An alternative to “Go Big or Go Home”

Greed is far more than a footnote in economic theory. In fact, it is such an affliction of the human mind that we keep discovering related versions and giving it new names.  Last month, however, helped by the twin effects of rising volatility and correlation, the most common one heard was ‘pain’.  

Axioma’s Applied Research group has written a number of posts this past month on how relatively well-behaved style factor returns have been in the rough seas of this past February. So, for those whose investment style is anything other than “Go Big or Go Home”, consider the guidance of a risk model.

In today’s parlance, a risk model is an app that uses a tree of factors to translate a string of seemingly unrelated stock price movements into a web of relationships.  In this framework a portfolio's future returns and its factor exposures live in each other, and it is by the fitness of the second that we judge the quality of the first.

Factor models provide a set of prescriptive rules that have become indispensable in many areas of investment management. They can lubricate comprehension, reduce misunderstanding, provide a transparent platform for the communication of one's investment thesis, and signal to the investor that the manager has exercised care in the crafting of their portfolio.

To ensure that factor exposures are consistent with the investment thesis, is the first duty of a portfolio manager. If he or she professes to have a systematic investment style, this duty becomes the more urgent, the neglect of it the more damaging.

In investments as in life, you can never be exactly right. All you can do is to make as sure as possible; and for that there is only one rule. Bet only on those sources of risk for which you have a high conviction of superior information. But success requires both conviction and humility in equal measure.  And, far from being impossible to be convinced while being humble, it is difficult to be consistently rewarded for the one without the other.

If sometimes you are too convinced and bet too much, and sometimes too humble and bet too little, the history of your factor exposures will leave a trail of forensic clues for you to always find your way home at your next rebalancing.

The best crafted portfolios should not be works of fiction, pinning the unsuspecting investor to an unrealistic vision of the future, which he or she must afterwards discover to be far from the truth. Instead, their exposures are constantly reassessed and rearranged to remain true to the investment thesis that gave them birth. How much of that investment thesis will bear the test of time, how much is clay, how much is brass? Only consistent exposures can reveal.  

Anyone can design a portfolio – a bad one, I mean – but because anyone can does not mean that anyone should.

All related posts can be found here.

Olivier d'Assier

Olivier d'Assier is Head of Applied Research, APAC, for Axioma and is responsible for generating unique regional insights into risk trends by leveraging and analyzing Axioma's vast data on market and portfolio risk. d'Assier's research helps clients and prospects better understand and adapt to the evolving risk environment in Asia Pacific.