THE RISK REBATE: MAKING THE MOST OF DIVERSIFICATION

FundsTalk

There are a number of reasons why diversification through investing in multi-asset funds is a sound – and popular – strategy for investors. One of these reasons is a technique which doesn’t always get much attention but has always played an important role, especially when modelling and calculating optimal asset allocations. We’re calling it the ‘Risk Rebate’.

Every portfolio has a certain amount of risk it can take on in order to meet its objectives, and diversification inherently reduces the risk of investing in any one asset class. Measures of projected risk and return are quantifiable, so fund managers can take the percentage of risk they’ve ‘saved’ through diversifying – the ‘rebate’ – and ‘spend’ it elsewhere. This additional risk budget can be used to add exposure to higher-risk assets, resulting in the potential for better returns without exceeding the overall risk limits of the portfolio.

DIVERSIFICATION

Diversification is a fairly straightforward concept, and it’s relatively easy to grasp its main benefits. Many factors affect an investment’s performance, such as the health of the economy or industry, interest rates, investor sentiment and unexpected events (both positive and negative). The impact of these factors may harm the performance of one asset type, but conversely improve the performance of another. And asset classes tend to perform in different ways over different time periods. By combining different types of assets in one fund, multi-asset managers seek to reduce volatility and smooth out overall performance by offsetting any falls in one asset class against gains from another. This is the well-rehearsed ‘eggs in more than one basket’ explanation, which remains the core rationale for diversifying investments – and something clients typically understand and like.

While the basic concept and core benefits are fairly simple, the design, implementation and management of an effective multi-asset portfolio can be complex. And perhaps the most challenging area of all is ultimately the most important: optimisation of the asset allocation.

OPTIMISATION AND THE RISK REBATE

Optimisation always strives to let investors have their cake and eat it, by creating asset allocations which could deliver the best possible performance without exceeding two ‘budgets’: the overall risk budget for the fund, and the fund’s charges. Add in other potential constraints, such as where the fund can invest and what strategies are available, and we can see that optimising an asset mix is a delicate and intricate process.

This is where the experts who optimise multi-asset funds’ allocations can really add value. Through analysis and modelling, they can identify how to squeeze as much potential performance as possible out of an available array of assets without exceeding risk or pricing limits. And one of their key tools is a ‘Risk Rebate’, which allows them to increase exposure to growth assets without exceeding the fund’s overall risk budget.

The Risk Rebate can be illustrated by two simple risk waterfall diagrams.

These graphics are purely for illustrative purposes.

Our Example Fund was invested in three assets when it was launched. Assets 1 and 2 are primarily growth assets and carry relatively high levels of risk. It also invested in Asset 3, which is more defensive and carries less risk. If we add the 3 assets’ risk levels together we can calculate Example Fund’s total gross risk. But the fund’s diversification lowers risk, so we can take off a diversification ‘Risk Rebate’ to calculate its total net risk.

Recently Example Fund’s asset allocation team conducted a full optimisation review. They could not increase Example Fund’s overall risk budget, nor increase the charges to customers, but they could broaden and change the assets the fund invests in. They opted for a broader asset mix.

The key point here is that Example Fund’s asset allocation team were able to factor in a much bigger Risk Rebate when planning and calculating the new optimal asset mix. Because they knew they were broadening and improving the diversification, they could increase allocations to riskier assets: the higher gross risk incurred could be balanced out by the greater Risk Rebate. Ultimately this means Example Fund’s investors would have more of their money invested in growth assets without increasing their investment risk, which could well mean they would get better returns over the longer term.

PUTTING THE RISK REBATE TO WORK

This theory may sound straightforward, but putting it into practice requires significant expertise, analysis, and modelling capability. Any additional asset classes need to be examined in isolation to determine their risk and reward characteristics, and then any proposed blends of assets must be rigorously tested and refined. This process – and the resulting asset allocation – take careful account of levels of correlation and how assets perform in different conditions. Lastly, but vitally, the overall costs cannot exceed the agreed charges, and any optimisation needs to factor in that some asset classes are more expensive than others.

Optimisation reviews and increasing diversification is important. As market environments change, different asset types become more readily available and more credible candidates emerge for use in asset allocation. This may be because they are now traded more reliably than before, have a longer and more measureable track record to allow for more accurate modelling, or because they are priced more competitively.

The Risk Rebate has a crucial role in planning and calculating any optimal blends of assets, because when applied correctly it allows for higher proportions in growth assets for a given risk budget, and thus improves potential performance, based on the previous performance of different asset types. It is founded on the simple logic that is at the heart of diversification, namely spreading the risk, but in the hands of asset allocation experts it is a key technique for increasing potential returns.

other articles in this edition

HIGH-YIELD BONDS

We look at the investment case for High Yield Bonds in a diversified portfolio, including the key attributes, how it has fared during the current market turmoil and the outlook for this asset class.

EMERGING MARKET GOVERNMENT DEBT

We look at the investment case for Emerging Market Government Debt in a diversified portfolio, including the key attributes, how it has fared during the current market turmoil and the outlook for this asset class.

REAL ESTATE INVESTMENT TRUSTS

We look at the investment case for Real Estate Investment Trusts (REITs) in a diversified portfolio, including the key attributes, how it has fared during the current market turmoil and the outlook for this asset class.

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