Asset allocation: Forward planning
How are multi-asset fund managers positioning their portfolios?
- Rising rates, increased equity volatility and greater correlation could make finding returns harder for DGFs but should also underscore the utility of these funds
- There is considerable variation in how DGF managers have positioned their portfolios ahead of this change in market conditions
- This is a reflection of the broad range of different portfolio styles along with differing investment views
- Downside protection strategies are available to most managers but tend to be used sparingly and only when the costs are justified
The macroeconomic outlook poses a challenge for diversified growth fund managers. As quantitative easing comes to an end and interest rates start to increase, bond valuations will start to fall. This could be accompanied by a correction in equity markets as investors spurn risky assets and return to bonds. Not only could bonds and equities move in the same direction, but the correlation between the two markets could strengthen. And over the next five years, inflation could return to the euro-zone.
Michael Spinks, co-head of multi-asset growth at Investec Asset Management, says: “Investment strategies will need to be more nuanced in order to make returns in this changing environment.”
But these changes could also have positive benefits for DGFs. Spinks says: “Interest rates going up and higher levels of volatility will introduce some variation into the market.” That will make it easier for managers to find opportunities.
And greater volatility will help DGFs to become a more valuable strategy. The appeal of these strategies in the aftermath of the financial crisis was that they provided smoother returns than equities. This helps defined benefit schemes to reduce the volatility of the funding gap and helps defined contribution schemes to maintain their members’ investment confidence.
But the stellar performance of both bonds and equities in recent years coupled with very low volatility has made some investors question the value of these strategies. Jonathan Cummings, diversified growth fund portfolio manager at JP Morgan Asset Management, says: “While that’s an understandable view, it only reflects the last few years.” Investment strategy performance should be judged over a market cycle, he adds.
Investment consultants can help to underline the utility of DGFs. Andrew Harman, senior portfolio manager of multi-asset solutions at First State Investments, says: “They can help their clients to focus on their investment objectives and underline their tolerance for risk and their timeframe.”
Equity market performance may seem appealing at the moment but if there is a 20% market correction, a 25% return is required to recoup those losses. Harman says: “Many institutional investors selected these funds because they provide an element of capital preservation which helps them to reach their funding targets.”
While the low-interest-rate environment may finally be coming to an end, many asset managers are shifting rather than radically changing their portfolios. Spinks says: “We have half of our risk in growth strategies including directional equities and some in relative value but we have increased the amount of defensive strategies.”
But Investec’s allocation to defensive strategies is not driven by a bottom-up rather than a top-down approach. Rather than deciding that the fund should have allocation to defensive strategies, they have picked those which have the best investment characteristics.
This bottom-up approach allows Investec to focus on leading rather than lagging economic indicators. Spinks says: “If an economy is turning down, it will be apparent in company performance before it is appears in economic surveys.”
For example, the UK’s GDP numbers indicate the economy is still growing. But the number of profit warnings from companies which are focused on the domestic economy has risen in recent months. “By monitoring certain sectors such as logistics and distribution or the consumer sector, it’s possible to have a much clearer picture of the current economic environment,” says Spinks.
Perils of market timing
But some think underweighting equities would not be the correct response to the current market conditions. Cummings says: “This is a late-cycle economic environment which tends to benefit equity investors rather than benefitting the holders of credit risk.”
While equities are likely to underperform once the cycle comes to an end, it is important not to move to an underweight position too soon. “A late-cycle environment can last for a long time and there would be a significant opportunity cost to being under invested,” Cummings says.
The position also reflects Cummings’ view that there is a low risk of the end of QE being a shock to the markets. “Central banks have confirmed that monetary policy will be tightened only gradually, which supports our positive position on risky assets,” he says. Others are more cautious. Harman says: “This guidance means we know the path and the direction of travel but we do not know the rate at which financial markets will take this into account.”
There is also inadequate compensation for this risk in developed markets, according to Harman, who says: “We have minimised our exposure to developed market sovereign bonds and we have strategies which will benefit from higher rates.”
Raiffeisen-GlobalAllocation-StrategiesPlus has also positioned its bond portfolio to benefit from higher interest rates. Peter Schlagbauer, fund manager, says: “We have an allocation of about 50% to inflation-linked bonds and only 11% to nominal corporate and sovereign bonds.” If the European Central Bank turns out to be more hawkish than the market currently predicts, this is likely to be driven by inflation. “That makes it important to have inflation protection in the portfolio hence our allocation to linkers and commodities,” Schlagbauer continues.
Another way to protect against a potential equity market correction while still being able to benefit from any further increase in equity valuations would be use derivatives such as options and futures to provide insurance. Not all do this in practice. Cummings says: “Buying insurance adds costs to the fund: it’s better to re-position the portfolio if there is an increased risk of an equity market correction.”
First State Investments’ Harman adds: “As part of our focus on risk management and capital preservation, we have one of the lowest allocations to equities we have ever had in the portfolio.” The fund is positioned so that if interest rates rise and equities fall, the fund will still perform, he says.
The fund uses trend-following strategies which aim to recognise downside movement and this has led the fund to take this position. “Our intention is to identify risk early on and adjust the portfolio accordingly,” he adds.
As institutional investors have long-term horizons, it could be argued that downside protection is not necessary as volatility will be smoothed out over the long-term. But it’s not this straightforward. “The investment time frame and the investor risk tolerance are not always correlated,” Harman comments. Although there is a long investment timeframe, the periodic review of the return objectives and risk tolerance occurs at much more frequent intervals.
Harman says: “That makes institutional investors have a much shorter view on investment policy.” This can lead to shorter-term thinking which increases the argument in favour of protection strategies in certain environments, he adds.
Using downside protection can have benefits for both the fund manager and the end investor, according to Colin Dryburgh, manager of the Kames DGF. “The need for downside protection does depend on the end investor’s time horizon,” he says. “This prevents the end investor from realising a significant loss should they have to unexpectedly raise cash during a period of market weakness. And it allows the fund manager to take advantage of cheap prices.”
But while there are benefits to using downside protection, it is something that should be done sparingly and only in very particular situations. For example, First State Investments will use short-term protection strategies if there is the potential for binary outcome in financial markets. Harman says his firm used protection strategies at the time of the referendum vote in the UK to allow the fund to control the potential impact on the fund.
Volatility is another example. Dryburgh says: “The market always prices in an increase in volatility.” The VIX is currently trading at 11 but a six-month VIX future is priced at 16. Dryburgh says: “The futures market is saying the volatility will increase by almost 50% over the next six months.”
It’s only worth buying protection against an increase in volatility if the fund manager believes it will increase more than the market is currently predicting. Dryburgh says: “That could be the case if central banks signalled they were going to be much more aggressive about tightening interest rates.” But in the absence of such an event, it’s not worth buying volatility protection.
Active risk management
Raiffeisen’s Schlagbauer takes a different approach to risk management. “We actively manage our equity, commodity and duration exposure using a quantitative, short-term momentum approach.” The quant strategy focuses on these three risks as both equities and commodities can be very volatile asset classes while duration is a very asymmetric risk.
It is these quant strategies which led the fund to lower its equity allocation to only 20%. Schlagbauer says: “It is our current strategic assessment of the attractiveness of equities on a long-term horizon which led us to reduce the equity allocation to about 20%.” If the overlay strategies indicated the equity exposure, should be hedged, this exposure could be reduced to 0%.
Schlagbauer says: “Our commodities exposure is currently at 18% but if our models recognised a downtrend in prices, we would halve the exposure.” Duration risk is principally managed by increasing the allocation to inflation-linked bonds and there is small overlay on the nominal bond portfolio.