Investment Style Drift: A Hidden Uncertainty
Yannis Sardis, 7 December 2020
“Everything must be made as simple as possible, but not simpler.”
Albert Einstein, Theoretical Physicist (1879-1955), Nobel Prize 1921
What are the subtle differences between systematic and mechanistic processes in complex dynamical systems? Loosely posed:
Systematic is a process that is determined by specific principles of implementation, guidelines that repeatedly conform with rules which are applied in an adaptive methodological manner through time. Mechanistic is a process that abides by strict rules which aim to provide an austere framework of automation, without much inherent adaptability to a system’s error tolerance through time.
Subjectively speaking, the perception of systematic emits a sense of critical and flexible thinking, whilst that of mechanistic feels restrictively impersonal and inelastic to react to emerging changes.
Asset Allocation Process
In financial markets, investors aim to select a mix of available assets that reflect both their risk/return profile and lifecycle goals over time. Consequently, asset allocation models are based on varying mathematical complexity and can be implemented via an optimized combination of active (seeking skilled Alpha) and passive (tracking market Beta) investment styles.
The ultimate purpose of the investment process is to create a portfolio of the highest possible diversification and the maximum risk-adjusted returns.
In an asset allocation process, geography, asset class, sector, and security must each be assigned upper and lower bounds for their portfolio weights, according to the criteria set by the client’s objectives, ensuring that portfolio parameters lie within the ranges initially agreed and that the portfolio does not gradually divert from its targeted goals and cause a style drift. The asset allocation mix is then rebalanced at frequent time-steps (which vary in duration depending on the investment strategy type), to bring the weights in line with the pre-agreed value ranges over time.
Investment Style Drift
In market regimes which are characterized by persistent upward or downward price moves, a style drift in a portfolio can occur simply due to the price fluctuations of positions, especially for buy-and-hold strategies. A style drift may also be caused by active fund managers who have the leeway to occasionally deviate from their stated benchmarks, as permitted by their investment policy mandates.
Are all types of style drift from the investment guidelines damaging to investors? Should they always be dealt with by immediate and strict reversion to the permitted benchmarks?
The answer may lie on the boundary between the systematic and mechanistic approaches to investment management. The way that a risk or a compliance officer of a pension fund perceives a diversion from the stated limits of an investment strategy is qualitatively different from that of an investment advisor or a hedge fund manager. In the former case, strict compliance to the regulatory constraints set from the financial authority is critical. In the latter case, the focus of the process is the maximization of risk-adjusted returns via the adaptation of portfolio parameters in a manner that may often exhaust the limits of flexibility allowed by the investment mandate.
A position’s under- or over-weighting should be assessed based on the impact that it has on the overall portfolio risk. While trying to chase returns, managers may overlook the change of a portfolio’s asset decomposition, ending up with a blend of highly correlated styles and increased risk exposures. The hunger for short-term gains based on concentrated positions can lead to the wrong investment style in diverse market conditions; managers should focus on long-term risk-cautious decision planning.
It’s important to differentiate between style drifts and the need to adapt a portfolio composition to evolving market conditions. Persistent, substantial, and over-looked style drifts can render an entire portfolio unstable. However, no style drift at all can also be quite risky; investment philosophy and goals change over time, as do client risk profiles.
Well-performing assets with strong macro-economic, fundamental, or technical characteristics that end up with slightly higher weights than initially allocated should be re-balanced in a systematic (and not a mechanistic) manner. Mechanistic rules for cutting losses or booking gains may make a manager’s life simpler and less demanding, but over-protection and lack of a Darwinian adaptability may lead to long-term damage and intellectual laziness.
Some natural drifts may occur over time if the proper tools are used to identify and quantify the portfolio risks introduced by these drifts. As mentioned earlier, managers should systematically follow general principles and guidelines and not just obey numerical rules in a vacuum.
Market volatility from political, geopolitical, macro-economic or health-induced uncertainty is the main threat to sustainable wealth creation. Investors should ensure that a solid and adaptable portfolio risk measurement framework is always in place. A combination of risk analytics should be used to monitor the gap between a rolling asset allocation and the allocation determined by the investment policy at each point in time, to evaluate the risk ramifications of any spread-widening.
How quickly and to which extent such gaps should be rectified may be a balanced act of continuous risk assessment and stress-testing that make the portfolio rebalancing more adaptable to the emerging economic conditions and market perceptions.
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