Cyclical Position Process: Increasing Portfolio Resilience

At Netwealth, our ambition is to deliver attractive portfolio performance over the medium-to-long-term to give our clients the best chance of meeting their investment goals.

Investment process

To deliver on these ambitions, our investment process has three distinct parts, with ongoing risk management an integral component of each one:

• Building strategic allocations: we construct high quality portfolios offering diversified exposure to international capital markets, with the aim of maximising returns for each client’s preferred level of risk over the longer-term horizon. These will also be the key driver of returns.
• Instrument selection: we ensure the instruments chosen to implement our investment views are the most appropriate to meet our goals.
• Adopting cyclical positions: at certain times, we consider departing from the strategic allocations to address specific economic or market risks that may threaten performance.

Further details on our entire investment approach can be found here. This article, meanwhile, explains the objective and motivation for the cyclical adjustments we make to portfolios.

Cyclical positions - objective

One of the key responsibilities of the portfolio management team is to consider any potential changes to portfolio positions to address specific economic or market risks that may knock the performance of our strategic allocations off track. As such, the objective of such potential ‘cyclical’ positions is to smooth the path of returns received by the investors in a given portfolio.

The team’s risk management approach ensures that cyclical adjustments will never significantly affect our diversified strategic allocations. However, the positions themselves aim to remove portfolio risks, rather than to seek additional exposure to risks which are already well-represented within our strategic allocations.

As a result, the standalone performance of individual cyclical positions, such as a currency hedge, or a reduction of a weighting to a specific asset class, will often be the reverse to the overall performance of a specific strategic allocation. For this reason, we expect cyclical positions to be more effective when portfolios are experiencing a challenging period of performance.

A visual illustration

The diagram below illustrates our approach, which details a simulation¹ of a possible strategic portfolio return series in grey and our desired return profile for a Netwealth portfolio with cyclical adjustments in navy blue.

Although the broad characteristics of performance are similar, the volatility of returns is much lower and consequently so are the portfolio drawdowns², which we feel is vitally important in improving our clients’ experience and reducing the chance of crystallizing losses after a market fall.

Referring to the shaded area above, we feel a client invested in the grey portfolio is much more likely to make knee-jerk decisions related to performance and miss out on the subsequent better returns, than a client invested in the blue portfolio, although they would also have suffered a period of disappointment. To reiterate, the motivation for making these adjustments is to improve portfolio risk-adjusted returns over the medium to long term.

Process

When evaluating the merits of adopting cyclical positions, the investment team considers the macroeconomic environment, inferred policy response, asset fundamentals and valuation levels, as well as market positioning. The process necessarily focuses on different specific metrics within these areas depending on the asset class concerned, but will typically have both quantitative and more qualitative contributions.

Technical analysis does not play a major role in decision-making beyond informing the timing of entry and exit points from positions. The impact of cyclical portfolio positions is considered primarily at the portfolio level but also monitored and measured on a standalone basis to retain investment discipline.

Current positioning

While the portfolio allocations are always focused on long-term, strategic thinking, our investment team constantly monitor cyclical risks to performance and will make changes in line with the objectives discussed above.

As such, over the past year, we have reduced exposure to certain assets where we feel market valuations offer the least cushion to negative surprises, such as US equities and corporate bonds. Conversely, our portfolios currently reflect a cyclical preference for European equities and emerging market fixed income versus the strategic allocations.

¹ The simulation is generated using a random walk with positive mean parameter (denoting a positive expected return) and positive sigma (to illustrate portfolio volatility.) This is not a forecast of future returns and is included purely for illustrative purposes.
² We define drawdowns as the negative return incurred from a local peak to the subsequent trough in the return series.

Please remember that when investing your capital is at risk.