Ensuring that investments don't drift away from stated limits about risk can be a difficult task, the author of this article argues.

The author of this article is Yannis Sardis, PhD, of BlueLake Associates LLC, and advisor to KlarityRisk. BlueLake is a Swiss consulting firm.  (More on the firms below.)

In this article, Dr Sardis writes about the challenge investors and managers face in making sure that the way assets perform conforms to the risk tolerances and limits set out. When asset performance moves away from such limits, it can be known as “style drift”. Take the case, for example, of an investor who might think his or her portfolio is run in a cautious way but finds that the actual disposition of the assets is high-risk, or vice versa. Given the focus by regulators and others on ensuring that investments are suitable for clients, it is easy to see why this issue is important. 

The editors of this news service are grateful for the chance to publish these views and add to debate; they don’t necessarily endorse all views of guest contributors and invite readers to respond. Email tom.burroughes@wealthbriefing.com

“Everything must be made as simple as possible. But not simpler.” 

Albert Einstein

Allow us to sketch a personal (non-academic) distinction between the notions of systematic and mechanistic processes in complex dynamical systems, at least as empirically experienced in the domain of investments. Systematic is a process dictated by principles of implementation which mean to provide guidelines that repeatedly conform with predetermined rules, applied in the same methodological way through time. Mechanistic is a process that strictly abides by specific rules that aim to provide an austere framework of automation, without much inherent adaptability vs. a system's error tolerance. 
Subjectively speaking, systematic emits a sense of critical thinking, whilst mechanistic feels restrictively impersonal.  

Investors aim to select a mix of available assets in a way that faithfully reflects their risk/return profile over time as well as critical future lifecycle goals. Asset allocation models can be thus created using methodologies of varying mathematical complexity and implemented via an optimised combination of active (seeking skilled alpha) and/or passive (tracking market beta) investment styles. The ultimate purpose of the process is the construction of a portfolio with the highest possible diversification and the maximisation of its risk-adjusted returns.

The asset allocation process involves upper and lower bounds for the portfolio weights that each geography, asset class, sector or security must be assigned, to reflect the criteria set in the client profiling at the inception of the process. Investment manager and client can therefore ensure that portfolio parameters lie within the range sinitially agreed and that the portfolio does not gradually divert from its targeted goals, thus causing a style drift. The asset allocation mix is then updated at frequent time-steps (with their length varying wildly and depending on the type of the investment strategy) to bring the weights in line with the pre-agreed value ranges over time. 

For simplicity, this note addresses style drifts caused only by over-/under-weighted positions that fall within the agreed investment strategy and not due to managers drifting from their course by allocating capital to assets outside the scope of the mandate in an effort of chasing returns by riding trendy themes. Admittedly, this may be an unrealistic assumption, considering the ever-increasing pressure managers often receive from their return/yield-chasing clientele and/or asset-chasing institutional managers to create short-term returns that are at par or better than their indexed benchmarks, at all times.  

In market regimes characterised by persistent upward or downward price moves, a style drift in a portfolio can simply occur by the emerging price fluctuations of positions, especially for buy-and-hold type of strategies. A style drift may also be caused by active fund managers, who have a leeway to deviate from their stated benchmarks, as permitted by their investment policy mandates, over time.         

Are all types of style drift from the investment guidelines damaging to investors and should be dealt with immediate and strict reversion to the permitted benchmarks? The answer is rather synthetic and may lie on the boundary between the systematic and mechanistic approaches to investment management.

More specifically, the manner that a Risk 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 relevant financial authority is of paramount importance, the aim being the protection of investors. In the latter case, the focus of the process is the maximisation of risk-adjusted returns via the adaptation of the 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. Whilst trying to chase returns, managers may overlook the alternation of a portfolio's asset decomposition and thus end 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 and should be sacrificed for the long-term risk-cautious decision planning.

Style drift is theoretically more difficult to occur in exchange traded funds than in mutual funds, as by design the former must adhere to their investment objective of closely tracking an index. Having said that, actively managed exchange traded funds may experience a style drift too, as their managers may have the permission to deviate from their stated benchmark. 

One should carefully differentiate between style drifts and the need for change and adaptation of a portfolio composition to the ever-evolving market conditions over time. 

The uncertainty that persistent, substantial and over-looked style drifts can inject in the stability of an entire portfolio has been highlighted. We would suggest, however, that no style drift at all can be quite risky too: Investment philosophy and goals change over time, as do 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 life simpler and less demanding but as in many biological, political and socio-economic dynamical systems, over-protection and lack of a Darwinian adaptability may lead to long-term damage and intellectual laziness. 

Some natural drifts may occur over time, as long as one uses the proper tools to correctly identify and quantify the portfolio risks that these drifts introduce. As indicated in the first paragraph, one should be systematic in following general principles and guidelines and not simply obeying numerical rules in vacuum. 

Various investor surveys present market volatility, emanating from political, geopolitical or macro-economic uncertainty, as the main threat to sustainable wealth creation. Investors should ensure that a solid and adaptable risk measurement framework is in place. Using a combination of risk analytics one should continuously monitor the gap between the current asset allocation and the allocation determined by the investment policy at each point in time, hence evaluate the ramifications of any such spread-widening on the portfolio risk. How quickly and to what extend such gaps should be rectified may be a balanced act of continuous risk assessment and stress-testing and the adaptability to emerging economic conditions and market perceptions.

Note
KlarityRisk is an award-winning software provider, specialising in Market Risk Analytics, Compliance Reporting solutions and Client OnBoarding services for the buy-side sector. www.klarityrisk.com. 
BlueLake Associates is an independent Swiss investment consulting firm which offers tailored investment solutions to international high net worth individuals, family offices and institutions. The primary objective of the firm is the incremental macro-driven risk-adjusted capital appreciation, via long-term strategic and shorter-term tactical asset allocation methodology. www.bllake.com.