When the walls came tumbling down

Increasing globalisation and the blurring of the lines between differing asset classes, means that the traditional approach to assessing investment risk may soon be obsolete. James Cielinski of Threadneedle Investments tells us more

Asset allocation has long been a key source of return for fixed income investors. High yield credit, emerging market bonds, investment grade corporates – these asset classes and others demand active investment views. Plan sponsors, consultants, actuaries and investment managers must continuously ask how much of an allocation each of these asset classes warrants.

How does one ascertain relative value across these asset classes? This question has never been easy to answer. Today’s shifts in the global economy and in the nature of fixed income risk, however, now make it even more difficult. Comparing a risky asset to an observed risk-free rate has been a customary method for analysing valuation, but what is one to do when there is no longer any such thing as a risk-free rate? All assets in today’s environment appear to have at least some degree of default risk. And what is one to do when the asset class definitions become so blurred as to become meaningless? The changes we are witnessing represent a seismic shift in fixed income market behaviour. Many of the old rules for asset class allocation are simply obsolete.

Asset class borders are crumbling
The characteristics that once defined fixed income asset classes have become less relevant and less pronounced. This has significant implications for the asset allocation decision. The ascendancy of emerging markets has been well documented, as has the deterioration of some developed market economies such as Greece, Ireland and Portugal. These are not short-lived curiosities. Many developed nations, following years of growing fiscal imprudence and higher leverage, are bankrupt. The healing process will be long and arduous, and will have a lasting impact on markets.

The blurring distinctions between fixed income sectors are seen readily in Figure 1. This shows the marketperceived credit risk of a range of issuers plotted against those issuers’ credit ratings.

For most of the last three decades, the different asset class categories would have appeared as reasonably tight clusters in this chart. The degree of overlap across asset classes is now unprecedented. Simply knowing which category an asset resides in offers very little insight into its price. Equally interesting is the extent of dispersion within the various asset classes, which also remains at historically high levels. Is it fair to call both Greece and France developed markets, when the underlying risk and observed prices have almost nothing in common?

Adapting to the New World
Investors should give careful thought to how they respond to these changes. If the shifts are indeed permanent, as we believe, the current framework employed to assess these risks is archaic and inadequate. There is a better way. We suggest investors adopt a combination of the following approaches:

1. Throw out the definitions and focus instead on “risk and return”. With artificial asset class definitions doing a poor job of capturing market behaviour, the focus must shift. Investors should focus on capturing the most attractive risk/return opportunities in the market, irrespective of asset class. Sponsors should broaden their opportunity, set for mandates, rather than limit them. Tearing down the asset class barriers is the best way to exploit the dislocations that emerge from traditional, definitional-driven investing. Broadening the opportunity set is hardly a new concept – it was historically a path to higher alpha and superior diversification. What is new is the compelling rationale as it is now essential to capturing the rapidly evolving array of global opportunities that emerge as asset classes blur.

2. Establish teams and processes to reflect reality. Few investors have materially altered their processes and approach in a way to capitalise on these developments. It is imperative to analyse assets of different structures, geographies, liquidity and credit risk in a way that aggregates the results into an investable outcome. Specialist investment teams need to work together in a way they never have before: an emerging market team may determine that Indonesian local bonds are attractive relative to Brazilian real rates, but the critical decision may be in determining whether Indonesia is attractive relative to assets in other areas, such as Irish mortgages or the subordinated debt of a German bank. Teams will need to carefully coordinate the scenarios they employ to evaluate assets, as scenarios will need to be consistent across all securities, regardless of asset class. A rigorous scenariobased analysis process is one of the few methods for coping with a proliferation of assets and return profiles.

3. Adapt market research to market drivers. The pace of globalisation has altered the importance of market drivers. Domestic GDP and inflation have always influenced markets, but today they are more often lagging indicators. Policy responses and the evolution of large global imbalances play the starring roles today, and a robust research effort should focus on those elements. Much of the future performance of various asset classes today hinges on key questions such as: 1) how does the Eurozone crisis play out; 2) can large debtors like the US, UK and Japan move to fiscally sustainable debt trajectories; and 3) can China navigate through accelerating price pressures? Research must address the questions that will determine success, but few have trulyamended their process to accomplish this.

4. Perform asset allocation using nontraditional factors. Most asset classes behave in a way that is more attributable to their risk characteristics than to their categorisation. Beta and momentum are two such factors that have grown more important in recent years. Momentum both in the economy and in markets can be highly persistent. As a result, many assets perform in a very similar fashion throughout the cycle, distinguished mostly by the degree of underlying risk (or beta). This was clearly seen in the high degrees of correlation all risky assets displayed in recent years. “Value” is yet another factor that helps in asset allocation. Many investors would be better served by replacing, or at least augmenting, their traditional asset allocation framework to include exposure to these factors. One approach might be to hire managers that could invest almost anywhere, but within a target range for a variety of these risk factor exposures.

Globalisation has finally consumed the fixed income markets
As borders in the fixed income markets disappear, asset class allocation may never be the same again. Yet, many plan sponsors and managers remain mired in an allocation process that is rapidly becoming obsolete. Too much time and effort is spent on exercises that may offer diminishing value in future years. Even worse, the analysis may be overly reliant on historical measures of risk and return, which bear little resemblance to how the global economy is evolving. The shifts we are witnessing today are the culmination of five decades of globalisation. As with all transformations, there will be dislocations that persist. Exciting opportunities await those that can take advantage of these historical shifts.

For use by institutional clients and consultants only (not to be passed on to any third party).The research and analysis included in this document has been produced by Threadneedle for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Threadneedle Asset Management Limited. Registered in England and Wales, No. 573204. Registered Office: 60 St Mary Axe, London EC3A 8JQ. Authorised and regulated in the UK by the Financial Services Authority. Threadneedle is a brand name, and both the Threadneedle name and logo are trademarks or registered trademarks of the Threadneedle group of companies. threadneedle.com