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The dynamic duo: how to really understand the nature of your investment portfolio

The dynamic duo: how to really understand the nature of your investment portfolio

07-04-2016 | Research | Alexander de Roode, Roderick Molenaar

The current volatile markets provide plenty of food for thought for investors. To make better-informed investment decisions, Robeco has further developed its Dynamic Strategic Asset Allocation and Stress Test tools. "These analyses help a professional investor to make his portfolio more robust to cope with different economic regimes.”

Speed read
  • The DSAA tool demonstrates the effect of allocation changes in various market regimes
  • It shows the risk/return trade-offs of current and alternative investment portfolios
  • The Stress Test tool provides insight into portfolio tail risk

Portfolio allocation is one of the most important decisions an investor has to make. However, constructing the optimal portfolio is anything but trivial. As markets fluctuate, a portfolio which is optimal in one market regime may not necessarily be the best solution in others.

To provide insight into the impact of different market environments on clients’ investment portfolios, Robeco has further enhanced its Dynamic Strategic Asset Allocation (DSAA) tool together with the Stress Test tool. These tools help professional investors to more clearly understand how a portfolio will behave in different scenarios and can help them to build more robust portfolios.

Portfolio strategists Roderick Molenaar and Alexander de Roode explain what these tools actually do and the benefits they offer.


Insight into the effect of allocation changes
insight-into-the-effect-of-allocation-changes.png

The DSAA tool helps the investor to analyze his current portfolio in various market regimes and demonstrates the effects of changing the portfolio weights and/or including other asset classes or investment strategies.

How can the DSAA tool help professional investors to become better informed?
De Roode: “By analyzing alternative portfolio strategies, the tool can help investors to identify a better portfolio allocation in terms of risk/return. It offers an insight into different types of risk, helping investors become aware of overexposure to specific risk factors, for example, or enabling them to make their portfolio less sensitive to one specific type of risk. In this way the DSAA tool can provide insight into how to develop a more robust portfolio in a range of different market scenarios.”

And how can stress testing add value for investors?
Molenaar: “The Stress Test tool allows investors to stress test portfolios using historical scenarios of turbulent markets, in order to address the extent of the risk in their portfolios. One important feature of the analysis is the ability to evaluate the drawdowns in a portfolio. Both analyses give an insight into how the portfolio would behave in certain historical scenarios. DSAA is about the risk-return trade-off, while the Stress Test is about tail risk.”

"For example, clients may worry about how their portfolio would perform in a recession environment, such as 2008, and have questions about how to improve the asset allocation and drawdowns in such a scenario. These tools enable us to give clients more information and help them with the choices they have to make.

"But it is not only about crisis periods. We use a database with a 30-year history, so any specific time period can be analyzed. The database is not static and is updated every quarter."

What makes these tools distinctive?
De Roode
: “The main goal of the DSAA tool is to verify whether an investment portfolio is aligned with the client’s preferences. If this is not the case, then the tool helps to determine a roadmap for improvement, providing insight into which steps might be taken to ensure better allocation.”

“Another distinctive element is the consistency of the model. It is really difficult to consistently align asset-class data, since not all asset classes share the same length of history. For those cases when there is no data available, we have developed statistical methods to complement the data.”

Why should investors currently want to analyze and stress test their portfolios?
De Roode: "Investors could have questions about how to position their portfolio in the current low interest rate regime or whether they should hedge their currency exposure or not. We can make an analysis of their portfolio and show the impact of possible changes.”

Molenaar adds: "To address questions about the characteristics of an investment portfolio in the current market regime, we use our forward-looking scenario Robeco's Expected Returns, a yearly publication in which Robeco makes various projections for the next five years. This allows us to show what the consequences of certain economic regimes would be on the portfolio as these may have different characteristics to the regime of the past five years."

You demonstrate how the DSAA tool works using an example where a low-volatility equity strategy is added to a global equity portfolio. Can you tell us more about the results?
De Roode: “To investigate the effect of adding a low-vol strategy to a 100% global equity portfolio, we replace 50% of the global equity with Robeco Conservative Equity. Using the DSAA tool we can show the risk-return characteristics of this new portfolio over the last five years and for the next five years. The results show that the portfolio with Conservative Equity would have had a slightly higher return over the last five years. As the volatility of global equity has been relatively low, the volatility reduction is less strong than it would have been over a longer horizon.” This is illustrated in the figure below.

“Given the current market environment, we expect future returns on equity to be lower, but volatility levels to be higher. Adding Conservative Equity to a portfolio in such a market environment could therefore be beneficial. The DSAA tool shows that the inclusion of the low-volatility strategy should result in a reduction in the volatility of the overall equity portfolio in the coming five years.”

risk-return-plot.png

De Roode: “Another way to analyze the proposition is to use the Stress Test tool. To demonstrate the extent to which a low-volatility strategy can offer downward protection, we evaluate the strategy in past turbulent markets. On basis of the results, we can conclude that a low-volatility strategy can offer protection in stress periods.”

“To further analyze the effect of including a low-volatility strategy, we can also look at the drawdowns of the portfolio. The analysis shows that a low-vol strategy can offer downward protection for equity portfolios in a stress period.”

What was the reason to further develop the tool?
Molenaar: "In response to client questions, we have added more asset classes and more market scenarios. Many asset classes are now available in the tool and for most we have historical data that goes back a long way. Not only equities and bonds, but also alternatives like commodities, real estate, hedge funds and private equity, the major currencies, swap curves and Robeco capabilities like equity and credit factor investing and multi-asset quant investing."

Molenaar and De Roode see investors struggling nowadays to establish the right asset allocation because of the volatile market, uncertainty about the global economy and the environment of extremely low interest rates. More insight into asset allocation, into the impact of certain investment decisions, and into the way a portfolio behaves under different market regimes, will help investors to make their portfolio more robust. De Roode: "That is difficult, but we are sure we can help."

Read more
If you are interested in more details on the Dynamic Strategic Asset Allocation tool and Stress Test, we refer you to our white paper 'Strategic asset allocation in different market environments'. This paper gives further insight into strategic asset allocation and also uses three investment cases to show how the tools can be applied. We demonstrate the use of the DSAA tool and Stress Test in a low-volatility equity strategy in an equity portfolio, to show how liquid alternatives can add value in a balanced portfolio, and for interest-rate hedging in a pension fund with liabilities using a LDI fund. Similar analysis can be carried out for other equity and credit factor strategies and this can be extended to portfolios with liabilities in an institutional context.

Roadmap to optimize your portfolio
If you are an institutional investor and would like a roadmap to optimize your portfolio, please contact your Robeco representative or Harry Horlings (w.h.horlings@robeco.nl) to have your portfolio analyzed by Robeco's Dynamic Strategic Asset Allocation tool and Stress Test.

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