Summary

Many asset allocations over the last five years are based on taking advantage of credit

spreads that may not be available in the future

If credit spreads decline to a low level, asset allocation is going be more dependent on

liquid markets where returns are uncertain

This uncertainty can be managed but not removed by four approaches:

o risk based asset allocation

o diversification between asset classes

o diversification within asset classes

o manager skill

A combination of the four approaches will give the largest improvement in risk/return

but varying the mix or leaving out one or two approaches will still leave most of the

improvement in place

Credit Spreads are Compressing

For the past five years, many asset allocations have relied on the returns available by taking

exposure to two (correlated and not always distinct) risk premia:

(i) Credit spread risk which is the compensation for taking credit default risk and

credit spread volatility

(ii) Illiquidity risk which is the additional spread earned for investing in credit assets

that are more illiquid than corporate bonds

These two risk premia have the advantage that at least for investment grade credit on a hold

to maturity basis they should give a fairly certain return, absent a level of defaults that has not

been seen in recent history in a diversified portfolio (of course it has been seen in non-

diversified ones).

However in recent months both credit and illiquidity spreads have reduced significantly and

are now below the required returns for many clients. If credit and illiquidity spreads revert to

levels closer to where they were pre the credit crunch, credit as a core asset allocation would

no longer be particularly attractive.

Indeed in the past there were long periods often associated with low defaults where credit was

not an attractive asset class unless leveraged, a strategy which clearly came unstuck in 2008.

Therefore, in looking to evolve our asset allocation strategies, we should prepare for a world

where asset allocations are centred around liquid markets that offer returns that are far less

certain over a given time horizon.

CIO Report: Asset Allocation in a World

without Credit Spreads

12th August 2014

Philip Rose, CIO – Strategy & Risk

Asset Allocation in a World of Uncertain Returns

Liquid markets offer many risk premia which historically have provided positive returns in

exchange for taking market risk. However there are significant drawbacks:

(i) Individual risk premia can fail to provide excess returns for years or even decades

so relying on a small number of risk premia may not meet flight plan targets

(ii) Some risk premia are much cheaper to access than others in terms of

management fees

(iii) Risk premia may be transient and will not endure in the future

(iv) Some risk premia may incur substantial transaction and balance sheet costs

In building an asset allocation there are four techniques that can be used to help partially

mitigate but not remove these drawbacks.

Risk Driven Asset Allocation

Rather than allocating to an asset on the basis of amount, risk driven asset allocation seeks to

allocate according to the risk of the asset (with risk being measured as volatility). This means

that as an asset becomes more volatile less is allocated to it and as it becomes more volatile

more is allocated to it. This approach has historically improved the risk/return ratio for many

asset classes and has the added benefit of substantially reducing the cost of buying downside

protection in the form of put options.

This approach can be applied solely in the risk premia that is cheapest to access, namely

equity risk or across multiple asset classes.

Example: Volatility Controlled Equity with Put Option

Diversification between Asset Classes

Asset classes such as government bonds and commodities can provide exposure to risk

premia that have historically provided positive returns combined with performance in

economic scenarios where equities can perform poorly. For example, government bonds have

often performed well when equities have fallen and commodities have performed well in

periods of high inflation. These characteristics may not continue in the future in line with any

other risk premia but combined with a risk driven asset allocation they can provide attractive

potential returns.

Example: Risk Parity

Diversification within Asset Classes

Risk premia within asset classes, such as value (buying assets that are “cheap” relative to

their fundamental vale and selling “expensive” assets) and momentum (buying assets that

outperformed their peers and selling those that recently underperformed) can be accessed via

long short strategies in individual asset classes. These risk premia are based on the

implementation of a systematic investment process, not manager skill, but do require both

trading and the ability to be easily long or short an individual asset. This means that

transaction and balance sheet costs (costs of financing a position) can be quite substantial.

Example: Style Premia Fund

Manager Skill

Manager skill is the return left over once the market “betas” for both individual asset classes

and systematic strategies within and between asset classes have been removed. True

manager skill or “alpha” is often expensive to access and runs the same risk of non-

persistence as any other risk premia. However, in recent years, a lot of the strategies that were

the preserve of “2 and 20” macro hedge funds have become available in much lower cost

funds.

Example: Relative Value DGF

A combination of these four approaches will produce the best expected risk/return

characteristics but changing the mix or leaving out one or two approaches will still leave most

of the risk/return improvement in place.

Contact

If you would like further information on this report, please do get in touch.

Philip Rose

CIO – Strategy & Risk

CIO@redington.co.uk

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