By Nicolo Bragazza, associate portfolio manager at Morningstar Investment Management Europe Limited
In a world where we often think in terms of linear relationships, the concept of convexity might sound a bit exoteric for most people without a solid grasp of financial theory and mathematical models. However, it comes down to a very intuitive concept – your portfolio should behave well in both up and down markets.
In fund analysis, this concept is usually approximated by using metrics such as up and down capture ratios, and ideally, investors want funds to capture more of the upside than the downside of a given benchmark.
How to bring convexity to multi-asset portfolios
Although the concept sounds intuitive and desirable, convexity is very hard to achieve in practice and is often quite expensive. One way to achieve convexity is by using option strategies, of which one of the most popular methods is a straddle. This is where an investor takes a long position in both a put and a call option, thereby profiting in both up and down market. However, this strategy is often quite expensive as investors need to pay a premium upfront.
Another way is to carefully construct a portfolio where the combination of assets with different characteristics can achieve the same outcome. Again, this is not a very easy task in practice. In the book ‘Beyond Diversification,’ Sebastien Page suggests one possible reason – correlations between assets are asymmetric and therefore tend to go up during phases of market stress, whilst they tend to decrease when the market goes up, preventing investors from achieving the desired level of convexity.
This is a real headache for active multi-asset investors because it means that it is not only difficult to effectively protect on the downside, but that this might come at the cost of further missing on the upside.
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However, there is at least one asset class in the investors’ toolkit that might give them some hope – government bonds. These have historically shown the ability to protect on the downside during equity led sell-offs. Although they have not been great in upside months over the past 25 years, there has been a convex relationship between the monthly returns of US treasuries and the S&P500, especially on the downside.
Very different, is the relationship between high yield bonds and US equities as the two tend to be significantly exposed to the business cycles and phases of market stress, thereby limiting any significant diversification benefit.
Other investments, such as momentum strategies or managed futures, have historically exhibited more convex payoffs than most alternative strategies – even governments bonds. However, this consideration heavily depends not only on the time horizon, but also on the benchmark.
Relying on historical realization, without additional considerations regarding history and implementation, could lead to disappointing outcomes for investors.
One logical consideration is that we should concentrate on assets with higher beta for better upside, and therefore higher sensitivity to the business cycle or market rallies. This observation leads to the conclusion that a more convex portfolio can be achieved through a ‘barbell strategy’.
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These strategies are designed for uncertainty in both directions and mean allocating to both defensive and aggressive assets so that investors can profit in both directions. The idea is that the right combination of cyclical and defensive assets should bring a sufficient degree of convexity to investors’ portfolios to navigate phases of uncertainty leading to increased volatility in financial markets.
Barbelling portfolios might sound like the appropriate way of delivering convexity, but investors should be aware that although convexity is a desirable trait, it is not the best for every market environment. It can also be expensive, as other portfolio strategies may be more appropriate in certain market scenarios and defensive assets may trade at a premium, thereby increasing the cost of building the portfolio. Additionally, the relationships of assets may change significantly in different macro regimes, such as during inflationary times.
Although investors are always looking for the silver bullet against any potential market risk, there is no such thing. Even if there was, it may be too expensive to deliver a big enough value for the portfolio.
This brings us down to our final point – convexity is a desirable aspect to have in a multi-asset portfolio, but investors should always think about whether it is appropriate for their objectives, and whether they are over-paying for it.
