Have you found your sweet spot of portfolio risk?

Head of Picton Mahoney's portfolio service explains guiding philosophy behind focus on high-quality returns and diversification

Have you found your sweet spot of portfolio risk?

It’s been a little more than a year since Picton Mahoney Asset Management launched its Portfolio Construction and Consultation Service (PCCS) to advisors. Inquiries from advisors have accelerated over the past few months.

“It makes sense when you think about the pressure of inflation, central banks entering a new tightening cycle, political conflicts, and the new surge of COVID that spilled over from Hong Kong into China,” says Robert Wilson, Head of the PCCS at Picton Mahoney. “Advisors are very interested to access tools and resources that are going to help them implement a disciplined and consistent approach when it comes to portfolio construction and risk management.”

One dictum of investment is that generating returns requires taking on a certain level of risk. But unless risks are taken intentionally and scaled appropriately, Wilson says a portfolio can become more exposed and vulnerable than an investor can tolerate.

He also emphasized that portfolio risk is not stationary. Over time and depending on market and economic conditions, certain types of risk can appear attractive, while others are less so. To have a good handle on their portfolio, Wilson says advisors and investors need to understand what their key sources of risk are, as well as a consistent process for measuring and monitoring those risks.

“A specific source of vulnerability we often see would be an over-reliance on government bonds’ interest-rate risk to mitigate overall portfolio risk,” he says. “There are many scenarios and market regimes where that's a very effective strategy, but there are others where historically, it hasn't tended to work quite as well. We believe investors should seek opportunities to use other assets and strategies, so that interest-rate risk isn’t doing all the heavy lifting in this aspect.”

According to Wilson, Picton Mahoney’s portfolio construction process focuses on helping investors achieve their goals with greater certainty, which comes from having a fortified portfolio with an enhanced quality of return. To accomplish that requires a focus on asset allocation that prioritizes diversification.

When deciding whether to raise or get exposure to a specific strategy or asset class in a portfolio, a good start is to consider ones that aren’t yet represented, but are able to offer uncorrelated returns. The first portfolio dollar invested in an asset or strategy, Wilson says, tends to provide an outsized marginal benefit.

“When we're analyzing a portfolio, the first thing we look at is whether there’s an asset class or strategy that's currently void in the portfolio, but which the academic and practitioner research suggests, could be an attractive building block to adopt or raise exposure to,” he says. “What that specific asset or strategy might be for a specific advisor is going to differ each time depending on how they're currently invested.”

For many advisors managing their clients’ portfolios, alternative investments and liquid alternatives can be a good way to reap the benefits of diversification. And according to a recent Environics Research survey of IIROC advisors commissioned by Picton Mahoney, nearly four out of five advisors are anticipating an increased proportion of alternative assets in their portfolios in the next two to three years.

That’s not to say diversification is absolutely beneficial. According to another recently completed piece of research at Picton Mahoney, which looked at all the liquid alternative funds in Canada with a three-year track record, there can be a tradeoff between quality of return and diversification benefits, with asset classes and strategies with relatively higher diversification benefits against equity risks also tending to have relatively lower-quality returns.

“What can be attractive is to lean toward the sweet spot: looking for strategies that have low-to-moderate correlation, which makes for good diversification benefits while still generating attractive risk-adjusted returns,” Wilson says. “But it can be hard for investors to manage that trade-off.”