Our Investment Philosophy and Process

Innova have a distinctive investment philosophy and process which approaches risk in a multi-faceted way and benefits from its unique partnership with the Milliman Group, one of the world’s largest actuarial and risk management firms.

 

Investment philosophy

 

Innova believe that clients define risk in multiple ways, and have different tolerance levels to each risk. This is in contrast to the traditional portfolio construction approach, where risk is defined as volatility. Further, Innova believe that the return characteristics of an asset class can be deconstructed into individual risk factors, such as valuations, inflation and term premium.

 

Innova build portfolios based on these risk factors, with a focus on diversification and ensuring that the resulting portfolios are exposed to the intended risk factors, which in turn is based on a quantitative model as well as the investment team’s views on the market environment. In terms of objectives, the portfolios focus on providing investors with the greatest return, given the risk factors they are exposed to and their expected range of returns, rather than trying to outperform a market index.

 

Core Beliefs

 

1.    Management of investment risk is critical to managing behaviour. Returns matter, but behaviour matters even more

2.    Price and therefore valuation drives long-term returns

3.    The vast majority of investment risk comes from, and is managed through, Asset Allocation

4.    While valuation drives long-term returns, asset class risks are driven by their underlying risk factors. To understand an asset class you must understand its underlying risk factors

5.    Diversify by underlying risk factor, not asset class

6.    Diversification for diversification’s sake destroys value.

7.    Focus on building robust portfolios, not optimal portfolios

 

 

1.       Management of investment risk is critical to managing behaviour. Returns matter, but behaviour matters even more.
When it comes to achieving the goals set by an individual, an organisation, charitable trust or group, it is the behaviours attached to those goals that have the greatest influence on the result. Investment returns can help to achieve goals (by being able to fund them), but unless a plan is put in place and followed, even the best returns will not be enough. Therefore investments need to be managed in a way that won't lead to clients reacting inappropriately to market events, and potentially derailing themselves from their plan. For this reason, investment risk management is critical, as investment risk can lead to behaviours that will adversely influence a well-laid plan.

 

 

2.       Price and therefore valuation drives long-term returns.

Of the things that can affect the return on an investment - the price, growth of the underlying instrument/business, macroeconomics, etc - only one thing is within the investors control - price (and hence valuation). If you overpay for an asset, no matter the quality, the likelihood of receiving a good return is low, and no matter how poor the asset quality, if you pay less for it than it is worth you can still make a profit. Evidence shows that valuation is also the only metric that has any meaningful influence on long-term returns - trying to forecast macro environments and pick market changes has no evidence of effectiveness, only valuation has that body of proof.

 

 

3.       The vast majority of investment risk comes from, and is managed through, Asset Allocation.

The vast majority of the variability in portfolio returns comes from portfolio Asset Allocation, not security selection - so Asset Allocation is Innova's focus and our primary tool for managing risk

 

 

4.       While valuation drives long-term returns, asset class risks are driven by their underlying risk factors. To understand an asset class you must understand its underlying risk factors.

Valuation is the greatest determinant of long-term returns, but the variability around those returns, and hence the risk attached, is driven by a multitude of risk factors. Every asset class has a number of these risk factors, and understanding them is key to understanding the asset class. Further, many risk factors are inter-connected across asset classes, so to understand a total portfolio, you must be able to recognise and model these inter-dependencies.

 

 

 5.       Diversify by underlying risk factor, not asset class
Diversification should be across sources of risk, or risk factors. Diversifying simply by asset class can inadvertently lead to doubling up on common underlying risk factors, meaning the portfolio is not actually diversified. When diversifying by source of risk, greater robustness is introduced to the portfolio - the core of true investment risk management

 

 

6.       Diversification for diversification's sake destroys value.
Concentrate positions when the potential upside is substantial and your confidence is high (when prices are low), and conversely when potential upside is minimal and confidence is low (prices and/or uncertainty are high) take more, smaller positions.

 

 

7.       Focus on building robust portfolios, not optimal portfolios

Optimal portfolio construction requires perfect foresight, something no-one has. Instead, portfolios should be built to be robust. The future is uncertain and can't be predicted. By focussing on robust portfolio construction, you give yourself a greater chance of weathering the variety of unforeseen storms your portfolio will inevitably have to face.

 

Why we are different

 

Innova manage investment portfolios to strict risk benchmarks (not capital market benchmarks such as the S&P/ASX 200 or a stock/bond blended benchmark), with the aim to earn the best possible return consistent with those risk benchmarks. The risk associated with capital market benchmarks varies through time and rarely coincides with clients’ risk tolerance, capacity or need. By managing to strict risk benchmarks, clients can be confident that Innova will vary their capital market allocations to fit their specific risk requirements, and if or when those change over time, clients can change their allocations to the various Innova portfolio offerings.

 

Investment process

 

Innova constructed its risk factor framework in conjunction with the Milliman Group. This involved identifying risk factors for each asset class*, and then determining the causal relationships between factors (i.e. calculating what drives correlations between risk factors and how they change in different market environments).
From these risk factors, an expected range of returns is then determined for each asset class, based on current prices and market conditions.

 

The model built by Innova and Milliman is run monthly to obtain these asset class forecasts, which are the cornerstone of Innova’s asset allocation decision making. All the outputs of the model are reviewed, and then brought to the team to discuss whether any asset classes/exposures look attractive or otherwise. Weekly meetings provide a qualitative overlay to the quantitative process, and allow consideration of external factors that may be strongly influencing the outputs and allow the team to consider potential enhancements to the model. However, while qualitative input is important, its primary function is to test the quantitative assumptions, and the team will only override the model if there is a strong qualitative view.

 

A key part of the process is scenario analysis, in that the model can stress the portfolios to see how they would perform in different market scenarios, such as a high inflation period or a recession. This, combined with the qualitative assessment of macroeconomic conditions, assists the team in determining the portfolios’ positioning.

 

The following illustrates an example of a stress test for a recessionary environment.

investment

Following the risk factor modeling and qualitative assessment, asset class forecasts are then combined to determine an expected range of returns for each portfolio. Portfolio asset allocation is therefore dynamic, and may change regularly based on the range of returns of different asset classes, changing market conditions and the investment team’s macroeconomic outlook.

* bearing in mind that some risk factors, such as valuation, are common to a number of asset classes.