Written By: Stephen Hearle
Stephen Hearle at Nordea Asset Management explains how a multi-asset investment approach can have the potential to offer the returns investors need and the diversification that they seek
Investors in equities have enjoyed more than a decade of strong returns, amid an environment of artificially supressed volatility. In fact, there have only been a few periods of material drawdown since the depths of the Global Financial Crisis in March 2009.
It is a similar story within the fixed income space, with bond markets – in addition to delivering crucial diversification benefits for investors – also generating solid returns. The yield compression in fixed income markets can be largely attributed to the incredibly accommodative stance from major global central banks.
However, after 11 years of continuous economic expansion, investors now face a number of challenges. Firstly, we have witnessed increasing recession scares, with the US Treasury yield curve recently inverting and then reverting. As for equities, global stocks are still generating positive performance, despite an environment where earnings growth is softening. We are also seeing heightened fears of a bubble in credit, due to the sharp rise for BBB-rated corporate debt.
In addition to this, the current low interest rate levels across the world are undoubtedly making it more difficult for investors to harvest stable income. It will also limit the ability of authorities to act ahead of a potential recession.
The danger for investors
With these numerous uncertainties, it would be understandable to expect returns to be lower in 2020 and beyond. However, no one knows when this current economic cycle will end. We do know one thing for certain, we are closer to the next recession today than we were yesterday.
In our view, the primary danger for investors is worrying about the wrong things. Rather than pursuing a robust and prudent diversified investment framework, investors typically do the opposite and agonise about missing potential bull market gains or allocate to the wrong diversifying assets.
Arguments in favour of diversification are also proving increasingly problematic, due to the fact diversification explicitly diminishes performance in rising markets. Also, many investors still believing in market timing and rotating portfolios according to short-term market movements. In addition, there is also the misguided view that investors can accurately position a portfolio ahead of an event – such as a major election.
Achieving true diversification
The good news is that diversification from macroeconomic turbulence can be achieved by investing in assets that behave differently during an economic cycle. In truth, diversification is not simply about piling into numerous asset classes, but rather identifying a select number of truly uncorrelated positions able to deliver for investors through most market environments.
By balancing carefully selected assets able to complement each other in recessionary and recovery periods, an investor does not necessarily need to repeatedly make the correct macroeconomic call in order to achieve a positive total return over time.
Is this the magic solution? No. Even with a diversified portfolio as described above, three big challenges remain. Firstly, there is the risk of overpaying for diversifying or conservative assets. Secondly, the challenge of how to allocate and weight exposure between the different asset classes. Finally, there is the question of unstable relationships or correlations. This also ignores political risk and, the elephant in the room, the limitations of central banks to lower interest rates further.
The lessons of risk premia
Building resilience into a diversified portfolio is paramount for stability and success. One approach to multi-asset investing is to view it through the lens of risk premia. This is akin to dissecting assets into what drives asset pricing, but there are challenges to be met in order to achieve true diversification.
Firstly, there is the danger of allocating to defensive safe haven assets that carry a valuation premium – such as what can be seen in the P/E ratio of the MSCI Minimum Volatility Index versus the MSCI World. The problem with buying defensive assets with a valuation premium is the fact this “defensiveness” has proven to deteriorate far more rapidly than other fairly-priced defensive assets.
The second challenge is weighting, or more appropriately, balancing. It is important to ensure that investors have a balanced exposure to cyclical risk premia, which captures performance in the expansionary period of the cycle, as well as anti-cyclical – or defensive – risk premia, which provides positive performance in environments when cyclical risk-on assets are in retreat. By balancing the risk exposure between these two different risk premia, it may be possible to build a market neutral portfolio. This approach has proven to manage drawdowns more efficiently and reduce portfolio volatility.
It is also imperative to take into account the behaviour of cyclical and defensive risk premia in a period of a booming expansion and a recession – when the market is 2-3 standard deviations above or below a “normal” level.
History is unlikely to repeat
Given that past performance is not an indicator of future performance, Investors performing a purely quantitative study could be fooled into believing government bonds still offer the same protection characteristics as pre-2008.
Instead, utilising valuation or asset pricing in conjunction with historical correlation can better assess the future relationship between assets, and thus deliver an attractive asymmetric return profile which can be ready for the different scenarios that may be encountered in this new decade.
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