Diversify assets focusing on risk not on geography, says Pimco’s Daniel Phillipson

Investors do well in considering asset diversification focused on risk, not simply traditional asset or geographic allocation.

The secular transformation of the global economy is altering the drivers of economic and financial relationships and increasingly challenging the long-term effectiveness of traditional asset allocation approaches, which equate asset class diversification to risk diversification.

This shift risks leaving investors short of their objectives and their portfolios potentially exposed to unintended, often concentrated shocks, which can meaningfully challenge returns.

Thinking outside the box

In the evolving global economy, characterised by increased leverage, shifting patterns of economic growth, and periods of market stress, a forward-looking investment allocation process which continually evaluates the evolving financial landscape is increasingly important in contrast to a model-based ‘black box’ approach largely based on historical returns and correlations.

Such a flexible, forward-looking investment strategy is reflected in the PIMCO GIS Global Multi-Asset Fund, which draws on PIMCO’s proven ability to manage multi-asset portfolios globally.

With €2.69bn in assets under management, as at 30 June 2012, the fund’s asset allocation expresses PIMCO’s global macro outlook, the cornerstone of its investment process. To navigate such a very dynamic and changing global economy, one with higher levels of risks, the fund’s managers consider a number of critical investment factors.

First, investments are considered in terms of risk factors, rather than asset-class definitions.

As different asset classes can carry similar underlying risks, simply diversifying across asset classes often results in portfolios which appear diversified, but leave investors with concentrated risks.

Portfolio managers take PIMCO’s views on key risk factors and express them in asset class space through global equities, global bonds, and real assets. A risk factor is a way of measuring how an investment behaves, rather than what it is called.

One example could be a bond of a company in a very strong financial position.

If the company’s financial position deteriorates to the point where it may even go bankrupt, that bond will turn into equity.

Correspondingly, that corporate bond’s sensitivity to the equity market increases throughout until it becomes in fact, an equity position.

Risk factors provide a diagnostic tool to understand and measure that change throughout, even though the asset class categorisation of that security may not change until its actual default.

Second, the fund utilises PIMCO’s broad platform to identify investment opportunities, linking investors’ asset allocation to PIMCO’s secular and cyclical views.

The investment approach is a qualitative, forward-looking process, focusing on identifying and managing exposure to underlying risk factors.

In contrast, more traditional asset allocation approaches tend to be backward-looking, relying on historical asset class relationships and volatilities for making asset allocation decisions.

And third, instead of relying on just-in-time risk management by trying to swap out risky with less-risky assets at the time of dramatic market events, which is often too expensive and too late, the fund allots a small portion of the portfolio to spend on purchasing inexpensive alternative investments that seek to protect the portfolio during periods of systemic market stress.

The idea is to be prepared just in case of that next market surprise, rather than trying to buckle-up the seat belt in the face of on-coming traffic.

When all is said and done at the end of the day, investors, faced with an uncertain, extremely fluid and evolving multi-speed global investment landscape, should take a critical view of their portfolio and ask themselves: “Am I thinking outside the box or are tried-and-tested traditions keeping me from achieving potential long-term growth while offering downside protection?”.

Daniel Phillipson is a product manager with PIMCO, based in Munich.

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