It is more important than ever for investors to protect themselves against the downside through asset diversification, according to JP Morgan’s Jimmy Elliot.
The co-CIO of the firm’s Global Investment Management Solutions team, who also co-manages nine funds, has decided to take risk off the table in the JPM Multi Asset Macro fund following August’s Black Monday and the impending rate rises that are creating waves of volatility in the markets.
Performance of indices over 3 months
Source: FE Analytics
He has done this through reducing his weightings in equities and fixed income assets and focusing on alternative strategies instead, which he believes will increase the stability of his portfolio.
Elliot is not the only investor to be turning to alternative strategies. In an article published yesterday FE Trustnet took a look at a survey by Natixis, which showed that 77 per cent of financial advisers believe traditional stock and bond portfolios are not efficient enough in managing risk and providing returns.
As such, the survey found that 70 per cent of advisers questioned use alternatives in their clients’ portfolios as a means of catering to their risk tolerance.
“What caused our reliance on the diversification between equities and fixed income to come down after April this year was that asset classes started seeming more challenged in valuation terms, particularly in the fixed income market relative to long-running history,” Elliot explained.
“Those valuations to an extent are a reflection of quantitative easing policies in Europe, Japan and the US over the last three or four years. That informed our sense that we were likely to need to look at a portfolio construction framework that de-emphasised the reliance on equity and fixed income diversification and sought a higher participation in strategies that we felt could do one of two things: provide diversification at times when the traditional stock/bond diversification was operating less optimally and perform better in a higher period of volatility.”
This step involved an increase in “sophisticated strategies”, which the manager defines as anything that isn’t a cash-invested, long position in either equities or fixed income assets.
Some of these new trades include being hedged against duration risk to keep interest rate sensitivity low; shorting emerging market currencies because of disappointing growth and external rebalancing in the region; and buying into long Asian credit default swap protection, which Elliot believes will benefit from the worsening of market sentiment.
The manager picks these strategies based on whether they fit within the fund’s macroeconomic framework over the medium term as positions in their own right, and whether they offer diversification relative to the risk and return profile of the more traditional holdings in the portfolio.
“We’ve chosen to be short emerging market currencies because we feel that normalisation of rates and the stronger US dollar puts particular pressure at this stage of the investment cycle on emerging market currencies,” he said.
“Another example of how we use sophisticated strategies would be our decision to place a strategy that gave us long exposure to European equity volatility relative to US equity volatility in March and April of this year. That was based on our view that, at that point, the markets were pricing the intermediate expected volatility of European and US equities at about the same level.”
“That came off the back of the markets’ view that quantitative easing from the ECB was likely to be a very good thing for European equities, which reduces the volatility or the implied volatility of European equities.”
Despite this, it is still Elliot’s view that on a three-year time frame, Europe will remain constrained by its demographics and by the number of political institutions in Europe that are required for any strategic decision-making.
It is because of this that he added the strategy to the fund’s portfolio in April this year, as well as the belief that it would add diversification if political impediments such as the Greek crisis rear their head in the future.
A further European trade the manager has on a short position on the European automotive sector, which is a play on weaker China, against a long position on European banks, which is a play on improving credit demand.
It is one of several ‘pairwise trades’ in the portfolio – these monitor the performance of two historically correlated securities and, when one weakens, the other one strengthens, which creates a market neutral trading strategy that enables profit to be made in a range of market conditions.
These new positions don’t mean that the manager has forgotten the value of more traditional holdings though. Currently, two of Elliot’s ‘traditional’ plays are the global healthcare sector and Australian government bonds.
“Our allocation to the global healthcare sector, which has been in place for three years is really informed by a number of different things, but the likely persistence of low levels of inflation is probably the primary reason,” he explained.
“Remember that all healthcare stocks have characteristics that are consistent with cash-flow generation and I think that, in the longer run, they provide exposure to growing parts of the global demand side of the economy as they are linked in to the need for increasing healthcare provision in the emerging world.”
The manager says that this means the portfolio has exposure to stocks that are beneficiaries of interest rates remaining low while also reaping the benefits of increased healthcare demand as a result of a rising middle class in some developing countries.
The fund’s position in Australian government bonds feeds into Elliot’s view relating to China’s economic transition from an export-led economy to a more balanced economic model.
“This shift has implications for commodity prices and has done over the last three years,” he continued.
“One of the natural conclusions you would make from taking the view that commodity prices have probably reached the end of a 10-year super cycle based around the growth of fixed asset investment in China, would be to look at those economies that have a high exposure to resources as part of their economic model.”
“Australia fits into that category, and we still think that Australian government bonds in real yield terms offer attractive valuations relative to the European bond market, for example, or a number of other bond markets globally in which valuations are much more challenging.”
Year-to-date, JPM Multi Asset Macro has achieved the fourth-best total performance out of the 90 funds in the IA Targeted Absolute Return fund, returning 13.29 per cent and outperforming its peer average more than 11 times over.
Performance of sector vs sector and benchmark in 2015
Source: FE Analytics
JPM Multi Asset Macro has an ongoing charge of 1.68 per cent.
