The principles of risk-based diversification underpin many multi-asset absolute return strategies, which is why they can be evaluated not only against their internal benchmarks, but also against both an equal weight and an equal risk contribution (risk parity) multi-asset benchmark.

Implementing risk-based diversification

Absolute return funds are positioned as alternatives to bonds to deliver an ‘all-weather’ portfolio.

The all-weather concept was pioneered in the 1970s by Ray Dalio of Bridgewater Associates and it refers to a strategy (formalised in 1996) designed to prevail across all market regimes (rising/falling growth and rising/falling inflation). This is the basis of their risk parity strategy that aims to deliver returns in all market regimes.

In academia, risk parity is further defined as an equal risk contribution strategy: namely the combination of asset weights such that each asset class contributes equally to the overall risk of the portfolio. Actual construction methodology can vary significantly.

A similar concept is Harry Browne’s “permanent portfolio” (1999), which is an equal weight strategy (25 per cent in equities, 25 per cent in gold, 25 per cent in bonds and 25 per cent in cash) that has an allocation to each asset that should outperform in any market regime.

Target absolute return (TAR) funds essentially have the same aims as all-weather strategies: to deliver a return in all market regimes and protect on the downside.

The first UK TAR fund was launched in 1993, and the largest in 2008 when that sector was created. Their make-up, allocations, strategy, risk posture and performance can vary wildly, making it hard to evaluate performance. Selectivity is therefore key.

Navigating the TAR sector is a challenge so using equal risk and equal weight strategies as benchmarks provides a useful standardised comparator in addition to a relevant hurdle rates.

Summary

Traditional equity/bond portfolios are insufficiently resilient for a more persistent inflationary regime. To build in inflation resilience, the use of alternatives to provide both asset-based and risk-based diversification should be evaluated.

While there is no shortage of alternative asset classes to choose from, sizing portfolio risk contribution – both from a liquidity and volatility perspective – is key. 

In particular, careful understanding of (changing) correlation structure is required, if true diversification is to be achieved. 

Henry Cobbe is head of research at Elston Consulting