Why You Should Make Your Portfolio More 'Dynamic'

by Vincent McCarthy, CFA, CFA Institute

So far in 2015, the financial markets can aptly be characterised by increased volatility, in terms of both the average level of volatility and the greater frequency of higher volatility.

In the first week of trading alone, the EuroStoxx 50 Index, made up of 50 blue-chip eurozone equities, moved by +/– 3% or more on three occasions. In the whole of 2014, it happened only four times! The much-quoted CBOE Volatility Index (VIX), a key measure of market expectations of near-term volatility, otherwise known as the “fear index,” averaged 14.17 in 2014. In January 2015, it closed above 15 every day, with an average above 19.

This increased volatility points to a market that is finding it more difficult to appraise the consequences of the political posturing between Greece and the eurozone, divergent monetary policy across the world’s major central banks, the recent oil price collapse, a lower global growth environment, and (most concerning) the risk of Europe becoming mired in deflation.

Periods of market volatility, such as we have seen recently, are usually challenging for investors. The headline world we live in exacerbates that feeling of fear — hyperbole sells! Volatility, however, is a natural occurrence in financial markets, and the irrational nature of market participants is what causes financial markets to be so volatile. This irrationality tends to be most prevalent in the short term, both on the upside and the downside.

Yet, to see volatility and risk as one and the same would be a mistake. Volatility is merely a measure of the fluctuation in the price of a financial security, which is simply a reflection of the collective behaviour of market participants at a point in time. Risk cannot be quantified by a single statistic, as much as financial practitioners try.

In the active management world, increased volatility can actually create opportunities for active managers to outperform. Research by Standard & Poor’s has shown that during periods of high dispersion — measured as the average difference between the return of an index and the return of each of the index’s components — there is a wider spread of active manager returns. In other words, increased dispersion separates the wheat from the chaff.

As I think about how best to design a more robust investment strategy to deal with the prospect of increased volatility becoming the new normal, the best model that comes to mind is from a sporting context: football (or soccer, to most Americans).

In preparation for every football match, a manager sets out his team and tactics to win the match, his game plan. As good as that game plan may be, no manager can legislate for how the game will actually evolve. One mistimed tackle here or one poor pass there can change the game. A poor refereeing decision — what economists might call an “exogenous factor” — can put the best-laid plans out the window. Still, the best managers set out their team to be able to adapt to anything that comes at them.

The financial ecosystem in which we operate is no different. We do not live in a static world. Even the most sophisticated economic and financial models have their limitations. We are all part of the very world we try to model, and despite the assumptions of many of the models we use, we are not always rational. As investors, if we can accept that a significant amount of what actually happens is outside our control, we can better design portfolios that are more adaptive to the circumstances of the environment that prevails.

From the lows of 2009, the world’s major central banks have helped orchestrate a situation whereby any reasonable strategic asset allocation delivered exceptional returns. But as we get deeper into this bull market and as central banks begin to move in opposite directions, we are likely to see the divergence theme play out more across asset class returns, warranting a more dynamic approach to asset allocation that incorporates tactical decisions.

Of course, the vantage from which to assess this changing environment is firm specific, based on available resources, which will dictate how well positioned one is to make tactical asset allocation calls. For most investors, I believe a prudent approach is to allocate capital to an investment manager with a strong track record of dynamically allocating across and within asset classes, allowing the manager sufficient flexibility around the allocation parameters and the use of portfolio insurance.

In the current environment, there is a temptation for investors to move into more esoteric strategies in the search for return or “alternative” sources of return. Although it can make sense for investment managers to have an unconstrained investment opportunity set in terms of implementing ideas, investors should not compromise on transparency with undue levels of complexity. The simple adage “understand what you invest in” still holds.

Ultimately, the objective of adding a dynamic allocation to portfolios is to complement the existing strategic asset allocation, making portfolios more robust in an increasingly uncertain and volatile environment. Whether in life, football, business, or investing, the ability to adapt to a changing environment is at the very heart of our survival.

On that note, I’ll leave you with a quote from the self-proclaimed “special one,” Chelsea FC manager Jose Mourinho. “In this moment our team are able to adapt to everything,” he told the London Evening Standard in October 2014. “What the game gives us, we can cope with. We are not the kind of team that play only the same way, think the same things. We can play in a different way and adapt to different situations.”

Vincent McCarthy, CFA, is a senior investment consultant at Invesco in Dublin, Ireland. The preceding article originally appeared in the May/June edition of CFA Institute Magazine.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Illustration by Timothy Cook

Copyright © Vincent McCarthy, CFA, CFA Institute