Four Ways To Avoid The Pitfalls Of Down Markets And Abnormal Return Distributions
Nov 2, 2021
Institutional investors know that asset allocation decisions determine strategic portfolio risk and return profiles. But a major challenge in constructing and evaluating strategic portfolios lies in the fact that the return distributions of both the portfolios and their components are often not normally distributed. So what’s the best way to construct and evaluate those strategic allocations? Read on to learn about four key points to consider when thinking about how to protect portfolios during down markets:
1. Go beyond conventional measures of return and standard deviation to target multiple measures of risk simultaneously.
Investing in the markets is inherently uncertain, with many types of risk to think about when building strategic portfolios. Beyond the most common measures of risk, like standard deviation or variance, investors also face risk in terms of falling short of investment objectives, portfolio drawdowns (the fall of investments from a peak to a trough), and the tendency of riskier assets to drawdown together. Looking at multiple risk measures simultaneously, like historical and simulated future drawdowns and asset class correlations in different market environments, provides investors additional tools and metrics to manage unforeseen adverse market events and to meet investment objectives.
2. Look at past and simulated future drawdowns, higher moments of the return distribution, and conditional correlations in different investment environments to insulate portfolios against the risks of non-normal return distributions
To build long-horizon strategic portfolios to meet long-term funding requirements that incorporate risk beyond the conventional metrics of mean and variance, forward looking simulations provide a powerful tool for evaluating portfolio outcomes during both expansions and recessions to assess the probabilities of potential drawdowns of the major asset classes that comprise portfolios. These robust simulations look at periods of crisis that produce bigger drawdowns than would be found using only static average expected return and covariance forecasts. Furthermore, these types of simulations can show correlation patterns for different asset classes under those varying economic scenarios. For example, US equities typically have a moderate positive correlation with commodities during expansions, but this positive correlation becomes more pronounced during recessionary periods. Similarly, US equity correlation with US Aggregate bonds also turns positive during recessions, but is slightly negative in expansions.
3. Mitigate risk by adding tail-risk hedging assets, such as a defensive equity allocation
Because stock market volatility is higher than that of other investments and equity returns aren’t normally distributed, including a defensive equity allocation to help to manage higher risk can help keep returns within your target. A defensive equity allocation that uses long-dated S&P 500 call options together with US Treasury bonds, like PGIM Quantitative Solutions’ Market Participation Strategy (MPS), can allow upside participation when the US equity market advances, while reducing the downside risk when markets fall. The call options let investors participate in rising markets, while US Treasury bonds serve as a safe haven during turbulent markets by providing downside protection. Using a disciplined process to actively manage market exposure, volatility, and duration can help to insulate strategic portfolios during changing market environment. In fact, a defensive equity allocation can generate approximately 85% of the annualized return of US Large Cap Equities with considerably lower volatility and reduced drawdowns over the long term.
Past performance is not a guarantee or reliable indicator of future results. Based on composite returns from 1/1/1992 – 9/30/2021. Source: PGIM Quantitative Solutions, S&P Dow Jones Indices LLC.
4. Introduce forward-looking simulations based on historical characteristics of asset classes to generate a range of possible portfolio options to determine which outcomes meet or fall short of investment objectives.
We’ve explained how simulating expansionary or recessionary market environments is generally more effective in estimating potential asset class drawdowns than looking only at normally distributed asset class simulations in assessing those potential drawdowns. Although normally distributed expected risk-adjusted return, or Sharpe ratio, is easy to calculate and provides one of the best measures of portfolio efficacy, it doesn’t address the risks of non-normal asset class distributions found in most multi-asset portfolios. That’s why looking at multiple historical and simulated risk characteristics is beneficial in constructing strategic portfolios. By using forward-looking simulations, we can generate a range of possible portfolio outcomes that can help determine whether we’ll meet or fall short of investment objectives. By evaluating multiple risk metrics, analyzing historical outcomes, and using forward-looking simulations that realistically incorporate more than one type of market environment, investors can apply strategies to help mitigate unforeseen risks.