Deutsche, Lombard Odier CIOs split on how to tackle volatility

Two investment heads agree on the benefits of portfolio risk budgeting, but hold different views on tail-risk hedging and illiquid assets.
Deutsche, Lombard Odier CIOs split on how to tackle volatility

Investors are open to any ideas that will help them staunch losses and boost yields these days, given that interest rates look set to remain low and market volatility and uncertainty is rife. AsianInvestor spoke to two chief investment officers from private banks about the approach they would take. 

Christian Nolting, global chief investment officer at Deutsche Private Wealth Management, and Jean-Louis Nakamura, Asia-Pacific CIO at Swiss firm Lombard Odier, both agreed that portfolio risk budgeting was a good approach, but they held divergent views on illiquid assets and tail-risk hedging.

Portfolios allocated based on risk budgeting will perform far better in the current uncertain and volatile type of environment than those constructed using the traditional approach, noted Nakamura, 

“Traditional portfolios based on a logic of capital allocation will be subject to much wider drift in their level of risk, when the volatility of the assets in which most of their risk is concentrated – equities – will spike,” he argued.

Nolting said that he, too, liked to construct portfolios using risk budgets and was seeing huge demand from clients to move away from pure benchmarking to pure budgeting.

Another growing trend, he added, was to take more risk but hedge against tail risks, especially in light of the major volatility sparked by Britain’s vote to exit the European Union.

Tail risk refers to market shocks that are so extreme and unexpected that they trigger widespread declines and can devastate a portfolio strategy; Brexit is a clear example.

Demand had been rising for tail-risk hedging among Deutsche Bank’s wealth management clients globally, even before the UK referendum on June 23, said Nolting, and it is much cheaper than hedging the whole portfolio.

In addition, he noted, correlation between equities and bonds is likely to become unstable and inconsistent, given current low and even negative interest rates – which calls for more diversification into asset classes not correlated to either bonds or equities.

As a result, Deutsche recommends that clients allocate more to alternative asset classes to achieve more stable returns. 

If clients have the ability to allocate to less liquid assets, such as private equity, infrastructure and private debt assets, they should do so, as the illiquidity premium is now very high, said Nolting. An IRR of 12%-13% has been possible for European or US private equity over a 10-year investment horizon, he added.

Nakamura is less convinced. For one thing, he does not recommend tail-risk hedging: “Either you have very good reasons to fear an imminent systemic-like crisis – which is not our scenario – and you can afford to pay high premiums for such protection, or you trap yourself into permanent high-cost out-of-the money options that will detract from performance.”

Nakamura argued that risk-based processes for allocating traditional liquid assets were a far much more efficient hedging strategy. For example, he said, long-term bonds offer a natural hedge against equity risk, with the benefit of low carry rather than paying a permanent premium.

Nakamura does not recommend illiquid strategies either. “In periods of rising volatility, there is the illusion that illiquid strategies will offer some protection,” he noted. 

But he pointed to the suspension of redemptions from UK property funds this week to show how such illiquid strategies were “the first victims” of a strong mismatch between the liquidity of investors’ assets and their liabilities.

Instead, Nakamura suggested that liquid and transparent alternative risk-premia strategies made sense. They offer additional diversification from traditional assets at a reasonable price and with high transparency and predictability, he said.

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