Preparing for the battle between deflation and inflation, looking beyond bonds for protection and a greater consideration of sustainability are some of the new rules of portfolio construction that investors need to take note of, according to Unigestion. 
Massive interventions by central banks and governments to shore up the global economy during both the financial crisis and the ongoing coronavirus pandemic have had wide-reaching effects on markets that investors should not ignore.
Fiona Frick, chief executive at Swiss asset management house Unigestion, said: “The past decade has seen the ever-growing influence of central banks’ unconventional monetary actions. Their role went from reacting to the economy and the market to driving them.
“This has triggered some disruptions in the expected behaviour of some asset class given their inclusion in massive asset purchases programmes. This unprecedented liquidity boom has also created a future potential risk of inflation.
“The challenge for investors is how to gain exposure to future growth and central bank stimulus while also protecting their portfolios against different macro risks and potential market shocks.”
Below, Frick reveals six ways that investors could adapt their portfolios for this new era.
Invest selectively in equities
Unigestion believes stocks continue to look attractive relative to bonds, given the massive amounts of liquidity being created by central banks and the likelihood that interest rates will remain lower for longer. Stocks also benefit from a significant reduction in the discount rate, or the return an investor expects for taking a certain amount of risk.
Performance of global equities vs bonds over 10yrs
Source: FE Analytics
“These factors helped major equity indices recover from their end-March lows at an unprecedented pace. However, it is important to be mindful of investing in equity indices due to their momentum characteristics and bias towards stocks that have performed well,” Frick said.
“Many indices are heavily concentrated in certain sectors or companies, perhaps most notably the S&P 500, where technology firms account for more than 28 per cent, with the top five stocks (Microsoft, Apple, Amazon, Facebook and Alphabet) comprising around 24 per cent of the index (as at the end of August). This situation increases the risk of a sudden mean-reversion of indices. Any idiosyncratic shock that could affect the performance of these five stocks would turn into a systemic index shock.”
She added that this fact creates opportunities for active managers, as a selective approach to equities can allow them to capitalise on any dispersion between stocks.
Unigestion currently has a preference for ‘defensive’ equities, or companies showing resilience in their activities, cash flow and balance sheets, as it thinks these firms are well suited to weather current conditions and thrive when the economy recovers.
Invest in private equity to diversify growth exposure
The number of public companies has shrunk over the past decade thanks to fewer IPOs and increased M&A activity. For example, the number of listed companies in the US has declined by 40 per cent from its peak in 1996.
This means investors cannot rely just on public equity markets to gain exposure to the whole economy and Frick suggested they consider private equity.
“Investing in private equity when facing a mixed macroeconomic scenario requires, once again, a selective approach, but there are still significant opportunities,” she explained.
“Looking back to 2007/08, some of the best vintages of the last 15 years emerged from the crisis. Private equity investors were able to benefit from lower entry valuations in the years immediately following the [global financial crisis], while the eventual economic recovery from 2009 onwards provided a useful tailwind for all companies. At Unigestion, we believe that the next couple of years will provide similar conditions for investors.”
Balance the competing forces of deflation and inflation
For much of the recent past, investors have been more concerned about the risks of deflation, leading to portfolios becoming tilted towards assets that hold up in this environment. But this does not mean they should forget about inflation.
“Investors should prepare for a future battle between deflationary and inflationary forces and balance their portfolios accordingly. The impact of Covid-19 will likely be deflationary at first, due to the demand shock and low growth,” Frick said.
“However, even if inflation seems off the radar for now, the seeds of higher inflation may already have been sown. The direct monetisation of budget deficits, a retreat from global trade and a rebalancing of social and political policies in favour of labour are all inflationary forces.”
Unigestion argued that an allocation to equities and private equity should provide a good long-term hedge against inflation, as this offers real exposure to the economy where inflation will be priced in.
Protect against market stress episodes
With the ongoing coronavirus crisis making markets vulnerable to further periods of stress, Frick said it continues to be important to add some downside protection to portfolios.
Traditionally, government bonds have been seen as ‘safe’ assets that can provide defensive risk diversification benefits. But as the table below shows, government bonds were less powerful as a diversifier during this year’s coronavirus sell-off.
Bond hedging capabilities continue to decline
Source: Bloomberg, Unigestion
“Bond hedging capabilities are now more limited, as yields are already at very low levels. Low bond yields mean small yield cushions, which directly reduces their defensive benefits. They also make the forward-looking risk-return profile of bonds unfavourably asymmetric,” Frick continued.
“We believe investors need to broaden their toolkit to protect against market corrections. For example, equity derivatives can help investors to protect their equity allocations against market downturns without having to significantly increase their exposure to cash.”
Unigestion also thinks investors should combine explicit hedging strategies – or selecting an attractive portfolio of options – with implicit hedging strategies – which rely on statistical properties, such as a negative correlation, trend-following or mean reversion – to best protect portfolios.
Invest towards a more sustainable future
One positive effect of the coronavirus crisis has been refocused attention on environmental, social, and governance (ESG) considerations.
While issues such as rising inequalities and climate change were well known before the pandemic, Unigestion believes 2020 has reached a “tipping point” where society will no longer tolerate these imbalances and said investors have their role to play.
“Unlike banks, which use short-term funding to allocate capital, asset managers use the long-term funding provided by institutional investors and so represent a crucial link between investors and the financing needs of the real economy,” the Unigestion chief executive added.
“However, the end goal should not be growth at any cost, but rather sustainable economic expansion that minimises the risk of another major crisis. We believe strongly that this kind of investment should generate better long-term risk-adjusted performance going forward for our investors and is therefore aligned with our fiduciary duty towards our clients.”
Enlarge the Model Portfolio Theory framework
Frick also argued that the Harry Markowitz’s Model Portfolio Theory, which is a two-dimensional risk and return model, is “no longer sufficient” for portfolio construction as it fails to account for the increased role of sustainability.
Instead, she said investors should move towards a three-dimensional model that considers ESG impact of an investment on our allocation alongside the risk and potential return.
Moving from two dimensions to three
Source: Citigroup Business Advisory Service
“Our analysis shows that adding both bottom-up and top-down ESG restrictions into the portfolio construction process under realistic transaction costs and liquidity assumptions does not change the efficiency of the portfolio in an economically significant way,” Frick finished.
“On the contrary, there is evidence of a slight improvement to the risk-adjusted performance and downside protection with additional ESG risk considerations. This means that investors can achieve their objectives in terms of both risk and performance, while at the same time addressing their ESG preferences.”