This paper was co-authored by Stephan Meschenmoser, Senior Portfolio Strategist, Official Institutions Group, BlackRock; Anthony Chan, Portfolio Strategist, BlackRock Investment Institute; Grace Qiu Tiantian, Senior Vice President, Economics and Investment Strategy, GIC; and Ding Li, Senior Vice President, Economics and Investment Strategy, GIC.
The introduction was written by Kevin Bong, Director, Economics and Investment Strategy, GIC and Alexander Brazier, Deputy Head, BlackRock Investment Institute.
The significant impact of Covid on the economic and financial markets landscape has brought into focus the importance of incorporating uncertainty into any investment process. The unusual, stop-start nature of activity has no historical precedent, meaning lessons from the past are unlikely to be very helpful. In addition, the world faces several structural changes such as the challenge of combating climate change, the implications of unprecedented monetary-fiscal coordination and the growing role of China.
The uncertain environment we are in warrants some humility around expected asset returns – the building blocks of strategic asset allocation. It is also important to acknowledge that there is no “optimal” portfolio for the wide range of significantly divergent yet plausible economic outcomes. Yet traditional portfolio techniques, such as mean variance optimization, take the approach of achieving an “optimal” asset allocation by assuming too much certainty in the economic outlook and expected asset returns. This is a significant risk at the current juncture that could impede investors from achieving their objectives.
Both GIC and BlackRock believe strongly in incorporating uncertainty from the outset of any portfolio construction process. In this paper, we set out two alternatives to traditional methods. We study an explicit scenario-based approach and a simulation-based one, and explore ways the two could potentially be combined. The two approaches share a common philosophy – both allow for uncertainty, acknowledge that there is no “optimal” portfolio for all outcomes, and are flexible in a way that an investor’s aversion to uncertainty can be reflected in the portfolio.
This paper provides an overview of how we are looking beyond traditional portfolio construction approaches to prepare for an increasingly uncertain world. It aims to push forward the conversation and stimulate debate around portfolio construction.