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A Sustainable approach to capturing market upside and limiting drawdowns

Our aspiration as an asset manager is to capture market upside while limiting downside and to do so in a sustainable way. In our case, "sustainable" has the double meaning of both referring to the investment philosophy and process being Sustainable and reliable in terms of return and risk management, and to the portfolio being invested in a Sustainable way. To continue the pursuit of these goals, we transformed our IT company to also include an asset manager in the early part of 2019 when we also launched our first white label fund in collaboration with ACCI Partners.

2020 proved to be a test for markets and investors to an extent where everything from structure finance to US equities only made it through Q1 with a firm helping hand from central banks. The speed and force of the corrections and the rebound was obviously faster and more forceful than both the "normal" and the "extraordinary" calamities we are set up to capture. Even if conditions were so extreme that they are unlikely to be exactly replicated in the future, they still proved to be a good test of risk management skills. For our part, we did not manage to get all our funds out of risk in time. As seen in Figure 1 below, the ACCI Diversified fund had a drawdown of 10% in March, which is more than what we wished. That said it is still respectable as the drawdowns was close to half of the Morningstar composite of USD Flexible Allocation funds. As we re-entered risk markets in two steps in May and June, we also managed to capture the safer part of the upside in the second half of the year.

Going forward, we have a dual focus. On one hand, we continue to improve the risk management and alpha capturing capabilities of our investment process. At the same time, we are moving towards more sustainable investment content supporting a positive transition of the global economy to a more viable form of economic growth. The latter is a gradual process. The former, relating to the strategic asset allocation, is driven by market and policy developments. By the middle of this year central banks had pushed government bonds so much up in price and down in yields that high-grade bonds have become much less attractive, both outright and as hedging and diversification instruments. Holding a traditional portfolio with 30-40% Equities and 60-70% Bonds could therefore not be expected to deliver much more than 3.5%-4% p.a. going forward (as high-grade USD bonds should not be expected to deliver much more than 1% p.a.). We therefore changed the allocation in the fund. To be able to capture more of the market upside we adjusted the "Benchmark" allocation of equities to 40% and the maximum or "Positive" allocation to 60%. At the same time, we increased the maximum allocation of highs yield bonds from 10% to 30%. As and when the cycle turns, there is obviously the risk that such a portfolio will deliver a significant loss.

Figure 1: Combining data science with investment experience into a sustainable investment philosophy

Especially if, as we expect, the next recession ends up being closer to the two previous ones than to the one this year. This is illustrated in figure 2 below where we show a simulation of the maximum drawdowns of the "Benchmark" 60% bonds 40% equity portfolio described above. One can expect that, if things evolve as in 2007-08, such a portfolio can lose 30-40%. Even if this episode took place a long time ago, it is still very relevant as losses are often correlated to the level of leverage in the system and this is again going up. For our part, we therefore stand ready to reduce this risk allocation as we did in March of this year and with faster algorithms. Our ambition is to have smaller drawdowns in the next crises and re-enter faster after the correction or crash.

Figure 2: Maximum drawdowns of ACCI Diversified vs its 60/40% Equity bond benchmark

As for the Sustainability and ESG considerations there isnow a decent set of instruments available to express one’s asset allocation across both active and passive asset class funds. An easy solution to create a Sustainable portfolio would therefore be to take a handful of these SRI an ESG labelled funds and combine them into a portfolio. We have seen many examples of this over recent years, but we hardly ever saw any quantification of what is achieved with this approach. We therefore developed our Sustainability Matrix to add numbers to the good intentions and the nice words. For example, we suggest that investors target a reduction of CO2 emission of 33% initially in 2021 and maybe 50% over the coming years. An area of continued challenges is sub-investment credit, and our hope is that initiatives are taken to ensure that these companies benefitting from strong central bank support in their borrowing take the problem more seriously and actually do something active to reduce CO2 and other emissions.

Figure 3: CO2 emission from two a traditional 40%/60% equity/bonds portfolio and from a more Sustainable version

Sustainability and Performance 20122020
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