Risk & Portfolio Construction: Portfolio dynamics
Jepser Kirstein sketches the profound changes in institutional portfolio design over recent years – and notes that a better understanding of risk enables investors to increase as well as decrease it
In recent years, we have seen evidence that institutional investors are moving away from traditional portfolio construction and turning towards portfolios that are better able to withstand the changing investment environment and the ensuing challenges. High volatility and low yields are the main drivers that have forced investors to re-think their approach.
Looking at the bigger picture, we have witnessed three distinct investment trends that have directly affected asset allocation – not least among institutional investors in the Nordic region, where significant internal resources are in place – but also on-going discussion of and increasing focus on the identification of alternative risk premiums and betas. Investors are not only trying to optimise portfolios, but also seeking entirely new ways to build them.
The first investment trend we witnessed in the search for yield was movement up the risk curve within fixed income. As interest rates dropped and the need to secure a reasonable return within bonds became imminent, investors have moved from high-rated sovereign bonds towards investment-grade corporate bonds. The credit spread on corporate bonds appeared to be a good opportunity to pick up yield and the spread has subsequently narrowed considerably. Within the credit space, the high-yield segment was the next asset class in which investors actively sought yields. The subsequent compression of spreads has been significant to the point where investors are now also seriously questioning the upside potential left in this space.
In the wake of the increased appetite for high yield, we have also seen an increasing investor interest in senior bank loans, which is perceived as a natural extension of a broader high-yield market. Concerns regarding liquidity, investment vehicles, legal issues and recovery rates have not deterred opportunistic investors in their continuous search for yield pick-up, and the lack of duration risk has also appealed to many investors.
But the search for yield has not stopped there: investors have been looking towards more exotic exposures, such as direct lending, distressed debt and mezzanine debt. In general, the deleveraging of bank balances has made investors significantly more opportunistic in their credit investments – it will be interesting to follow the risk appetite of investors in this area.
Emerging market debt is another asset class that has witnessed strong inflows in recent years, as investors have become more comfortable allocating to this area. In a world where the bonds of indebted developed nations provide negative real returns, higher yielding bonds from emerging economies exhibiting strong fundamentals appear to be a natural choice, especially as the asset class has matured and liquidity has improved. The possibility of currency appreciation in local-currency issuances provide an extra source of return, at the same time as some investors seek to reduce their G7 currency risk.
Finally, the credit premiums available in corporate emerging markets bonds complement the investors’ existing opportunities in the credit space. In general, emerging markets debt is appreciated both for its diversifying characteristics as well as the access it provides to relatively high yields in a low-yielding environment. In the future, a further segmentation of this asset class is likely to occur, for example as corporate bond issuances in local currency become more common.
While the first investment trend saw investors crawl up the risk curve within bonds, the second investment trend saw investors go down the risk curve within equities, not least prompted by the search for lower volatility. Recent academic publications have underlined the superior risk-adjusted returns of low volatility equity and the performance of such strategies has been very impressive in the aftermath of the financial crisis. Investors have sought exposure to low-volatility stocks on a large scale through different strategies, some of which focus on high-dividend stocks, consumer staples or explicitly low-volatility quant strategies, which have been in high demand. The emphasis on low-volatility strategies has been particularly apparent among Dutch investors.
One of the apparent consequences has been that end-investors and asset managers alike have flocked around the same individual stocks, which, in turn, has resulted in large overlaps between many portfolios. Due to these large flows into quality stocks with similar defensive characteristics, and the fact that the recent market environment has not rewarded low-volatility strategies, some investors have started to question valuations and the viability of such strategies – at least in the short term.
The third investment trend we are currently seeing, especially in Denmark, is towards alternative investments, often as low-risk alternatives to nominal fixed income investments. Investors are becoming more focused on how the alternative asset classes may contribute to a more robust and resilient investment portfolio.
The demand for simplicity, cost and transparency favour some alternative asset classes over others. We see that direct investments in real estate, infrastructure and private equity is a focus area for many large pension funds, as such investments fulfil these demands to a greater extent than, for example, hedge funds. Furthermore, investments in government-backed infrastructure projects or core real estate, for instance, may deliver attractive and stable cash flows, a degree of inflation protection, and potential diversification benefits next to the overall portfolio. Long-term investors who want to secure the purchasing power of their members’ money are now looking towards these alternative spaces in an effort to pick up attractive illiquidity premiums and real positive returns.
Alongside the three distinct investment trends that have directly affected asset allocation, we have seen many discussions revolving around the inefficiency of market-cap weighted benchmarks and the identification of new sources of beta and risk premium.
The way I see it, the problem with a traditional 60/40 portfolio construction can be that you are not getting the diversification and robustness in your portfolio that might otherwise be possible. Some of the asset classes within bonds have more equity-like characteristics, and vice versa. If you are not aware of this, it can be a problem. It is important that investors try to understand how asset classes react to volatility and risk-on, risk-off scenarios in general.
The mapping of risk factors can help you uncover some of these mechanics and the underlying exposure, although you also have to be keenly aware of the dynamic nature of risk factors. This focus is healthy, but one should, of course, be careful not to stare oneself blind on graphs and impressive numbers. A lot of the models and the backtesting that has been done within risk parity, for example, makes certain strategies appear very attractive on paper – but the risk is that one ends up designing the best possible investment strategy of the past 10 years instead of the coming 10 years. Equities have generally been a volatile, low-return asset class over the past 10 years – but of course this does not necessarily mean that this will be the case for the next decade.
Institutional portfolios and portfolio construction has undergone profound changes over the past five years, and those changes have involved both taking risk and decreasing risk, and both understanding and seeking diversification.
Jesper Kirstein is the CEO and founder of the Copenhagen-based institutional investment consultancy Kirstein