Investors have been rewarded less for taking greater market risks this year, according to data from JP Morgan Asset Management.
The firm plotted a three-year rolling Sharpe ratio of global bonds, global equities and a 50/50 balanced mix and found that, since the end of 2014, it has dropped significantly for both the balanced portfolio and for global equities.
Source: JP Morgan Asset Management
This suggests that investors are getting paid a lot less for investing in the markets and as such, the JP Morgan multi-asset team has reduced risk levels across its portfolios.
“I think market investors are starting to debate where we are in the cycle and they’re starting to think about whether the beta trade is a bit long in the tooth,” Talib Sheikh, portfolio manager in the JPM multi-asset solutions team, said.
“If you think about where the market has been over the last three to five years, and it certainly hasn’t felt like it at times, it’s been a relatively easy time to make money, so we decided to calculate a naïve portfolio – and find out what’s the Sharpe ratio? What’s the risk-adjusted return of holding that portfolio?”
“The data tells us that beta has been the right thing to be in for the last three-to-five years and long equities and long fixed income have delivered positive returns, but perhaps more importantly there’s been a negative correlation between those two asset classes which has led to a nice risk-adjusted return.”
In the past, investors have held a combination of bonds and equities to maximise downside protection and to provide asset diversity. This year, though, the asset classes began to behave similarly and ended up correlating positively in August as China’s stock market plummeted and 30-year US treasuries fell simultaneously.
Performance of sectors in 2015
Source: FE Analytics
Sheikh was unsurprised by this because of the high levels of uncertainty in the markets and the fact that the same macro-economic factors have been driving the volatility across most asset classes.
“There’s definitely been uncertainty about policy, and so in August you lost money in fixed income, you lost money in credit and you lost money in equities because the market was debating and thinking about what would happen if central bank policy were to become divergent and create a more uncertain world, and that creates volatility across asset classes at the same time,” he explained.
“We’re not hugely bearish on equities here and we’re not particularly bearish on where we see bond prices going, but I think what we have the most conviction about is that the risk-adjusted return of holding those long assets is likely to degrade from here.”
In such an abnormal environment where investors are being rewarded less, the manager says that it is vital to maintain portfolios that are as diversified as possible.
“Investors need to be thinking about taking asset allocation to the next level and becoming incredibly granular in terms of how they’re implementing their asset allocation,” he continued.
“The world is becoming more divergent, we’re likely to see the Fed raise rates next week for the first time in nine years, against the backdrop of the ECB extending their QE programme, against a further backdrop of more potential easing from the People’s Bank of China and from the Bank of Japan.”
“There are divergences across the global economy in terms of relative value which, for the astute investors, offer rich pickings.”
Sheikh says that the Sharpe ratio data also demonstrates the need for investors to focus on risk-adjusted returns and other ratios as well as an investment vehicle’s total return.
He says that, over the last few years, it has been a common theme for investors to attempt to maximise their return irrespective of the risks they were taking due to the strength of the market.
Now, though, he warns that investors should be focusing on risk levels as strongly as they have been returns over the last three-to-five years.
“Again, we’re not hugely bearish on markets here, but I think you’ll have a very difficult time pointing to any individual asset class across the globe as having table-pounding amounts of value, so people are going to have to be much more focused on entry points, much more focused on the price they’re paying for their assets and much more focused on asset class diversification,” he added.
While Parmenion’s Meera Hearnden is also a firm believer that diversifying portfolios by asset class can lead to attractive risk-adjusted performance, she warns that an investment vehicle’s Sharpe ratio should not be studied in isolation as it has some flaws.
“It can’t distinguish between upside and downside volatility and it can’t tell the difference between intermittent losses and consecutive losses,” she explained.
“The Sharpe ratio should not be used in isolation, but in conjunction with other risk metrics in my view. The chart above, despite its very basic illustration and limitations, shows the Sharpe ratio actually on an upward trend since 2009, so a roll over should not come as a surprise - whether this downward trend is sustained is another thing.”
Performance of manager vs composite over 10yrs
Source: FE Analytics
Talib Sheikh co-manages 14 onshore and offshore funds at JP Morgan. Over 10 years, he has outperformed his peer group composite by 18.47 percentage points, providing an average return of 55.11 per cent.
