Written By: Christian Lehr
Christian Lehr of Nordea Asset Management surveys current trends in multi-asset funds, where traditional approaches are giving way to a focus on risk management
Multi-asset funds have been a proven all-purpose strategy for years. In order to live up to this reputation in the future, the asset class is reinventing itself. The traditional approach of breaking the boundaries between stocks and bonds to give the fund manager the freedom to be flexible in the markets is no longer enough. The market environment promises to remain restive and requires a change in perspective that focuses on risk management.
The yield problem
In today’s late-cycle environment, investors should diversify their portfolios to a high degree. This is more important than ever, as the economy is at the end of the cycle. As the yield curve flattens, bonds are becoming less lucrative. It is increasingly difficult to generate attractive returns with manageable risk. The correlations between traditional asset classes have increased significantly over the past few years. This is a tangible problem for traditional multi-asset portfolios – especially if they promise a stable earnings target – because they cannot go beyond the traditional investment spectrum. However, to provide effective protection against losses even in volatile times, this is exactly what is needed: the benefit of the entire range of equities, bonds and currencies as well as the use of alternative return drivers.
The worsening earnings situation is affecting a broad range of multi-asset funds. Year after year, the fund companies have launched hundreds of new variants – aggressive, defensive and balanced. And no wonder, because the demand is enormous: institutional investors are increasingly turning to multi-asset funds. According to a Scope survey1 published in 2018 among 106 institutional investors, around 37 billion euros were invested accordingly. In recent years, they have primarily redirected returns of expiring bonds. At the top of their list were absolute return products, which promise positive returns in every market phase.
Alternative solutions for turbulent markets
However, there are now so many funds that it is sometimes difficult for investors to differentiate the strategies and make the right choice for their investment objectives. Add to that the extremely low interest income to which portfolio managers of traditional multi-asset products react differently. Some raise risk budgets by raising the equity ratio. Others overweight certain markets or securities in the short term, although that also increases risk.
Now is the time for liquid alternative strategies with strict risk management. This promising approach no longer uses allocation based on asset classes, but instead focuses on risk premia. The fund managers use new opportunities to manage the investment risk, thus achieving more diversification and higher risk-adjusted returns. The idea is that each asset class several return drivers or risk premiums are hidden. For example, the performance of a corporate bond depends firstly on the interest rate development and secondly on the spread trend. These two factors correlate negatively. In order to predict reliably how the portfolio behaves in different market scenarios, the individual return drivers are divided into those that function in more recessive phases (defensive) and those that perform well especially during market recovery periods (aggressive). Simply put, risk premiums reward investors for the risk they take on strategies that generate more than the risk-free rate.
Risk control instead of yield maximisation
In this way, speculation about what will happen in the markets becomes superfluous. Portfolio managers who look at return drivers behind individual asset classes can create an optimal combination: robust risk management means combining the return drivers on the basis of their individual risk/return profile so that both defensive and aggressive drivers are always in the portfolio and the prescribed risk budget is adhered to. Against this background, it makes less sense to strive for unconditional yield maximisation than it does to create risk compensation through low-correlated investments. The result is a good positioning in any market environment with stable positive returns over time.
Another advantage of the risk premia approach is that within liquid asset classes such as equities, bonds and currencies, return drivers can be divided into traditional and non-traditional categories. For example, within equities, traditional risk premia include the equity market beta, while within fixed income they include for instance the duration exposure. Non-traditional risk premia (alternative risk premia) can, for example, consist of the exploitation of momentum, in the case of equities, or different carry strategies, in the case of bonds. These risk premia use, among other things, market inefficiencies or behavioral patterns of investors in the market. Hence, fund managers have a wide selection of alternative income sources that they can tap into, depending on their risk budget, without losing liquidity. Liquidity is important so that investments can be sold in a short time at reasonable transaction costs.
Trim portfolios to customer needs
Depending on the client’s needs, tailor-made investment solutions with different risk-return profiles can be put together to achieve attractive returns with controlled risk. It is not unusual for a multi-asset fund to utilise more than 30 different risk premia across all asset classes, which are constantly monitored and tested to determine the most attractive combination. Such multi-asset portfolios based on the allocation of risk premia correlate only slightly with traditional asset classes. This allows investors to diversify within their portfolio to mitigate long-term market risk without sacrificing return.
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