CHAPTER 1
An Introduction to the Multi-Asset Investment Problem

The last decade of financial market research and asset management has focused a great deal on the generation of alpha, the separation of return into alpha and beta, and in debating active versus passive management. Indeed, the majority of the investment industry across the world today is structured to support these facets of managing assets. The majority of market research carried out in investment banks is at the individual security level to advocate potential investments expected to generate excess return over the market benchmark. The majority of active asset managers in any asset class in any geographic region of the world claim to have skill in finding the "right" stocks and bonds, which would allow them to beat market benchmarks, and thus charge active management fees. Even asset owners, be it sovereign wealth funds, corporate and government pension plans or endowments have the majority of their effort and resources focused on selecting the right strategies and hiring and firing external managers.

This structure of the financial industry, however, seems to be at odds with a basic tenet that all of us have learnt over and over again - that asset allocation is responsible for 90% of the risk and return of a portfolio. While the actual number of 90% has been disputed by many, it is still widely accepted that asset allocation as a function accounts for a large part if not the majority of a portfolio's total return. Why then do we have the bulk of the global financial services industry structured to focus on the 10% related to research and investment strategies based on security selection? Meanwhile, the main meat of the investment problem, portfolio allocation, remains pitifully under-researched, under-innovated and remains the single biggest cause for asset owners, institutional or individual, failing to reach their portfolio objectives.

A realization of this fact has led to an interest in global multi-asset investing. Initially starting with a focus on asset allocation, the field of multi-asset investing has become diverse, and is called by different names and positioned differently in different organizations. Apart from multi-asset, this research area has been called asset allocation, risk allocation, factor allocation, risk budgeting, strategic asset allocation, tactical asset allocation, macro investing, investment solutions and policy portfolio creation, to name a few, and is used at almost all levels of the investment spectrum from asset owner strategic portfolio creation to creation of fund of funds.

In this text we examine the many facets of multi-asset investing and propose a generalized framework that puts the nomenclature of various market activities in this field into perspective. We argue that all assets today operate within a global multi-asset context, and the "real" active management skill required for the successful management of asset owner portfolios is one of allocation. What is represented today as active or passive management relative to a market benchmark is a problem of considerably smaller significance. However, the multi-asset absolute return problem is far more difficult than a relative return investment problem, and requires better tools and methodologies than are available in the investment world today. This book hopes to propose some practical suggestions in this continuing evolution.

  1.1 WHAT IS MULTI-ASSET INVESTING?

We define multi-asset investing as any investment activity where more than one asset class is involved in the composition of an investment product, service or solution. This includes everything from the client requirement and product design, to the various components of the investment process and portfolio analysis required to manage such a product.

Figure 1.1 depicts a framework showing the broad architecture of all multi-asset activities covering this broad field. In the investment decisions category this covers asset forecasting, allocation, portfolio construction, implementation and risk diagnostics. A greater variety is emerging in the asset forecasting processes, both judgmental and systematic, along with greater introspection of the choice of buckets being used for allocation purposes. This variety of forecasts can then be formulated on the basis of return, risk or a combination of the two, at multiple investment horizons. Portfolio construction of a multi-asset portfolio is evolving to incorporate "real risk" constraints, along with greater focus on the management of tail risk. Implementation of the multi-asset portfolio is becoming more flexible, not only with active managers as is traditionally done, but with the newly available derivative instruments. This has brought back the active-passive debate, with the popularity of smart beta as a product category. Finally, the portfolio analysis or diagnostics framework needed to analyze issues and design improvements in the investment process is becoming a basic necessity. At the product decision level, there is greater effort to customize the investment product being offered. This has led to the creation of multiple multi-asset strategies, each of which is relevant to a category of asset owners, where their specific requirements and constraints are incorporated into the investment solution.

Figure 1.1 The variety of investment and product and decisions required in a multi-asset investment platform

In this book, we challenge some of the long accepted beliefs in the management of global multi-asset strategies, and propose some heuristic solutions to problems that are faced by practitioners. We propose tested non-standard solutions to some of the actual practical problems faced in global multi-asset investing. In many cases, it is difficult to prove with an academic level of rigor that the proposed solution is theoretically optimal; however, what we can say is that we have used each and every one of these tools successfully in the management of large asset pools. The techniques described here may not be the final end product of the investment process evolution, but seem to be a more robust solution than what is used in many investment processes today. Finally, we aim to provide a structure that can serve as the basis for the direction of future research initiatives in the many areas that encompass multi-asset investing.

  1.2 THE CONVENTIONAL STRUCTURE

The original concept of investing across multiple asset classes in a portfolio was based on the premise that it provided diversification and that investing in equities would earn a risk premium. These two concepts of diversification and risk premium spawned the creation of multi-asset investing for asset owner portfolios. However, the two basic tenets of the traditional framework stand challenged today as cross-asset correlation is much higher and risk premium lower and more volatile. The basic requirements of an asset owner of a target return and managed drawdown risk are therefore more challenging to meet. This has led to greater focus on all aspects of the multi-asset investment process which can be improved. An evolution in the creation, management and deployment of multi-asset products is therefore underway in order to accommodate the more complex global financial markets, where hybrid instruments and derivatives are more readily available.

  1.3 TRANSITIONING FROM ACTIVE MANAGEMENT TO EXPOSURE ALLOCATION

The concept of asset classes based on instruments used in corporate capital structure has been at the foundation of multi-asset investing. Having segmented the financial universe into these asset classes, the majority of investment resources in both asset owners and asset managers are focused on beating the respective asset class market benchmarks to create alpha. But is separation of alpha and beta necessary for a better investment outcome or simply for deciding what is an appropriate fee structure? We propose a structure which generalizes the concepts of alpha and beta, and argue that there is no clear distinction between alpha and beta. The demarcation is actually between commoditized and non-commoditized beta exposures, which changes as the market evolves. We believe that the implications of this framework for active investment and risk management processes, is that the investment management industry will transition to a structure where greater resources and effort are spent on allocation, compared to alpha generation.

Another ramification of the instrument-based asset class structure is that this categorization has also been used as the basis for asset allocation decisions. However, while allocation is improved by using uncorrelated silos, we know that there is a conceptual overlap between credit and equity as parts of a single corporate capital structure. Disentangling interest rate risk present in sovereign bonds, credit risk present in corporate bonds and equity risk present in equity securities, would allow the creation of a stacked structure for estimation of risk and risk premiums. We believe this may be a more appropriate structure for allocation decisions.

  1.4 CREATING AN IMPROVED ALLOCATION STRUCTURE

Most plan sponsors formulate a single long-term asset allocation for their assets, and then spend a great deal of effort to select a number of active managers within each silo of asset class or style....