Multi-Asset Investing A Practitioner's Framework

Despite the accepted fact that a substantial part of the risk and return of any portfolio comes from asset allocation, we find today that the majority of investment professionals worldwide are focused on security selection. Multi-Asset Investing: A Practitioner’s Framework questions this basic structure of the investment process and investment industry.

• Who says we have to separate alpha and beta?
• Are the traditional definitions for risk and risk premium relevant in a multi-asset class world?
• Do portfolios cater for the ‘real risks’ in their investment processes?
• Does the whole Emerging Markets demarcation make sense for investing?
• Why do active Asian managers perform much poorer compared to developed market managers?
• Can you distinguish how much of a strategy’s performance comes from skill rather than luck?
• Does having a performance fee for your manager create alignment or misalignment?
• Why is the asset management transitioning from multi-asset strategies to multi-asset solutions?

These and many other questions are asked, and suggestions provided as potential solutions. Having worked together for fifteen years, the authors’ present implementable solutions which have helped them successfully manage large asset pools.

The Academic Perspective

“Multi-Asset Investing asks fundamental questions about the asset allocation investment processes in use today, and can have a substantial impact on the future structure of the finance industry. It clarifies and distils the techniques that investment professionals need to master to add value to client portfolios.”

—Paul Smith, President & CEO, CFA Institute

“Pranay Gupta, Sven Skallsjo, and Bing Li describe the essential concepts and applications of multi-asset investing. Their treatment is far ranging and exceptionally lucid, and always with a nod to practical application. Buy this book and keep it close at hand.”

—Mark Kritzman, MIT Sloane School of Management

“Innovative solutions to some of the most difficult investment problems we are faced with today. Multi-asset Investing tackles investment issues which don’t have straight forward solutions, but nevertheless are faced by every investment professional. This book sets the standard for investment processes of all asset managers.”

—SP Kothari, MIT Sloane School of Management

The Asset Owner Perspective

“Multi-asset means different things to different people. This is the first text that details a comprehensive framework for managing any kind of multi-asset investment problem. Further, its explanation of the commercial aspects of managing a multi-asset investment business for an asset manager, private bank or asset owner make it an indispensable tool”

—Sadayuki Horie, Dy. Chairman - Investment Advisory Comm., Government Pension Investment Fund, Japan

“Multi-Asset Investing shows the substantial scope there is to innovate the asset allocation process. With its novel approaches to allocation, portfolio construction and risk management it demonstrates the substantial value that can be added to any portfolio. The solutions proposed by Multi-Asset Investing are creative, thought provoking, and may well be the way all portfolios need to be managed in the future.”

—Mario Therrien, Senior Vice President, Caisse de Depot et Placement du Quebec, Canada

The Asset Manager’s Perspective

“Never has astute asset allocation and diversification been more crucial than today. Asset Managers which are able to innovate their investment processes and products in this area, are more likely to be the winners. Multi-Asset Investing provides both simple and sophisticated, tested and implementable techniques for successfully managing multi-asset portfolios.”

—Vincent Camerlynck, former CEO BNP Paribas Investment Partners, Asia Pacific

The Investment Strategist Perspective

 “For plan sponsors, portfolio managers, analysts and risk managers, Multi-Asset Investing is an unparalleled guide for portfolio management. Its approach to blending the quantitative and fundamental, top-down and bottom up and the risk and return frameworks makes it a valuable tool for any kind of investment professional. It clarifies a complex subject into a series of practical ideas to help add value to any portfolio.”

—Ajay S. Kapur, Chief Strategist, BOA Merrill Lynch Asia

PRANAY GUPTA has over 25 years of experience in managing multi-asset and multi-strategy portfolios of up to US$85 billion across the world for asset managers, sovereign wealth funds, insurance companies, pension plans, endowments and high-net-worth individuals. He has served as the Chairman of the Investment Committee at the CFA Institute Research Foundation and has been awarded as the Best Discretionary Asset Manager in Asia.

SVEN R. SKALLSJÖ has designed and developed risk models at Ignis Asset Management, AGL Structured Finance and Shell Asset Management.

BING LI is the president of BC Capital Management Ltd., a Hong Kong-based firm providing investment solutions for high-net-worth individuals in mainland China.

Preface xiii

About the Authors xv

1. An Introduction to the Multi-Asset Investment Problem 1

1.1 What is Multi]Asset Investing? 2

1.2 The Conventional Structure 4

1.3 Transitioning from Active Management to Exposure Allocation 4

1.4 Creating an Improved Allocation Structure 5

1.5 Constructing a Multi]Asset Portfolio to Manage Tail Risks 6

1.6 Multi]Asset Investing in Emerging Markets 6

1.7 From Multi]Asset Strategies to Multi]Asset Solutions 7

1.8 Structuring a Multi]Asset Business 7

2. The Traditional Allocation Structure 9

2.1 The Traditional Investment Process 10

2.2 The Asset Allocation Process 12

2.3 The Belief in Diversification 13

2.4 Harnessing Equity Risk Premium and the Investment Horizon 19

2.5 Asset Classes as Mutually Exclusive Silos 20

2.6 Organization Structure and Resource Allocation 20

2.7 Implications for Skill Required in Asset Allocation 21

2.8 Requirements for a Revised Allocation Solution 22

2.9 Parallel Debates Created in the Search for a Revised Allocation Solution 23

3. Transitioning from Active Management to Exposure Allocation 25

3.1 A Historic Rationalization of Alpha and Beta 26

3.2 Progression of Active Management 27

3.3 Generalizing the Beta Concept 27

3.4 The Demise of Asset Class Demarcated Allocation 28

3.5 Implications for the Active Investment Process 29

3.6 Investment Strategy Categorization 30

3.6.1 Fundamental, Quantitative and Technical 30

3.6.2 Top]down, Bottom]up and Relative Value 31

3.7 Positioning of Alternative Investments 31

3.8 Obsolescence of Portable Alpha 32

3.9 Positioning of Fundamental Indexation and Smart Beta 32

3.10 Risk in an Exposure]Based Framework 33

3.11 Horizon]Based Organizational Demarcation 34

3.12 Transition from an Asset]Based to an Exposure]Based Organization 34

3.13 Conclusion 37

4. Redefining Risk Premium for Multi]Asset Allocation Decisions 39

4.1 Incumbent Risk and Risk Premium Frameworks 40

4.2 Framework for the Concurrent Presence of All Asset Classes 41

4.3 Incorporating Intra]Horizon Risk 42

4.4 Risk and Return Premium for Allocation Silos 43

4.5 Asset Class Premiums – Comparison of Traditional and Proposed Methods 45

4.6 Asset Class Premiums – Impact of Different Investment Horizons 46

4.7 Asset Class Risk – Comparison of Traditional and Proposed Methods 47

4.8 Asset Class Risk – Impact of Different Investment Horizons 48

4.9 Sovereign Risk and Risk Premium 49

4.10 Application to Various Multi]Asset Investment Problem Scenarios 51

4.11 Conclusion 52

5. A Multi-Strategy Allocation Structure 53

5.1 Categories of Allocation Approaches 54

5.2 A Multi]Strategy Framework for the Allocation Problem 58

5.3 The Benefits of Strategy Diversification 59

5.4 Individual Allocation Methodology Requirements 61

5.5 Example of a Multi]Strategy Allocation Approach 63

5.6 Conclusion 66

6. A Fundamental Exposure Allocation Approach—Business Cycles 67

6.1 The Passive Economic Model 67

6.2 An Active Economic Approach 68

6.3 A Five Cycle Asset Allocation Approach 69

6.3.1 Cycle I – The Global Business Cycle 69

6.3.2 Cycle II – The Local Business Cycle 70

6.3.3 Cycle III – The Monetary Cycle 71

6.3.4 Cycle IV – The Credit and Capex Cycles 73

6.3.5 Cycle V – Market Cycle 73

6.4 Cycle Limiting Risk Parameters 73

6.5 Segregating the Core and Cyclical Components 74

6.6 The Composite Five Cycle Framework 75

7. A Systematic Exposure Allocation Process — Active Risk Budgeting 77

7.1 Modeling the Business Cycle 78

7.2 Modeling the Monetary Cycle 80

7.3 Risk Adjustment for Equity Valuation 81

7.4 Creating an Adjusted Risk Budgeting Allocation Methodology 82

7.5 Simulated Performance Results 85

7.6 Confirming Robustness of ARB Allocation Methodology 90

7.6.1 Performance in Different Time Periods 90

7.6.2 Performance in Different Market Conditions 90

7.7 Implementation of a Drawdown Management Process 94

8. Estimation of Asset Allocation 97

8.1 The Consensus Asset Allocation Dataset 97

8.2 Using Consensus Data for Allocation Decisions 98

8.2.1 Basic Allocation Decisions 98

8.2.2 Creating Tactical Allocation Changes 99

8.2.3 Conviction Level in Allocation Stances 102

8.2.4 Currency Hedge Ratio Decisions 103

8.2.5 Separating the Poor Forecasters from the Accurate Ones 105

8.2.6 Contrasting the Variety of Allocation Methodologies 105

9. Optimization for Multi-Asset Portfolios 107

9.1 Evolution of the Mean Variance Framework 107

9.2 Portfolio Allocation and Measures of Performance 109

9.3 A Utility]Based Approach 110

9.4 The Fund Manager’s Objectives 110

9.5 The Efficient Frontier 112

9.6 Optimal Portfolio Choice 113

9.7 Incorporating the Constraints 114

9.8 Tail Risk Constraint 115

9.9 Event Risk 115

9.10 Macro Risk 116

9.11 Regime Risk 116

9.12 Correlation Risk 117

9.13 Formulation of the Optimization Problem 118

9.14 The Unconstrained Allocation 119

9.15 Applying the Constraints 121

9.16 The Preferred Portfolio 127

9.17 Conclusions 130

10. Managing Tail Risk in Multi-Asset Portfolios 133

10.1 Portfolio Management – The Practical Setting 134

10.2 Asset Allocation – The Practical Setting 134

10.3 Creating a Real Risk Measure: End]of]Horizon vs. Intra]Horizon Risk 135

10.4 Model Uncertainty 139

10.5 Stop]Losses 143

10.6 Implementing Tail Risk Management 150

10.7 Notation and Variables 153

11. Multi-Asset Investing in Emerging Markets 155

11.1 Observation 1: Sub]Optimal Geographic Categorization of Emerging Markets 155

11.2 Observation 2: Inappropriate Sector Classification for Emerging Markets 156

11.3 Observation 3: Stock Concentration in Equity Indices 158

11.4 Observation 4: The Potential for Active Management 159

11.5 Observation 5: Performance of Active Managers 159

11.6 Observation 6: Over]Dependence on a Single Investment Decision 162

11.7 Summary of Observations 162

11.8 Pitfalls in Emerging Market Investment Frameworks 163

11.9 An Improved Framework for Emerging Market Investments 164

12. The Importance of Asset Allocation in Asian Equities 169

12.1 Impact of Breadth on Portfolio Excess Return 169

12.2 Impact of Varying Cross]Sectional Dispersion on Portfolio Excess Return 170

12.3 The Relative Importance of Asset Allocation and Stock Selection 172

12.4 Comparing the US and Asian Equity Investment Universe 173

12.5 Conclusions 176

13. Implementing a Multi-Asset Strategy – Active or Passive 179

13.1 Investment Determinants for the Active]Passive Decision 179

13.2 Asset Owner Constraints Impacting the Active–Passive Decision 184

14. An Exposure-Based Risk Diagnostics Framework 185

14.1 Shortcomings of a Traditional Risk Analysis Approach 185

14.2 Evaluating Intended and Unintended Risk 186

14.3 A Multi]Dimensional Risk Architecture 187

14.3.1 Skill Analysis 188

14.3.2 Investment Process Component Analysis 189

14.3.3 Regime Risk Analysis 189

14.3.4 Style and Factor Risk Analysis 190

14.3.5 Macro Risk Analysis 190

14.3.6 Stress Event Risk Analysis 191

14.3.7 Peer Group Comparison Analysis 192

15. Impact of Manager Compensation on Allocation Decisions 195

15.1 Compensation Structure 196

15.2 Managerial Constraints 197

15.2.1 Managerial Skill 198

15.2.2 Managerial Risk Preferences 198

15.3 Optimal Activeness 199

15.4 The Distribution of Performance 202

15.5 The Importance of Skill 203

15.6 Activeness and Age 205

15.7 Implications for a Multi]Period Setting 206

15.7.1 Compensation Structure 206

15.7.2 The Distribution of Performance 206

15.8 Examples of Managerial Contracts 208

15.9 Conclusions 209

16. From Multi-Asset Strategies to Multi-Asset Solutions 211

16.1 Current Phase of Industry Transition 213

16.2 Multi]Asset Solutions as an Industry Function 214

16.3 Characteristics of a Multi]Asset Solution Provider 215

16.4 Customization Parameters for an Investment Solution 215

16.5 Requirements for a Standardized Implementation 219

16.6 The Importance of Attributing Performance 219

16.7 Conclusions 220

17. Multi-Asset Investing for Private Wealth Assets 221

17.1 The Private Wealth Multi]Asset Investment Problem 221

17.2 Business Model and Organizational Issues 224

17.3 Incumbent Investment Frameworks 226

17.4 A Multi]Asset Private Wealth Investment Platform 227

17.5 Goals]Based Allocation 228

17.6 Implication for the Long]Only Active Manager 230

17.7 Conclusions 230

18. Structuring a Multi-Asset Investing Business 233

18.1 Product Structure and Positioning 233

18.2 Product Advantages and Disadvantages 235

18.3 Product Investment Skills 236

18.4 Target Client Segmentation 237

18.5 Where Did Existing Products Fall Short? 238

18.6 Client Segment – Expectations and Evaluation 242

19. Competing for Better Institutional Investment Outcomes 245

19.1 Mission and Beliefs – The First and Most Critical Step 246

19.2 Frameworks: Traditional Asset Class Versus Risk Premium 248

19.3 Linking Beliefs With Return Drivers and Portfolio Construction Decisions 250

19.3.1 A New Perspective 252

19.3.2 A Wider Opportunity Set for Exploiting Alpha 253

19.3.3 Ensuring That Everything Is Consistent with Beliefs 255

19.4 Governance Consideration 256

19.4.1 Closing the Governance Gap: Build or Buy 256

19.4.2 The Separation of Governing and Executive Functions 257

19.5 Choosing an Implementation Route for Delegation 259

19.5.1 Bundling Multiple Investment Strategies into Pooled Funds 259

19.5.2 Fully Bespoke Implementation 260

19.6 Monitoring 262

19.7 Conclusions 263

Bibliography and References 265

Index 269

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