It looks like genuine multi-asset investors have a lot of head scratching to do when it comes to building a properly diversified portfolio for 2016. 
As they will be well aware, concerns are rife in regard to both bond and equity markets as valuations within both asset classes have risen since the global financial crisis on the back of ultra-loose monetary policies from the world’s central banks in the form of very low interest rates and quantitative easing.
Of course, bonds are the main area of worry as many believe that with rates rising in the US and yields at historically low levels, the end of a multi-decade rally in the asset class is nigh. Equities are certainly not risk free, though, as macro headwinds persist in the form of slowing emerging market growth, unspectacular earnings growth and high valuations.
In truth, it has been these woes which have made 2015 a difficult year of multi-asset investors. While the likes of direct commercial property and high yield bonds have generated a mid-single digit return, all asset classes have delivered substantially higher levels of volatility than in previous years.
Performance of sector and indices in 2015
Source: FE Analytics
So, how should multi-asset investors approach 2016?
Trevor Greetham (pictured), head of multi-asset at Royal London Asset Management, says every multi-asset portfolio should be structurally biased towards equities over fixed income. He says that given the recent sell-off in global stocks markets, now is a good time to up exposure.
“We are taking advantage of recent market weakness to add to equity overweights in the multi-asset funds we manage,” Greetham (pictured) said.
“Stock markets have dropped sharply with weakness triggered by a decline in the oil price to seven-year lows and stress in the US credit market ahead of the first potential interest rate hike by the Federal Reserve in nine years. The UK equity market has been particularly hard hit given its high exposure to companies in the energy and natural resources sectors.”
“Our sentiment indicator is flagging a contrarian buy signal for the first time since the summer sell-off. Investor sentiment is depressed with our indicator 1.5 standard deviations below average. Stock markets are volatile, individual investors are pessimistic and US company directors are also buying shares in their own companies, which is a positive sign.”
“We expect global growth to pick up in 2016, in part due to the stimulatory impact of the lower oil price, and we do not expect gradual interest rate rises to derail an upturn in the US economy. The recent dip in the market looks like a good opportunity to add to stocks.”
John Stopford, co-head of multi-asset at Investec, agrees with Greetham.
He has targeted more growth-orientated assets within his portfolios such as equities, high yield corporate bonds, emerging market debt and property over very defensive securities like government bonds and cash due to a rising interest rate environment in the US but recognising the large amounts of stimulus being pumped into the financial system elsewhere in the world.
“This creates a benign environment for financial markets, characterised by modest growth, low inflation and relatively loose monetary conditions, supporting the view that this could be an extended economic cycle with recession still some time away. This should benefit growth assets, particularly equities, which only tend to peak finally just before a recession,” Stopford said.
“The backdrop for emerging market assets looks less compelling, as does the outlook for corporate bonds. Policy divergence should support further gains by the US dollar, although its rally is already advanced and may constrain how quickly US interest rates are raised.”
Relative performance of currencies over 2yrs
Source: FE Analytics
Lucy Walker, fund of funds manager at Sarasin & Partners, says investors could even afford to ignore traditional safe-haven bonds entirely within their portfolios.
She says that yields on most government bonds are likely to rise over the short to medium term and that they may even fail in their traditional role of providing diversification against equity market falls.
For example, bonds have tended to rise in value during periods of equity market weakness. However, the increased correlation between the two asset classes as a result of quantitative easing means that both are likely to fall together now, according to Walker.
“Historically, holding a mix of equities and bonds has delivered much better returns per unit of risk than investing in any single asset class and this diversification is one of the major strengths of investing in a balanced portfolio,” she said.
She points out that in the crash year of 2008, the FTSE All Share lost 30 per cent while the Barclays Sterling Gilts index made 13 per cent. Therefore, if an investor had a portfolio of half equities and half bonds, they would have only seen a loss of 9 per cent.
Performance of indices and composite portfolio in 2008
Source: FE Analytics
Walker continued: “The problem today is that if equities fell, treasuries would struggle to deliver as aggressive a return. In fact, even if the whole treasury market went to a yield of 0 per cent, that would equate to less than a 15 per cent rally. Of course, yields could go negative, but investors are locking in future negative returns at that point, and are better served holding cash.”
“Meanwhile, if bond yields rally, it is also quite unlikely that the equity market would be a big beneficiary, especially if yields rise faster than the very gradual path currently expected. Higher yields mean higher interest expenses, less credit, less credit-driven growth and pressured earnings, while higher interest rates also make equities look less attractive on a relative yield basis.”
“Corporate bonds are similarly challenged, while cash won’t go down but yields nothing, and won’t go up in a crisis either.”
Therefore, to protect her investors against equity market volatility, Walker is holding more “alternative” assets such as stock index options, asset leasing funds and hedge fund-style strategies.
Jason Hollands, managing director of business and communications at Tilney Bestinvest, is far more cautious on equities than the other experts mentioned in this article.
For example, he says central bank intervention has distorted all major markets and asset classes and says investors need to be prepared for lower returns but higher volatility than has been witnessed over recent years.
As a result, he favours absolute return funds rather than anything else.
“Allowing the tap of liquidity to remain turned on for too long, has allowed the gross misallocation of capital creating valuation distortions in markets and has prevented a normal default and bankruptcy cycle in the real economy,” Hollands said.
“You might think the latter is a good thing, but allowing businesses to fail are a necessary and cathartic process to cleanse an economy of past excesses to make way for new dynamism.”
“The provision of so much liquidity, for so long has also helped fuel the alarming debt-issuance binge in Asia and the emerging markets, which is coming home to roost as these regions are now reeling under the pressure of servicing dollar-denominated debt as the dollar has strengthened.”
As a result, he favours absolute return funds rather than anything else.
“Overall we are cautious on both equities and bonds for 2016 given the risks that have built up, the potential dislocation that might occur as monetary policies diverge between regions and the continued spectre of a slowdown in China.”
He added: “So where should investors park their cash?
“In the medium term we think investors might take another look at absolute return funds that pursue low volatility strategies that are not reliant on directional movements in markets.”
