity may
flexibility to allocate across the quality intended for individual investors. provide an “equity-like” return, but
spectrum of fixed-income securities. will most likely lag traditional long-
Now alternative strategies available in
This may also be an advantage in a low only strategies.
pooled funds can bring these benefits to
interest rate environment, as lower-
individual investors. Alternative funds can
quality bonds can provide opportunities • If stocks go down, hedged equity
provide the added benefits of liquidity,
for the pursuit of higher yield and total declines may be less severe.
transparency and lower expenses. In
return. Additionally, bonds with higher
addition, alternative strategies with • If stocks are flat or move sideways for a
coupons or current prices well below
strong risk controls designed to limit period of time, earning premiums from
par value may help offset the negative
volatility can make alternatives exposure call options can still generate a return.
effects of periods of rising interest rates.
appropriate for the core allocation.
However, these bonds may be exposed to A traditional long-only equity portfolio
greater economic, political and currency may generate a higher return than its
fluctuation risks. hedged counterpart from time to time.
But hedged equity may provide more
consistency to buffer the effects of steep
losses, which may make it easier to stay
committed to long-term investment goals.
Natixis Investment Strategies Group
Not For Use With The Public • June 2010 ASSET AlloCATIoN IN A NEW ErA oF rISK 5
Asset allocation with the new core
Traditionally, asset allocation models have In this example, the traditional plus Figure 3: Comparison of
been based on a mix of equities and fixed- alternatives core pared back global equity
hypothetical asset allocation
income products. and fixed-income exposure to 40% each
and added a 20% position in alternatives.
from 4/1/90 to 3/31/10
Figure 3 compares a traditional core This modification resulted in a higher TrADITIoNAl CorE
allocation (50% global equity represented return with noticeably lower volatility, a
by the MSCI World Index and 50% better risk-adjusted return and a lower
global fixed-income represented by maximum drawdown.
Barclays Capital Global Aggregate Bond
Index) with two other hypothetical The risk-managed core went even further, Global Global
Fixed-Income Equity Global
portfolios that consider the impact of dividing the equity position into non-U.S. 50% 50% Fixed-Income
implementing components of the new global equity and hedged U.S. equity,
core. Each portfolio shows annualized and retaining the alternatives allocation at
return, and highlights measures of 20%. This hypothetical portfolio had the
volatility and risk. highest return with the lowest volatility, ANNUAlIzED rETUrN 7.13%
a better Sharpe ratio and the lowest
• STANDArD DEvIATIoN mEASUrES ANNUAlIzED
maximum drawdown. 8.60%
ToTAl volATIlITY – Lower standard STANDArD DEvIATIoN
deviation indicates a historically less All asset allocation scenarios are for SHArPE rATIo 0.34
volatile portfolio. hypothetical purposes only and are mAX DrAWDoWN -29.60%
not intended to represent a specific TrADITIoNAl PlUS AlTErNATIvES CorE
• SHArPE rATIo mEASUrES
asset allocation strategy or recommend
rISK-ADJUSTED rETUrN – A higher
a particular allocation. Each client’s
Sharpe ratio indicates better historical Alternatives Alte
situation is unique and asset allocation 20%
decisions should be based on a client’s
• mAXImUm DrAWDoWN mEASUrES risk tolerance, time horizon andEquity
Fixed-Income Global Global Global
financial situation. 50% 50% Fixed-Income Equity Fixed-Income
WorST-CASE DoWNSIDE PErFormANCE 40% 40% 40%
– A lower drawdown indicates a less
severe historical portfolio loss.
ANNUAlIzED rETUrN 7.35%
SHArPE rATIo 0.43
mAX DrAWDoWN -27.64%
Hypothetical portfolio annualized returns include reinvestment of dividends and capital gains,Alternatives
if any. Alternatives
Past performance is no guarantee of future results. 20% 20%
Indexes are unmanaged. It is not possible to invest in Global
any index. Hedged
Global U.S. Equity
Equity Global Global
Global fixed-income is represented by Barclays Capital Global Aggregate Bond Index, Global equity is represented
Fixed-Income Global 20%
by MSCI World Index, Alternatives are represented by HFRI Fund of Funds Index, Global equity ex U.S. is Equity
50% 50% Fixed-Income
represented by MSCI World Index ex US, and Hedged U.S. equity is represented by BXM Index. 40% 40% Global Equity
Barclays Capital Global Aggregate Bond Index is an unmanaged index of domestic debt issued by the U.S. ex U.S.
government, its agencies, and U.S. corporations. 20%
HFRI Fund of Funds Composite Index is a composite of over 800 hedge funds that have at least $50 million in
assets under management or have been actively trading for at least 12 months.
ANNUAlIzED rETUrN 7.71%
CBOE S&P 500 BuyWrite Index (BXM) tracks the performance of a hypothetical S&P 500 covered call strategy.
S&P 500 Index is an unmanaged index of U.S. common stock performance. ANNUAlIzED
SHArPE rATIo 0.54
6 ASSET AlloCATIoN IN A NEW ErA oF rISK mAX DrAWDoWN -24.31%
Not For Use With The Public • June 2010
Beyond the core
Many advisors also recommend satellite take on greater risk. Possible satellites Post-crisis asset allocation:
investments for their clients, to provide could include asset classes thought to be
alpha potential from a skilled manager or undervalued, short exposure to asset classes
exotic asset class. In post-crisis portfolio thought to be overvalued, an experienced • For INvESTmENT FIrmS – Consider
construction, with a risk-managed core, absolute return manager, sector fund expanding platform offerings to
satellite investments may be able to exposure or alternative alpha. include risk-managed mutual funds,
particularly hedged equity, global bond
and alternatives, to help meet demand
from financial advisors and their clients.
The new core/satellite model
• For FINANCIAl ProFESSIoNAlS –
Become familiar with the new models
Alternative of asset allocation and the investment
alpha solutions available to help create better
Alternative risk-managed portfolios for investors.
Hedged • For INvESTorS – Learn more about
U.S. Equity the new realities of today’s financial
Global 20% landscape and how investments other
than traditional stock and bond funds
40% Global Equity
may help improve diversification and
20% Short exposure potentially lower overall portfolio risk.
Sector fund to overvalued
Asset allocation in a new era of risk
As investors consider diversification in a new light, strategies that can help reduce market risk, improve risk-
adjusted returns, and lower overall correlation may become the foundation of asset allocation. Understanding
the tradeoffs may help create more durable portfolios that are better adapted to this new era of risk.
Not For Use With The Public • June 2010 ASSET AlloCATIoN IN A NEW ErA oF rISK 7
Natixis Global Associates
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