• 14/09/2017

The Best of Both Worlds

The Best of Both Worlds

By Matt Sherwood

Today, investors face many challenges in managing their portfolios, including high equity market volatility, heightened macro uncertainty and the unwinding of a 40-year global leverage boom. At the same time, investors are looking for downside risk management in the wake of recent market turmoil, but in many cases they also need to aim for relatively high ‘CPI+’ returns in order to meet their investment objectives. While this is true of all investors, it is particularly acute for those getting closer to retirement, and for those in the post-retirement phase.

Diversification key, but how can investors find it?

In finance it is generally accepted that investors who seek higher returns will need to embrace higher risk in their portfolio. In essence, investors only have two tools to manage this risk – diversification and hedging. However, the vast array of correlated losses during the 2008/09 Global Financial Crisis (GFC) exposed the weaknesses in portfolio designs, as most risk and return dynamics had been tested when markets were assumed to be liquid and rational. After the GFC, many investors questioned whether the benefits of diversification were attainable or dead – this prompted investors to question perceived assumptions and the relevance of the current status quo. Since then, investment strategies have been evolving to include an ever-expanding universe of alternatives and strategies that offer investors more diversification; including multi asset ‘real return funds’; private equity, hedge funds and a plethora of credit and debt strategies. While many of these still have a high short-term correlation with equity, the ability to provide short-term downside protection, coupled with alternative sources of return during protracted periods of market weakness is attractive.

The irony of being ‘balanced’?

Broadly speaking, funds that pursue a high return target (e.g. Inflation plus five percent) needs to have a high weighting to risky assets to achieve it. No matter where investors live, traditional investor portfolios are tilted excessively towards equity market risk. Traditional portfolios are constructed with a large exposure to equities have constraints within which they operate, including: an inability to use leverage, operating in an environment of monthly surveys of peer group relative returns, an inability to cope with large amounts of illiquidity; a perception that derivatives are risky and so portfolios should be constructed using mostly physical assets in a controlled and slow moving asset allocation framework. In order to provide a sustainable superior risk and return outcome several of the traditional constraints need to be relaxed.

Investors, the center of investment decisions

Investors will continue to have a significant exposure to equity, but in an environment of continuously modest and volatile equity market returns (likely to be contributed by dividend income relative to the past 30 years) and low yields on government bonds, the lack of focus on asset allocation skill and excessive focus on ‘manager selection’ within asset classes is no longer a prudent approach for investors.

As the global population ages and savings pools are progressively drawn upon, the managing downside risk becomes even more important for investors. They need to manage the ‘path’ of returns, as much as the overall return itself. This requires a re-think of investment strategies. Investors will need to employ strategies which are more flexible and adaptable to the markets that prevail; including being more active in asset allocation and allocation to non-correlated alternatives.

Win-win in alternatives and ‘real return funds’

The positive development of today’s investor is the growing access to alternatives and strategies that allow flexible asset allocation, even with a moderate capital base. In this way the morphing of the institutional investment universe and retail has begun. New investments such as ‘real return’ funds, infrastructure debt, private equity, commodities and syndicated loans, can serve as investment complements to traditional balanced fund assets.

For instance, the goal of these ‘new balanced’ or ‘real return’ funds is to embrace the value of diversity of approach (manager skill). It also provides transparency and allowing the manager to have joint accountability for outcomes with the investor. What was once only available to institutional funds is now available to everyday investors, with low costs and daily liquidity.

Today’s wise financial professionals are no longer chasing the asset class that is ‘in play’. Rather, they are focused on finding and implementing new investment techniques and asset classes that can deliver consistent risk and return outcomes with much less dependence on a supportive macro-environment. This approach can be a win-win for advisors and their clients, and probably the early stages of this process becoming an investment norm. BM