SINGAPORE (June 12): Both institutional and private wealth investors have historically allocated to outcome-oriented strategies. Outcome-oriented investing is an investment approach that considers achievement of desired outcomes in addition to return and risk objectives. Asset owners have embraced a diversified and balanced approach, including yield-seeking strategies across asset classes. In addition, sovereign wealth funds have paid more attention to environmental, social and governance (ESG), generally — and climate change-related outcomes, specifically — over the past few years.
On the other hand, some wealth managers and advisers historically adopted a “high-conviction” approach, allocating to active funds with targeted outcomes or deploying discretionary portfolios backed by high-conviction ideas. Is there a way to marry the two disparate approaches? We examine three examples in this article.
Using barbell approach to achieve desired outcomes
For example, could investors use a “barbell” approach combining high-conviction ideas and a strategy that aims to replicate an index (“an index-based portfolio”) to achieve desired outcomes?
We first looked at a generic case where investors sought to enhance returns through investing in the equity asset class. At each year-end from December 2009 to December 2019, we simulated hypothetical buy-and-hold high-conviction portfolios based on the top 15, 30 and 50 stocks that were commonly held by high-conviction equity funds. Then, for every simulation, we created 50/50 barbell portfolios by allocating 50% weight to the high-conviction buy-and-hold portfolios and 50% to a rebalanced portfolio that tracked the MSCI ACWI Diversified Multi-Factor Index over one-, two- and three-year periods over the 10 years.
Breaking down those holdings by factors, using MSCI FaCS®, we see that, on average, the high-conviction portfolios were exposed to large-size, low-liquidity, high-quality and low-volatility factors. Comparably, the 50/50 barbell portfolios had a less significant bias to the size factor and higher exposure to value and momentum.
In terms of performance, the high-conviction portfolios, on average, outperformed the MSCI ACWI Index by 0.77%, 0.85% and 0.13% per year, respectively, over one-, two- and three-year investment horizons.
But we found even stronger results when we compared the 50/50 barbell portfolios to the MSCI ACWI Index. In that case, the barbell portfolio outperformed the MSCI ACWI Index by 1.51%, 1.21% and 0.93% per year, respectively, over the same periods with a lower tracking error. In addition, the 50/50 barbell portfolios outperformed the high-conviction portfolios in 59%, 67% and 63% of the simulated results, respectively, over one-, two- and three-year investment horizons.
Investing for outcome of income
What about wealth investors investing for sustainable income? Could an index-based high-dividend-yield model portfolio complement a high-conviction approach?
Similar to our methodology in the previous example, we simulated hypothetical buy-and-hold high-conviction high-dividend-yield-focused portfolios at each year-end based on top 15, 30 and 50 stocks that were commonly held by high-conviction global equity dividend funds from December 2009 through December 2019. Then, for every simulation, we created 50/50 barbell portfolios by allocating 50% weight to the high-conviction buy-andhold yield portfolios and 50% to a rebalanced model portfolio that tracks a basket of MSCI High Dividend Yield Indexes over the following one-, two- and three-year periods.
Chart 2 shows that while the historical performance of the 50/50 barbell portfolios were largely on par with the high-conviction portfolios, the yield outcomes differed.
On average, the 50/50 barbell portfolios improved yields by 5.4 basis points (bps), 8.4 bps and 9.7 bps per year, respectively, compared to the high-conviction buy-and-hold portfolios over the one-, two- and three-year investment horizons. In addition, the 50/50 barbell portfolios’ yield enhancement increased with investment horizon.
Integrating minimum-volatility tilt into private wealth portfolios
Some growth-oriented wealth investors could be concerned with heightened market volatility during Covid-19 and the potential negative impact on the performance of their equity portfolios. In this case, we looked at overlaying high-conviction holdings (either in active funds or discretionary portfolios) with a minimum-volatility approach.
We examined two scenarios: allocating 10% and 30%, respectively, to investments that track the MSCI ACWI Minimum Volatility Index, and the rest to an active global equity fund during the sample period from December 2009 to March 2020.
Chart 3 shows that a 10% allocation to a minimum-volatility tracking portfolio, increased returns in 91% and 97% of the cases, over the full sample period and during periods with elevated market volatility, respectively.
With a 30% allocation, we saw return enhancement and risk reduction for 90% of the active equity funds during the full sample period: The average return enhancement was 1.4%, and the average net risk reduction was 2.5 percentage points. Both results were more pronounced during periods of elevated market volatility: The average return enhancement was 5.1%, and the average net risk reduction was 3.1 percentage points.
A strengthened approach?
Despite being a relatively new concept to private wealth investors, factor investing has some similarity to an outcome-oriented investing approach in achieving targeted outcomes such as equity growth, yield enhancement and risk mitigation. While a high-conviction and active approach could offer simplicity and the potential to harvest alpha, an index-based approach may deliver greater transparency in portfolio construction and higher investment capacity than the high-conviction approach we analysed. As we have seen, a barbell strategy that combines both approaches could help achieve a variety of targeted outcomes efficiently.
Zhen Wei and Shuo Xu are executive director and vice president, respectively, at MSCI Research
