1. Summary
 Many asset allocations over the last five years are based on taking advantage of credit
spreads that may not be available in the future
 If credit spreads decline to a low level, asset allocation is going be more dependent on
liquid markets where returns are uncertain
 This uncertainty can be managed but not removed by four approaches:
o risk based asset allocation
o diversification between asset classes
o diversification within asset classes
o manager skill
 A combination of the four approaches will give the largest improvement in risk/return
but varying the mix or leaving out one or two approaches will still leave most of the
improvement in place
Credit Spreads are Compressing
For the past five years, many asset allocations have relied on the returns available by taking
exposure to two (correlated and not always distinct) risk premia:
(i) Credit spread risk which is the compensation for taking credit default risk and
credit spread volatility
(ii) Illiquidity risk which is the additional spread earned for investing in credit assets
that are more illiquid than corporate bonds
These two risk premia have the advantage that at least for investment grade credit on a hold
to maturity basis they should give a fairly certain return, absent a level of defaults that has not
been seen in recent history in a diversified portfolio (of course it has been seen in non-
diversified ones).
However in recent months both credit and illiquidity spreads have reduced significantly and
are now below the required returns for many clients. If credit and illiquidity spreads revert to
levels closer to where they were pre the credit crunch, credit as a core asset allocation would
no longer be particularly attractive.
Indeed in the past there were long periods often associated with low defaults where credit was
not an attractive asset class unless leveraged, a strategy which clearly came unstuck in 2008.
Therefore, in looking to evolve our asset allocation strategies, we should prepare for a world
where asset allocations are centred around liquid markets that offer returns that are far less
certain over a given time horizon.
CIO Report: Asset Allocation in a World
without Credit Spreads
12th August 2014
Philip Rose, CIO – Strategy & Risk

2. Asset Allocation in a World of Uncertain Returns
Liquid markets offer many risk premia which historically have provided positive returns in
exchange for taking market risk. However there are significant drawbacks:
(i) Individual risk premia can fail to provide excess returns for years or even decades
so relying on a small number of risk premia may not meet flight plan targets
(ii) Some risk premia are much cheaper to access than others in terms of
management fees
(iii) Risk premia may be transient and will not endure in the future
(iv) Some risk premia may incur substantial transaction and balance sheet costs
In building an asset allocation there are four techniques that can be used to help partially
mitigate but not remove these drawbacks.
Risk Driven Asset Allocation
Rather than allocating to an asset on the basis of amount, risk driven asset allocation seeks to
allocate according to the risk of the asset (with risk being measured as volatility). This means
that as an asset becomes more volatile less is allocated to it and as it becomes more volatile
more is allocated to it. This approach has historically improved the risk/return ratio for many
asset classes and has the added benefit of substantially reducing the cost of buying downside
protection in the form of put options.
This approach can be applied solely in the risk premia that is cheapest to access, namely
equity risk or across multiple asset classes.
Example: Volatility Controlled Equity with Put Option
Diversification between Asset Classes
Asset classes such as government bonds and commodities can provide exposure to risk
premia that have historically provided positive returns combined with performance in
economic scenarios where equities can perform poorly. For example, government bonds have
often performed well when equities have fallen and commodities have performed well in
periods of high inflation. These characteristics may not continue in the future in line with any
other risk premia but combined with a risk driven asset allocation they can provide attractive
potential returns.
Example: Risk Parity
Diversification within Asset Classes
Risk premia within asset classes, such as value (buying assets that are “cheap” relative to
their fundamental vale and selling “expensive” assets) and momentum (buying assets that
outperformed their peers and selling those that recently underperformed) can be accessed via
long short strategies in individual asset classes. These risk premia are based on the
implementation of a systematic investment process, not manager skill, but do require both
trading and the ability to be easily long or short an individual asset. This means that
transaction and balance sheet costs (costs of financing a position) can be quite substantial.
Example: Style Premia Fund

3. Manager Skill
Manager skill is the return left over once the market “betas” for both individual asset classes
and systematic strategies within and between asset classes have been removed. True
manager skill or “alpha” is often expensive to access and runs the same risk of non-
persistence as any other risk premia. However, in recent years, a lot of the strategies that were
the preserve of “2 and 20” macro hedge funds have become available in much lower cost
funds.
Example: Relative Value DGF
A combination of these four approaches will produce the best expected risk/return
characteristics but changing the mix or leaving out one or two approaches will still leave most
of the risk/return improvement in place.
Contact
If you would like further information on this report, please do get in touch.
Philip Rose
CIO – Strategy & Risk
CIO@redington.co.uk
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