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Subscribe to Our NewsletterThe trade-off between risk and reward is a key foundation of modern portfolio theory. There is a positive, long-term relationship between these two elements. If investors wish to achieve higher returns, they must take more risk. Similarly, if they desire more safety, then they must settle for lower returns. Simply put, investors cannot have their cake and eat it too; higher return portfolios are inextricably associated with greater risk, and increased safety comes with the cost of lower returns.
The traditional approach to portfolio construction in the investment management industry clearly reflects this trade-off. Investors with higher risk tolerance and longer time horizons typically have a high percentage of their portfolios invested in stocks and a correspondingly low percent invested in bonds. By the same token, investors with lower risk appetites and shorter time horizons have relatively large allocations to bonds rather than stocks.
Between a Rock and a Hard Place
Historically, a conventional bond allocation filled a valuable purpose within investors’ portfolios. If investors wanted to reduce their risk, they could allocate a significant percentage of their portfolios to bonds. In addition to reducing portfolio volatility, bond allocations produced a reasonable, if unspectacular yield, thereby allowing investors to lower the volatility of their portfolios without sacrificing an inordinate amount of return.
In the post financial crisis world of record low interest rates, traditional bond allocations are no longer able to successfully accomplish what they have in the past. Investment grade bonds now offer investors negative real yields on an after-tax basis. While bonds can still reduce the volatility of one’s portfolio, the cost of this increased safety (i.e. negative real, after-tax yields) is far greater than in the past. Investors are currently wedged between the “rock” of over-weighting equities and taking substantial risk to generate reasonable returns and the “hard place” of accepting anaemic returns in exchange for reducing portfolio risk via a significant weighting in bonds.
Breaking the Mold
Practically every wealth manager follows a static approach to asset allocation, which is commonly referred to as a “strategic” or “buy and hold” asset mix. Once the asset mix is determined based on an investor’s financial situation and preferences, these weightings are typically set in stone. Regardless of changes in the investment environment (i.e. bull or bear market), the asset mix of the portfolio will remain largely unchanged.
Without a doubt, the trade off between risk and return is both applicable and accurate in the context of traditional, buy and hold portfolios that maintain a constant, unchanging asset mix. However, it is not applicable to strategies such as our Global Tactical Asset Allocation (GTAA) mandate, which uses quantitatively-driven algorithms to dynamically alter its asset mix and risk profile.
Our GTAA strategy goal is to increase exposure to positively trending markets and cut exposure when markets are falling, enabling our clients to participate meaningfully in rising markets while avoiding severe losses during precipitous market declines. This combination of characteristics can enable our clients to overcome the “rock and hard place” problem of traditional, buy and hold portfolios and achieve strong, long-run returns without suffering severe losses in bear markets.
Our ability to accomplish these objectives was evident both during the strong markets of 2017, when the strategy produced attractive returns, as well as during the challenging markets of 2018, when we protected our clients from losing money.