Strategic asset allocations are a key component of long-term investing, but the models used to formulate them depend on static or slow-moving risk and return assumptions, which keep them from adapting to market conditions.
Equities are an especially vulnerable asset class and are often the largest source of risk in your portfolio. In heightened-risk regimes, you may have serious unchecked risk. Figure 1 provides an illustration of the relationship between equity market volatility regimes and returns for global equity markets over time. It’s clear that the risk and return outcomes of this asset class vary significantly over time, yet traditional strategic allocation models often do not.
Potential downside exposure in changing risk regimes presents a significant threat for investors, as it leaves them exposed to the “curse of compounding”. Not only do negative returns represent a loss in value, but they also require a portfolio to earn even higher returns just to get investors back to a breakeven point.
Common Remedies
Portfolio managers have taken a number of steps in recent years to address this problem, including the use of alternative assets, low volatility strategies, and even tactical asset allocation.
Alternative assets, such as absolute return strategies and private equity, often come with high fees, liquidity risk, and hidden equity beta. Adding low volatility strategies offers important equity diversification and risk reduction, but these have somewhat static, lower beta exposure and generally don’t participate fully in a market’s upside. Tactical asset allocation can help navigate these risk regimes, but this introduces market-timing challenges. This approach can also increase implementation costs and raise governance issues.
Rebalancing, reallocating and timing asset classes are not enough.
Variable Beta
What if you could reduce the overall risk of equity investing without sacrificing returns? A variable beta strategy seeks to do just that. These types of strategies are designed to adapt automatically to equity risk regimes in order to protect on the downside and participate in the upside. A variable beta strategy is a hybrid of active core and low volatility equity strategies. They attempt to reduce risk exposure when it counts, thus providing better long-term risk-return profiles.
In risk-on environments, the equity beta of a variable beta strategy may be closer to 1, while in risk-off markets the beta adjusts downward, reducing systematic risk as seen in Figure 2. Ideally, adjustments are made in a systematic and disciplined manner to improve consistency and smooth the equity return profile without the requirement for unreliable market-timing decisions.
The value proposition for equities changes with a variable beta strategy, offering the potential for improved compounding and downside protection that asset owners seek during periods of market turbulence.
To learn how variable beta strategies adapt within a strategic model, download our eBook: “Are Your Asset Allocation Models Exposed Right Now?”
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