Contrary to the expectations of many at the start of the year, government bond yields of major developed markets continued to fall. Lacklustre growth and central bank bond purchases mean safe haven assets have been in short supply and these forces have driven yields lower. As growth picks up, recent uncertainty over central bank policy and political risk have led to some reversal.
As ongoing market volatility serves to remind us, equities have become more volatile, and divergence in performance has become more extreme. It is questionable whether monetary policy is reaching its limits, leaving some to ask how much more support risk assets stand to gain from further easing.
Against such a backdrop, delivering attractive returns is not a simple task. However, we believe that diversified growth strategies should be equipped to rise to the challenge if they have wide flexibility in terms of asset allocation, as well as the ability to look beyond simply relying on rising markets to deliver returns.
Diversification through fundamental thinking
Multi-asset absolute return funds should have the tools and flexibility to navigate changing market conditions. Asset allocators can alter their portfolios to emphasise assets that are in a favourable environment, and avoid investments that are facing less conducive conditions.
They might also aim to manage downside risk either by using derivative-based protection strategies or by using broad investment strategies, such as diversification, to help smooth returns.
We believe that better outcomes can be achieved through a blend of these approaches, but it is not straightforward. For example, diversification works by blending investments that behave differently from one and other, but these relationships are not static. Correlations between asset classes change over time.
The relationship between government bonds and equities is instructive. Generally speaking, in recent years, both asset classes have performed well. But, when equity markets have wobbled, exposure to government bonds has normally helped to smooth returns.
But fund managers must continue to assess whether the relationship between the two asset classes is likely to change. Some managers rely on statistical correlation matrices to drive their expectations on how asset classes will interact.
At Insight, we tend to think more in terms of “fundamental diversification”, which focuses on understanding how changing economic environments will impact the correlation between asset classes.
Based on such analysis, we have observed that the correlation between government bonds and equities tends to be negative when investors are more concerned about the outlook for economic growth, and the correlation turns positive when the market is more concerned about real rates or inflation.
Coming into 2016, many investors were focused on the Federal Reserve and the prospects of a US interest rate hike, but we believed that the fragility of global growth, and the failure of economic activity to accelerate to a self-sustaining rate, would become the key concern for markets.
At the start of the year economists were forecasting up to four interest rate increases in the US in 2016 – now it appears there may only be one. Expectations for a US rate hike have been pushed back despite US economic data being comparatively robust.
This led to a constructive environment for bonds but the likely negative correlations between government bonds and equity markets had added to the appeal of the former.
In our portfolio, we had maintained good levels of exposure to government bonds, which has been positive for performance.
However, it’s important to recognise that these forces can change quickly and portfolios need to adapt. The result of the US presidential election, and ensuing uncertainty over monetary and fiscal policy, is a case in point.
The ability to assess changing trends quickly, and to alter asset allocations dynamically, can help portfolio managers respond to changing market conditions. We have designed our strategy so that we have wide flexibility to vary the level of exposure we have to different assets.
We do not have an asset-weighted benchmark to guide our exposure. Instead, our exposure to assets is driven by our return expectations while also being sensitive to other issues such as expected volatility and correlation with other investments and tolerance for loss.
Over the life of our strategy this flexibility has been an important tool and helped to deliver the smoother return outcome we seek. Figure 1 shows how our asset allocation has evolved over time, and that we cut our equity allocation to zero during the financial crisis.
So having wide asset allocation freedom can help capture returns and manage downside risk. This can be extended further by also employing strategies which can generate positive returns without simply relying on rising markets. These strategies often have the added attraction of improving diversification beyond reliance on the different interaction between primary asset classes.
One example is relative value strategies, where managers can profit from the spread of performance between different segments of the same asset class, rather than the absolute performance of the overall asset class.
For instance, a position favouring the FTSE 100 index relative to the FTSE 250 index would generate a gain or a loss depending on the relative performance of the two indices, regardless of the overall direction of the UK equity market. This position might make sense if you believe that larger companies will benefit in future from sterling weakness given the greater proportion of international revenues, and that they will be less exposed to a slowdown in the domestic UK economy.
Another example of a relative value trade would be a long position in 10-year gilts held against a short position in 10-year German bunds, which might reflect a belief that UK yields would fall further than bund yields. Of course, there are a wide range of other strategies that can be employed using exchange-traded derivative instruments that can allow precise targeting of specific return drivers and ranges.
Ingredients for growth in a changing world
We have argued that a broad investment universe and wide asset allocation flexibility are important tools that can help to deliver long-term returns while also smoothing volatility.
However, we believe they should be augmented with robust downside risk management on individual positions. After all, even the best managers will get some views wrong.
Simply buying protection is, in our view, expensive, so we have designed a range of approaches tuned to the different characteristics of the investments we make. These help us scale and manage exposures sensitive to expected volatility and tolerance for loss.
But by combining sources of return and allocating dynamically, multi-asset investors should be able to cost-effectively manage downside risk, enabling them to target long-term returns with less volatility than global equities.
Source: Insight, as at 30 September 2016. Positions are shown on a net basis ¹ Cash: Includes cash at bank, FX forwards and money market instruments. Allocations are subject to review and may change without notice.
Important Information
The value of investments can fall. Investors may not get back the amount invested.
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Any views and opinions are those of the investment manager, unless otherwise noted. For further information visit the BNY Mellon Investment Management website. INV00517 exp 28 February 2017