Building (and Explaining) Portfolio Resilience

Building a portfolio to succeed in different return environments is an increasingly important goal of active asset managers—and explaining often-complex strategies is another.

The development of new tools and analysis allows portfolio managers to better analyze the theoretical performance of their strategies across different economic conditions, explains Christopher Thompson, head of intermediary distribution, marketing and product at Columbia Management. This raises important questions for financial advisers, including those working with both defined contribution (DC) and defined benefit (DB) retirement plans, around how much clients need to know about the complex technical details underlying their active managers’ risk calculations.

Investors will always demand some explanation of the actively managed products they purchase, Thompson says, but more and more they seem interested in understanding an investment’s basic role within their portfolio and how it affects long-term goals. Investors want to know what an investment is going to accomplish and what broad factors could derail portfolio potential, he says. Once the obtain this knowledge, investors tend not to seek the deep technical details underlying the investment’s exposure and granular risk considerations.

Thompson directed a panel on the evolving subject of how to build and explain resilient portfolios during the final day of the 2014 Money Management Institute (MMI) convention in New York. Panelists were in strong agreement that active management in the next decade should match wider shifts in the investment marketplace away from beat-the-benchmark investing and toward more individualized goal setting and liability-driven investing (LDI). What remains to be seen, panelists said, is what actively managed LDI products will emerge to meet such demand, and to what extent investors will be able to understand and use them.

Even with the education issues, this is favorable for investors, the panel argued, as more advanced tools and analysis should expand the use of portfolios that can perform well across more challenging return scenarios. It also puts a burden on financial advisers to inform clients about what the new strategies are designed to accomplish.

This is especially true for advisers in the retirement savings space, the panel says, where the relatively muted performance of fixed-income investments forces more plan participants and pension funds to look to new places for reliable income streams.

Panelist Jim Celico, managing director of alternative investments at F-Squared Alternative Investments, says newer methods of building resilient portfolios are often hard to explain because they don’t necessarily maintain the same risk profile or asset exposures over time. Instead, to deliver more reliable performance across different economic scenarios, active managers are given leeway to drift across traditional style distinctions, asset classes and market segments, depending on market conditions.

“So you can’t just pull up the Morningstar Style Box and explain one of these strategies,” Celico says. “For us, we’re focusing in large part on providing strategies that can address major downturns, for instance by converting a portfolio to cash under certain conditions. That’s probably not a tool or strategy that most investment consultants are used to having or explaining.”

Part of the goal is to give asset managers better tools to confront “catastrophic downturn” events like the 2008 financial crisis, Celico explains. But a secondary goal is to address deepening correlations and persistent volatility across investment areas that in earlier decades could provide strong diversification for a portfolio, such as emerging markets or commodities. Today it is not enough to achieve global exposure to achieve true diversification and optimize risk-based performance.

“It’s a message that is somewhat at odds with what we’ve been doing in the active management industry for 30 years now,” Celico says. “But we know now that what motivates most clients is that they want to keep their money relatively safe, but they also want it to grow when markets are doing well. That's our task.”