To illustrate this, back in 2017 Aviva Investors conducted a study evaluating every US investment-grade corporate bond recommendation from five sell-side research departments, capturing ‘outperform’, ‘market perform’ and ‘underperform’ recommendations across each rating category.
The data showed there isa clear low-quality bias to the outperform recommendations: the number of outperform recommendations for triple-B bonds is six times higher than for single-A bonds.
If portfolio managers are looking to research analysts for investment ideas, they will naturally be biased toward riskier securities.
Not only is this important before implementing a new idea, it is also essential to monitor invested ideas on an ongoing basis, to track whether they are behaving in line with expectations and, if not, to understand why not.
Resilience targeting, meanwhile, is about choosing the ‘efficient’ portfolio that best leverages the central investment thesis but will not be materially affected should it fail to deliver.
For instance, focusing on volatility as a primary measure of risk helps add alpha rather than beta to a portfolio.
This can be further enhanced by incorporating sensitivity analysis of investment ideas or portfolios under multiple scenarios. These analyses illustrate the level of risk taken in pursuit of returns and what can happen to a portfolio when the central thesis does not play out.
There are two kinds of scenario analysis. The first assesses portfolios’ sensitivity to volatility under different market conditions. The second is run by risk teams and is also known as stress testing.
Stress testing provides critical insight on when to reallocate or resize investment ideas, enabling managers to generate returns while acknowledging there will be periods of volatility and exogenous shocks to the market that cannot be predicted.
For much of the past decade, preaching the virtues of portfolio construction would have fallen on deaf ears as ultra-loose monetary policy has made it easy to generate decent returns through simple (and cheap) exposure to a variety of asset classes.
But Covid-19 – the impact of which has severely damaged companies, sectors and entire economies – has shifted the debate once more.
Building portfolios that can hold up in the most testing of circumstances is a matter of design, not good fortune; which results from sound investment and risk management processes and good, old-fashioned skill and judgement.
Unfairly miscast as an expensive ‘Cinderella science’ during the bull years, portfolio construction now has its chance to shine.
Josh Lohmeier is co-manager of the Aviva Investors global investment grade corporate bond fund and head of North American investment grade credit