Index-based building blocks for portfolio management
However, in order to benefit from these attractive properties, attention must be paid to portfolio construction. While the old adage claims that diversification is the only free lunch in financial markets, a careless cook can ruin that lunch. Strategy combination approaches range from simple weighting schemes to sophisticated quantitative and view-based approaches that aim to provide additional value through the optimal incorporation of non-price-based information. As always, the golden rule is to achieve the proper balance between robustness and sophistication.
Increasingly, investors in systematic strategies approach portfolio construction on the basis of risk allocation, employing a range of methodologies that achieve better diversification than simple allocation techniques while at the same time avoiding the potential lack of robustness of full statistical optimisation procedures, such as mean-variance analysis. For example, a portfolio construction method involving the equal weighting of notional exposures ignores relative risk contributions (the commodity value strategy of the previous section is almost three times as volatile as the curve strategy, so should they be weighted equally?) and fails to diversify the portfolio properly. By contrast, equal risk-weighting of strategies ensures that predicted portfolio risk can be equally attributed to each of the strategies in the portfolio (equal-risk-weighting is optimal in a mean-variance framework under the assumption that ex-ante Sharpe ratios across constituents are assumed to be the same, and as such can be considered to be a good starting point for overlaying views). Tactical allocation and optimal incorporation of views is a rich source of investment performance for active investors.
As an example of a portfolio diversified across styles and asset classes, we create a basket of tradeable Barclays Capital systematic strategy indices that give exposure to various risk premia across equities, rates, commodities, currencies, and volatility. We employ equal volatility weighting to construct the portfolio as a simple implementation of a risk-weighting approach. Figure 6 illustrates the resulting index over the past ten years. Note that the example shows back-tested performance1. Historically, the portfolio has achieved stable returns with relatively low levels of risk and relatively minor drawdowns.
Figure 7 shows average returns for the risk premia portfolio, compared with average returns on the S&P 500. The returns are grouped by the sorted deciles of the benchmark index. In other words, from the left to the right we show firstly the average for the 10% lowest returns on the benchmark over the past decade, and lastly the average for the 10% highest returns, which are compared with the average strategy portfolio return over the same time periods. The strategy basket performs well, independent of the return of the benchmark. Remarkably, some of the highest average returns are realised when the equity market suffers most.
Figures 6 and 7 illustrate the attractive properties of portfolios of risk premia strategies as components in asset allocation.