Avoiding the risk of standing still
Note: This is the second in a three-part series of blog posts focusing on how to potentially get returns in today’s bull market while protecting against the downside—in other words, how to run with the bulls without getting trampled. Part 1 can be viewed here.
In late cycle investing, dynamic portfolio management can help investors continue to get the upside while protecting against the downside. But we believe few asset managers can do it well.
A key part of multi-asset investing is dynamic portfolio management, where all the aspects of a portfolio are adjusted—as often as daily—to work toward a definable set of investment goals, such as saving for retirement, closing the funding gap of a corporate pension plan or meeting the objectives of an endowment.
Three approaches to portfolio management
As an example, let’s look at that second goal—an institutional investor’s desire to close their funding gap. Investors in this space are typically called on by three main flavors of service providers:
- 1. The first service providers are consultants, who tend to specialize in asset allocation and in recommending or hiring specific money managers to work on the individual asset classes within a portfolio. There are some very smart consultants out there, but their approach comes with its own structural limitations. Consultants typically don’t have access to holdings-based risk systems to know what their client owns on a daily basis across all liquid asset classes and managers down to the security level—it is hard to know where you want the portfolio to be. A smaller handful don’t advocate for dynamic management, believing that a quarterly meeting cycle is adequate to make adjustments. Even if adjustments are proposed, they may not have the implementation expertise in-house to make it happen in a timely or cost-effective manner. This cadence can obviously create issues, as markets, last time we checked, move more than four times a year.
- 2. The second are asset managers who claim to provide dynamic portfolio management, but who do so only within the confines of a bolt-on fund. While the rest of the portfolio is managed in more of the quarterly-meeting style, one separate fund attempts to respond to rapid changes in the market. We see this as an improvement, because at least some dynamic management is happening. But this is far from a total portfolio approach. The portfolio manager of the dynamic fund may not know what other managers within the overall portfolio are doing on a daily basis. In our decades of meeting with some of the world’s largest institutional clients, we’ve seen this approach result in unintentional gaps or doubled-up exposures.
- 3. The third kind of service providers do what we would call true dynamic portfolio management. They accomplish this with comprehensive data on their daily holdings—a daily view, not a quarterly view, of the complete holdings of the portfolio. And they balance tactical, opportunistic tilts with a long-term, total portfolio view.
We put ourselves in that third camp, and we believe it is a best-practice approach. In my previous series of blog posts, I talked about the three things required to succeed at this approach:
What’s required to do it right?
If this is, as we believe, the best-practice approach to dynamic portfolio management, why don’t more asset managers do it? First of all, the barriers to entry are high. It takes many years and constant commitment to build the infrastructure to pull this off. We’ve been investing in this approach for decades. At Russell Investments, we believe best-practice asset managers need capabilities in manager research, trading, transition management, overlays, currency, and precise positioning strategies. Every year, we invest heavily in data systems and analysis that informs our portfolio managers on where their portfolios are positioned, down to the single-security level.
Success with this approach also requires us to educate our clients—or the financial advisors who work with us—that a dynamic approach like this is designed to be less risky, not more risky.
It’s understandable that the human brain may see any change as a chance to introduce risk to a portfolio. Follow that logic, and it may seem reasonable that fewer changes equate with less risk. Here’s the problem with that logic: Markets change daily. We believe portfolios should be aligned to that same rate of change. Refusing to adjust portfolios at the same speed can cause portfolios to miss significant short-term opportunities or increase exposure to downside risk. Every day there is a new opportunity to consider or a new risk to protect against: earnings reports, interest rate increases, trade negotiations, or the constant barrage of geopolitical events. Compound that with our view that current markets are late in their cycle, and we believe dynamic management is not just portfolio management, it is risk management.
We also educate investors and advisors by explaining our commitment to the following:
- A consistent, repeatable process
- Our access to best-of-breed money managers using an open architecture framework
- An integrated approach to portfolio management and implementation, where our portfolio managers and our trading desk work together
- Our set of strategic beliefs that work to anchor any short-term moves by adherence to time-tested strategies that work over the long term
There are other potential objections to this approach. Let’s tick those off now.
What about price sensitivity? This approach can be very price competitive with some institutional and individual investors preferring not to be active everywhere all the time, or having predetermined fee budgets. A multi-asset approach—whether in an institutional portfolio or in an individual model portfolio—can also include positioning strategies or more explicit passive exposures to manage cost and deliver solutions within a fee budget.
What about complexity? Isn’t simple always better? The unavoidable fact is that financial markets are more complicated today than they have ever been. We believe it is our fiduciary responsibility to relieve our clients of those complications and work to deliver success in the simplest ways. But the solution must be fittingly robust. We would be failing as fiduciaries if we addressed market complexity in an insufficient manner. So instead, we work to hit performance requirements and also provide the service, reporting, and attribution that makes an investor’s experience a simpler one.
Our industry makes fiduciary responsibility unnecessarily complex. We work to simplify it by focusing more on outcomes and less on the often-artificial measurement known as benchmarks. Benchmarks can create their own goals that may or may not align with desired outcomes for investors. Benchmarks raise the important concern: Be careful what you measure, as it will guide the results.
Outcomes, on the other hand, are simple: Has your funded status improved? Are you on track to fund your retirement? Is your funded status volatility high or low? Did you beat inflation by five percent? And did you do it with less risk than the market or your peers delivered? We dynamically manage portfolios according to outcomes like those.
It’s not easy. Not everyone can do it. But we believe it’s worth it.