The Efficient Frontier – definitely not static, but still robust and relevant in today’s unpredictable world.

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Parmenion Investment Management (PIM) use well established risk control techniques to blend more and less risky assets to construct a broad spectrum of usefully spaced, risk graded portfolios. These portfolios display increasing volatility (and return) from a level not dissimilar to cash at Risk Grade 1, right up to a Risk Grade 10 portfolio which behaves in a way consistent with its aim to deliver higher risk, higher return investment.

The bedrock for this portfolio construction process is the analysis of historical risk/return data across over 70 discrete sub asset classes over a period of 20 years.

The basis for selecting that period of time is that it extends sufficiently far back to capture a host of relevant key events in recent market history. For example, if we were to cast our minds back 20 years, where were we? 1995 opened with the collapse of Rumbelows the domestic retailer. In the Far East, Nick Leeson brought the 200 year old Barings Bank to its knees in February, with the loss of £800m through unauthorised, or rather unsupervised, derivatives trading.

The Government of John Major was hanging on, with just a wafer thin majority in the House of Commons, and the year saw a succession of Tory defections and by-election defeats weaken his hold still further. Cool Britannia was still a couple of years away. But in the stock market, 1995 was a different story. And compared to 1994 a complete transformation. The FTSE market rose 25% against a loss in the previous year of 13%. Quite some swing.

Similarly a brief survey of the intervening years brings to the top of mind the Russian debt default, the dotcom boom and bust, 9/11, the second Iraq war, the credit bubble, the Credit Crunch and the Euro Crisis. All the while China grew and grew and grew.

Roll forward and we anticipate seeing a marked realignment of our Risk Framework to account for a year in 2014, which overall delivered solid positive returns across many asset classes. The background to this was the 1% fall in long term US interest rates to 2.95%. The effect of a large fall in such a key rate is to bolster both the capital value of debt securities and improve the present value of future equity returns, thereby boosting share prices.

So how will this effect the distribution profile of our risk graded portfolios? Advisers familiar with Parmenion will be aware that our risk graded portfolios are designed to sit close to the ‘Efficient Frontier’. This is because for medium to long term investors we believe in the merits of asset class diversification to deliver superior risk adjusted returns.

fp-frontier-graph

The notable feature in the chart is that the ‘Efficient Frontier’ constructed using 20 years data to the end of 2013 has a kink in it, as risk grades 9 and 10 show declining returns for the additional risk they incur. Understandably this has led some to question the validity of the process.

For PIM this merely reflects the dynamic nature of the process and why it is imperative that investors are committed to investing for the long term. Why do we have such faith? Because once our models are brought up-to-date the distribution profile of our risk graded portfolios will undoubtedly change.

An early provisional analysis of the 1995 – 2014 Risk Framework suggests an upward shift in returns across the entire spectrum of risk grades is being seen, and interestingly that the kink in the higher risk grades has been considerably smoothened out.

This will be useful to Advisers because the fundamental concept, one PIM have established at the very heart of our process, that risk and reward are inextricably linked, is so much more clearly visible to customers, in the shape of the efficient frontier.

Advisers will therefore be equipped to show their clients the merits of long term investment across the range of our Risk Framework to assist in assigning a suitable risk graded portfolio to match with their clients’ individual tolerance for risk and capacity for loss.

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