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Portfolio > Portfolio Construction

Right on Target

By John Sullivan

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The sunny view from Scott Wolle’s high-rise office in downtown Atlanta is an apt—if somewhat obvious—metaphor for his view of the retirement fund space as a whole, and Invesco’s place in it. The balanced-risk allocation strategy he’s developed, which is the focal point of the Invesco Balanced-Risk Allocation Fund and the Invesco Balanced-Risk Retirement Funds, is unique in that “no one is running their target date portfolios this way,” he boasts.

He and his seven-member team have been together for 10 years and currently manage approximately $9 billion in assets. Although the retirement fund itself is relatively new, they’ve been executing the balanced-allocation strategy from the beginning.

“The balanced-risk allocation fund is the cornerstone,” Wolle says. “The more distant retirement funds are invested 100% in the balanced-risk allocation fund. As they get closer to the retirement date, we start to dilute the volatility with money market funds.”

When asked how he defines balanced-risk, he begins with the standard “we’re trying to win by not losing,” but thankfully gets more specific by explaining that it’s about understanding possible economic outcomes and ensuring enough risk is in the portfolio that’s associated with those outcomes to reduce the probability of a prolonged period of negative return.

“That doesn’t mean the fund can never have negative returns,” he admits. “It’s really making sure the fund is built in a way that it’s unlikely to have those minus 30% or minus 40% events that we saw with more traditional funds in 2008.”

But does downside risk trump all other variables when considering these outcomes?

It is a key consideration, he says, but it gets back to the basic math of compound returns, where if 50% of the fund’s value is lost it will take a 100% gain to recover. But participating in the upside and limiting the downside are really two sides of the same coin, he notes.

A run-through of the team’s investment process gives us a look at how he balances those two sides. The team first looks at the assets that make sense to include in the portfolio. One key element, of course, is diversification.

“Diversification is a term that’s so widely used I’m not sure it carries as much meaning anymore,” he laments. “It’s really about how assets perform in different economic environments. Rather than saying, ‘Bonds should be X percentage of your portfolio’ we go a step deeper to say, ‘What kinds of bonds make sense and what roles can they play in the portfolio?’ For example, when we think of the different economic outcomes, we think of non-inflationary growth, the ‘Goldilocks’ periods where equities do really well, but certain bonds do well also, like high yield. Then we think of recession when long-term government bonds will be best. Then there are the inflationary periods when you really need to protect the portfolio against unexpected rises in inflation. By calibrating the assets in the portfolio based on those outcomes we think we set ourselves up to be able to build a better portfolio for investors, whether it’s an inflationary growth period or a non-inflationary growth period.”

After deciding which assets make sense to include in the portfolio, the team then considers how to best put the mix together. This, he says, is crucial. With a typical 60/40 portfolio, stocks are three times as risky as bonds and the investor actually ends up with 90% of the portfolio associated with equity risk.

“What that means is (going back to the set of economic environments we previously mentioned), the environment where equities do best is in non-inflationary growth. So implicitly you’re saying ‘I’m willing to bet that we’re going to end up with a pretty pleasant economic outcome and therefore I’m willing to put most of my risk in equity risk.’ The way we think about it is to say ‘We hope that will be case, but we also note that there are going to be periods when things aren’t quite so equity friendly. Therefore, it makes sense to have an equal amount of risk associated with each of those three economic outcomes.’ That creates a different kind of portfolio; one with a much higher allocation to commodities and bonds than would typically be the case in a traditional portfolio.”

The last part of the investment process, he says, is active positioning and including tactical allocations in the portfolio. Wolle says that although over the long term he thinks one-third of the risk in each of those outcomes is appropriate, at certain times various assets will be more or less attractive based on the economy. He wants the flexibility to emphasize or de-emphasize those assets in periods when they’re less likely to do well.

When asked how he’s avoiding the bond bubble (whether real or imagined) Wolle lists important items to consider in bond valuation. The most important, he says, is what investors are trying to accomplish by including them in the portfolio.

“In our case, we think that bonds are crucially important to protect against recessions and crises,” he says. “That was evident in 2008 and during the European crisis. That’s been a very consistent theme throughout history. Bonds do a very, very good job of protecting against volatility in the economy. Second, when we buy bonds, we don’t just buy U.S. bonds. We also buy currency-hedged exposure to a number of other bond markets, many of which are not as richly valued” as the United States.

Last, Wolle thinks about the amount the investor should have in bonds, which gets into questions of volatility and how the bonds move relative to other assets. If bonds were to start behaving in a much more volatile manner than they have historically, he says, he would end up reducing his exposure to bonds.

“Tactically, it’s easy to raise the question ‘Do we think bonds are expensive?’” he says. “Generally speaking we think that, yes, bonds are expensive relative to the fundamentals. Based on our work, however, I would not argue that bonds are so radically overvalued that one would necessarily call that a bubble. It’s actually in a consistent range of valuation relative to a 30-plus year history in government bonds. So I’m not sure this is radically different from what we’ve seen before.”

When asked what he currently likes and where he’s finding alpha, Wolle begins broadly and stresses he’s not a stock picker. He’s using futures and futures-linked derivatives; he is still overweight equities globally. He has exposure in North America through U.S. large caps, and small caps throughout Europe and Asia.

“Really the only market that we are not overweight right now relative to our strategic position is Japan,” Wolle says after a moment of thought. “We’re also overweight commodities. General commodities are an area on which we spend an enormous amount of time doing research because, as you may be aware, there’s a big debate among practitioners and academics about whether a commodity should have excess return relative to cash.”

Does he like gold?

“We are absolutely still interested in gold and, generally speaking, when central banks set their monetary policy in a way that is likely to reduce the value of the currency, which is certainly the case right now in the U.S., gold is likely to continue to benefit.”

All of this sounds great, but why, as he claims, is it so well-suited to a target-date strategy?

“The first thing to consider when you look at target-date funds is why they are managed the way that they are,” he says. “The traditional financial theory is to fund the optimal portfolio and then either lever that up or dilute it with cash to get to the right risk/return profile. What we find is that in order to try to get risk up, you end up with an increasing equity allocation, which moves the portfolio much farther away from an optimal portfolio structure. What we’d rather do is build a better mouse trap from a portfolio perspective; we want to keep that portfolio structure, and then start to introduce cash into the portfolio to reduce the volatility as people get toward retirement.”

This has a couple of key benefits, he says. One, because of the higher degree of diversification, it’s helped investors get more bang for their buck in terms of return per unit of risk. Secondly, the argument over whether the funds should be allocated in a way to get the client “to retirement” or “through retirement” is really what Wolle refers to as a “false dichotomy.” What investors need at that point in life, he argues, is to make sure they have enough return to continue with their lifestyle, but also a portfolio that’s sensitive to inflation.

John Sullivan can be reached at [email protected].

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