In this new era of lower returns with higher risk, investors must rethink how they balance risk, liquidity and returns with greater discernment and due diligence
For over a decade after the global financial crisis, central bank policies focused on quantitative easing (QE) created an environment of abundant liquidity, low interest rates, and rising asset prices. In this ‘rising tide’ market regime, beta-driven investment strategies flourished.
Many asset owners allocated to passive equities and cashflow-matching corporate bonds, alongside illiquid assets like infrastructure, real estate and private equity, for the promise of diversification and higher returns.
This strategic asset allocation approach delivered for most investors, with limited need for active management. But the world has changed. The playbook that succeeded in the QE era no longer aligns with today’s dynamics.
Inflation, though off its 2022 highs, remains persistently elevated, influenced by structural factors like fiscal deficits, ageing populations, and geopolitical fragmentation. These forces are ushering in a more uncertain and volatile investment environment.
Today’s investors face more volatility in inflation, greater market dispersion, and shorter economic cycles. Traditional assumptions about the behaviour of asset classes are under scrutiny. Equities no longer enjoy liquidity tailwinds from central banks, bonds are less reliable diversifiers, and high cash rates are eroding the excess return – or premia – that market betas once offered.
In this new regime, markdowns and underperformance in private assets could leave portfolios vulnerable to illiquidity risk, with limited flexibility to navigate future shocks.
The combination of higher cash rates and lower risk premiums underscores the need for high-quality strategies that do not rely on leveraging ever-rising markets. Investors must rethink how they balance risk, liquidity and returns with greater discernment and due diligence.
The total portfolio approach: An investment overhaul
Leading asset owners are pivoting away from siloed, benchmark-driven strategies towards a total portfolio approach (TPA).
This holistic framework prioritises total portfolio outcomes over individual asset-class performance. It allows for greater flexibility, a focus on risk-adjusted returns, and the integration of innovative strategies into portfolios.
A TPA also encourages asset owners to allocate risk budgets to their highest-conviction ideas, breaking from the traditional strategic asset allocation model. It is a profound shift, requiring collaboration across internal and external teams and a recalibration of investment processes.
In this new era, relative-value, market-neutral and long/short strategies are emerging as vital tools for achieving equity-like returns with lower volatility. Their structure allows investors to capitalise on macroeconomic uncertainty and asset-class dispersion, creating opportunities for alpha on both the long and short sides.
Crucially, these strategies are cash efficient. By implementing them through derivatives, investors can collateralise positions with cash, earning a return on both the cash and the alpha stream from the strategy.
For instance, a €100 investment in a relative-value strategy uses €100 in cash as collateral, capturing cash rates in addition to the overlay return.
This dual benefit – alpha generation and high cash returns – aligns perfectly with the realities of the current economic landscape.
Hedge funds, often associated with high fees, poor alignment of interests and opaque structures, are undergoing a transformation. Asset owners are demanding greater transparency, alignment, and cost efficiency.
Approaches like multi-strategy and systematic macro have been gaining traction as defensive diversifiers, offering the prospect of better downside protection than bonds without sacrificing upside potential.
According to research by Australia’s Future Fund, the era of using government bonds to diversify equity risk is over. Hedge funds, particularly liquid diversifiers, are being embraced for their resilience across market regimes.
However, this time around, investors are crystal clear that this new breed of diversifying strategies must offer greater liquidity, transparency and better value for money.
Collaboration and innovation: Most admired asset managers
The shift from strategic asset allocation to TPA has profound implications for asset managers. As asset owners consolidate relationships and insource capabilities, they require fewer but deeper partnerships with managers who can act as expert extensions of their teams.
The most successful asset managers understand clients’ unique goals and challenges. They will offer modular building blocks that complement internal and external portfolios.
Sharing knowledge openly to build institutional expertise will be crucial, as will collaborative innovation to develop tailored solutions that respond to evolving needs.
The current cash rate environment is not a blip – it is a fundamental reset. Investors must recalibrate their strategies to thrive in a world where beta offers less and liquidity is at a premium. Embracing new approaches like relative-value strategies and adopting a total portfolio mindset could be essential for achieving resilient, long-term outcomes.
As market participants navigate this paradigm shift, collaboration, transparency and adaptability will define the next generation of investment success.
Mitesh Sheth is CIO of multi-asset at Newton Investment Management
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