Eight Key Factors in Effective Portfolio Management for Turbulent Times

How can investors better manage their portfolios in these turbulent times?

This central question framed an engaging session led by Pranay Gupta, CFA, last month at the second annual India Investment Conference in Mumbai. Gupta is chief investment officer for the Asia Pacific and global head of investment solutions at Lombard Odier, a Swiss private bank. He is also a founder of the Global Association of Alternative Investors.

Turbulent markets, according to Gupta, are generally characterized by the following attributes:

• The volatility of asset returns tends to remain at higher levels.
• Asset price correlations tend to be at higher levels, especially when the market is turning up or down sharply, resulting in considerably reduced diversification benefits.
• Sentiment changes tend to be much more volatile and emanate from local as well as cross-border sources, and their impact becomes stronger.
• Dispersion of market views and outlooks, as well as asset return forecasts, are all much wider. Managers are mostly either outperforming or underperforming the median by a wide margin, with fewer in the middle around the average.

Gupta shared several key takeaways from his many years of experience managing multistrategy, multimanager, and multifactor portfolios for institutions and private wealth owners. Although these are not rigorously derived from theoretical formulation and empirical research, Gupta explained, they are based on years of hands-on investment experience and can help improve the portfolio management process in practice.

Gupta’s eight key takeaways are highlighted below:

1. Understand each strategy thoroughly and know the environment in which each strategy will deliver the expected outperformance. Strategies based on fundamental analysis tend to perform well around market turning points, while strategies based on systematic or quantitative models tend to perform better when the market is continuous and trending.
2. Assess your skill and available resources in selecting managers. If the organization has the experience, skill, and resources to select and monitor managers properly, allocate a higher proportion to active managers; otherwise, stay mainly with passive index mandates.
3. Downside risk is more important than volatility. Investors must know their risk capacity in terms of how big a drawdown they can afford to take. The traditional modern portfolio theory framework appears inadequate in capturing this very important aspect.
4. Intra-horizon risk is as important as end-of-horizon risk. In many situations, it is not enough to focus on just end-of-horizon risk. What could happen throughout the investment period must also be carefully analyzed. Longer investment horizons actually encompass higher risks. A composite of intra-horizon risk and end-of-horizon risk should be used.
5. The impact of leverage could be significant. Use of leverage increases downside risk and fat-tail risk significantly. The traditional mean-variance framework generally does not analyze the impact of leverage adequately.
6. Consider allocating more to alternative strategies. Alternative strategies tend to be more risk-return efficient. Passive equity beta strategies, for example, tend to have more volatile returns than equity long-short strategies, which often have better risk-adjusted performance — higher Sortino ratios and Sharpe ratios.
7. Many commonly used incentive compensation structures tend to increase “blow-up” risk. Incentive compensation structures are commonly touted as promoting the alignment of interest for the investor and the manger, but this alignment is on the upside only. There is no alignment of interest on the downside. High-water mark considerations combined with this “call option” for the manager tend to increase the probability of “blow-up” situations.
8. A new approach that goes well beyond the mean-variance framework is needed. Gupta proposed a portfolio management framework incorporating constraints on tail risk and event risk. A working paper that he coauthored, titled “Risk Management in a Multi-Strategy Framework,” provides the details. The framework calls for dynamically changing the allocation as market conditions evolve.