Monday 15 February 2016 12:36 pm

Multi-asset: Boosting risk-adjusted returns

Tom Welsh is City A.M.'s business features editor.

Tom Welsh is City A.M.'s business features editor.

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As the huge swings in share prices over the year so far have shown, markets have become increasingly unpredictable. This has exposed investors to significant volatility, and the minimal (and sometimes negative) returns offered by “risk-free” assets like developed country government bonds have been no more reassuring. Many financial institutions, like insurers, are now sitting on large cash reserves or low yielding short-dated bonds.

The situation for financial institutions is complicated by recent regulatory changes, which are increasingly restricting what can be invested in and how. Under the new Solvency II rules, for example, if an insurer wishes to invest in equities, they must hold twice as much capital as they used to. This is pushing them into the very limited asset class of fixed income. Similarly, wealth managers are increasingly being required to diversify their portfolios away from pure exposure to equities, with an impact on returns.

Historically, investors and institutions would have looked to multi-asset investing as a mechanism for risk management, with a mixed portfolio of bonds and equities theoretically being less correlated (capping upside, but limiting downside too).

Unfortunately, over the past six or seven years, asset classes have largely moved together. Yet there is another way of looking at multi-asset that can have big advantages for both financial institutions and high net worth individuals.

Essentially, it involves taking vanilla equity and fixed income and overlaying various derivatives that aim to improve risk adjusted returns. Take the example of long-dated fixed rate bonds. An individual investor will have two concerns when investing in such an asset: credit risk (will I get my money back?) and interest rate risk (do we really know where interest rates are going over the next 10-15 years, and do you want a fixed return the whole period?).

Using the services of a multi-asset solutions team, it is possible to turn part of the long-dated fixed rate bond into floating, thereby lowering interest rate risk. It creates a return profile that doesn’t normally exist, and enables institutions to enhance their yield. And the same thing can be done for equities.

This is a complex and sometimes esoteric field, so when accessing these kinds of services both transparency and simplicity on the part of the provider is essential. Many providers will offer black box solutions, but instead of adding huge complexity, it can be preferable to start with the existing portfolio and investment objectives and adjust these to improve returns.

Having a long-term relationship with a provider who will provide such a customised service will allow for solutions that are better matched to the risk profile of the individual or institution. This is vitally important. People and businesses too will have personal perceptions of risk – each person and institution has gone through its path, and this will affect their perception of risk. In short, the longer the relationship, the better you can address the ongoing and changing challenges the client faces.

This article is provided for information purposes only and should not be construed as advice of any nature. The views and opinions expressed are subject to change without notice.