Systematic Allocation Portfolio: Staying agile in volatile markets

Risk mitigation on the downside, participation on the upside.

By UBS Client Investment Specialists

Pick up any newspaper or turn on any news channel and you are almost guaranteed to hear or read about the ups and downs in today’s markets. Investments into financial markets always involve a certain amount of risk. But one of the goals of our model-driven strategy, the Systematic Allocation Portfolio (SAP), is the management and the reduction of risk in more volatile periods.

Constructing a diversified portfolio is an important objective for most investors, and effectively managing the equity risk exposure is key to that challenge. This is true for two reasons: First, equity risk dominates overall portfolio risk, even for well-diversified portfolios. This is because some asset classes, specifically equities, contribute much more risk to the overall portfolio than others. This is often underappreciated. The second reason why managing equity risk should be a priority is that it changes over time. There are market environments in which it is desirable to have a high allocation to equities because of their upside return potential, and other times when it may be optimal to have a very low allocation to equities due to their large downside risks. The challenge lies in distinguishing between those market regimes.

The equity allocation of the SAP is driven by a quantitative assessment of current market momentum and the business cycle. The continuous assessment is condensed in the CIO World Equity Market indicator, which drives the equity allocation in the SAP portfolios. For the last two years, the indicator signaled a mostly positive environment for equity investments amid broad-based improvements in global earnings, macro-economic momentum and rising equity markets. However, late in 2018, the signal suggested shifting – in two quick steps – from an equity overweight to neutral, and eventually to an underweight in equities. This was after volatility in financial markets proved persistent, equity market momentum globally turned negative and clear warning signals were picked up from credit markets.

So how does the SAP protect client assets during these more volatile times?

The model’s reaction to the recent market moves and the negative signal means that the strategy has moved to the low equity allocation. A large part of the portfolio is now invested into high grade bonds, which are a much safer asset class than equities. This helps to reduce the risk in the portfolio.

But more importantly, if equity markets calm down and start moving higher again, clients could also benefit.

As observed in October and also early November the model can react quite quickly. Within only a few weeks the signal dropped more than 40%, mainly driven by market data. Since most of the economic data remains supportive for equity markets, an improvement in market momentum could lift the signal again above the 0 threshold.

So if markets start to recover, volatility calms down and fundamental data remains strong, the model will react and likely move back to the medium and possibly high equity allocation in a timely fashion.

2016 and 2017 were positive years for the SAP as the portfolio participated in rising equity markets. Across all three strategies, the SAP performed in the range of 6% to 10% in 2016 and 9% to 18% in 20171. In 2018, the most defensive strategy ended a difficult year with positive performance while the Medium and Dynamic strategies performed slightly negatively1.

In summary, the SAP dynamically manages the equity risk exposure of a diversified portfolio. It does so with the goal to mitigate portfolio risks during periods of below-average economic and earnings growth and above average market risks, while allowing clients to re-enter the equity market in a timely fashion once crises are receding, enabling them to benefit from economic upturns that are accompanied by rising equity markets and low volatility. The result is a portfolio that enables investors to stay fully invested through all market conditions.